Why software valuations could drop more if things don’t change soon

Startups have seen better years. Last year, for example.

We’ve worked to highlight bits of good news where possible (signs of resilient software revenue growth, indications that valuations can partially recover and that a good number of startups have oodles of cash on hand), but today we are working in the opposite direction.

A good question to ask today is whether tech stocks, particularly shares of software companies, are being sold too readily. If so, we could expect their revenue multiples to rise on the public markets in time. For tech startups being compared to their public counterparts, this would be an enormous relief.

The Exchange explores startups, markets and money.

Read it every morning on TechCrunch+ or get The Exchange newsletter every Saturday.

There is reason to believe that this could happen. Altimeter Capital partner Jamin Ball, whom we consider to be a pro-bono data journalist, wrote earlier this week that the “median software multiple is now 5.7x,” which is “close to 30% below the long-term pre-COVID average for the cloud software universe.” (Note that Bessemer Venture Partners’ Mary D’Onofrio and Andrew Schmitt arrived at a 6.6x median ARR multiple for public cloud companies this week, which is close enough to give extra weight to Ball’s mathematics.)

If you feel cloud and software stocks should not trade for less than their historical average, then you have cause to cheer. But is that a valid perspective? Should we expect cloud and software stocks to trade at a discount to their pre-COVID revenue multiples? Let’s find out.

The bear case

The Federal Reserve is expected to raise rates sharply today, perhaps by as much as 75 basis points. The hike will come in the wake of a 50-basis-point raise back in May, which was the first time the Fed increased rates by that much in 22 years. The Fed is tightening not only interest rates — the price of money — it is also allowing its total asset base to descend.

Rising rates are generally anticipated to be inversely correlated with the value of highly priced assets, including stocks that traded at richer-than-average revenue multiples. That means tech and software stocks. There were several reasons for the huge ascent in the value of software revenues last year, but their descent and the resulting market hangover are inversely correlated to the price of money, which is about to go up. Again.

The following chart is a bit crude but makes the point. Here we contrast the Effective Federal Funds Rate and the Bessemer Cloud Index, which trades as the WisdomTree Cloud Computing ETF:

Image Credits: YCharts

Now throw in another 75 basis points, and what do you expect to happen? One of two things: Either tech stocks and software shares take more damage, or they hold fast at their current prices as new rate pressure prevents a rebound.

Now imagine another 50-basis-point hike later this year. That would add even more pressure on already depressed shares that have seemingly fallen out of favor with public-market investors. Would that be the time for software valuations to rebound? Probably not.

Naturally, investors could buck conventional wisdom and reinflate software valuations, headwinds be damned. I just don’t want folks to bet the farm on that happening. At least for a year or two.

This means that the argument that because software revenue multiples are now below historical averages, they, therefore, have room to rise is possibly specious.

The unicorn question

When we talk about the public markets, we’re also discussing the largest, most richly valued startups. Private companies worth $1 billion that have raised venture capital are valued like public companies and will need to exit to either a major tech concern or go public to provide liquidity to their backers.

These are the startups most sensitive to changing market conditions, and there are a lot of them — Crunchbase counts 1,338 unicorns worth $4.6 trillion, though we doubt that the latter number is accurate.

The idea that software multiples are not on the cusp of a Lazarus redemption arc is a gloomy one for unicorns, many of which were re-priced last year and got expensive price tags they have to live up to. The possibility of software multiples compressing further is downright terrifying for this cohort.

We don’t know where the bottom lies for tech stocks and software multiples, but we’re watching it incredibly closely. And we’re getting close to the numbers Fred Wilson discussed back in 2011:

If you have a SAAS business, then your company’s valuation should roughly be 5x this year’s revenues and 4x next year’s revenues. These are for public companies. Investors will typically take a 20%-25% discount for private company valuations because private company investments are not liquid. So maybe 4x this year’s revenues and 3x next year’s revenues is an appropriate multiple for a privately held SAAS business.

How many unicorns hold on to their membership to that particular club at 3x NTM revenues? If the Fed keeps hiking, we may find out the hard way.