Estimates of capitalization of technology companies in 2016: the end of troubled times - a time of unsustainable growth

Original author: Rory O'Driscoll
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What is happening in technology investment now? 2001 again, when did the technology market collapse? Or 2008, when the whole world collapsed, but technology broke through? Or how about Facebook in 2012 - a surge in capitalization estimates and a chance to buy?
Jokes about the "dead unicorns" are not accepted. The explanation should begin with a structure and qualitative description of what drives the markets - then fill this model with data. This is my model and my data.

Capitalization assessment + investment = market engine

Venture startups live in a crazy hypercyclical world under the influence of constant and interconnected dynamics of investment and capitalization assessment. It is easy to be like a respectable retired politician, “worried about high investments” or “worried about high ratings,” but investing tolerance and willingness to pay for rapid growth are key aspects of the whole venture model.
The question is always whether the invested funds create sufficient real value (income, customers, etc.) to justify a high assessment of capitalization. From this perspective, an absolute assessment of capitalization (billions of dollars, “yes” or “no”) is not a measure that should be used. It represents an exit, not an entrance - and is extremely prone to emissions in any direction, as the last five years have clearly shown. At that time, capital markets were "in love with growth" from growth.
Fast-growing companies earned a high appreciation of capitalization, which allowed them to increase capital and direct it to further growth, which again led to an increase in the assessment of capitalization. The result is an endless cycle of high investments, higher growth, even higher capitalization estimates - in general, a loop with strong positive feedback.

Bubbles grow slowly, but collapse quickly.

This encourages companies to maintain growth at all costs. Since the number of profitable investment routes for each company is finite, at some point the pressure pushing for growth leads to investments that, indeed, provide growth, but at the expense of profit. Unprofitable sales channels, subsidies for acquiring customers and expensive advertising campaigns are signs that the company is focused on growth at any cost, and not on profit growth. Companies are becoming imprudent.

Problems appear through numbers ...

The basic financial model for each technology company is the same: spend a certain amount on research and development (R&D) of the product, then invest in sales and marketing to earn income. The hope is that (ultimately) the revenue received from customers, minus the costs required to acquire these customers, will be large enough to cover R&D and other expenses, and the company can become profitable.
This is the reason why all the talk about "investing" is quickly turning into talk about the profitability of the client. All other expenses are approximately fixed, but the speed with which the cost of marketing products gives income from the client is a key financial indicator for the company. If something goes wrong, it will show up here.
Consider an example. For companies SaaS (Software as a Service = Software as a Service) in which I invest, the easiest and most affordable measure of customer profitability is sales efficiency, i.e. the ratio of quarterly revenue growth to sales and marketing costs required to create such growth. The chart below shows the average sales performance of all public SaaS companies in 2012-15.

Unstable growth time will end.
Steady verified growth will return.

It is a key measure of capitalization for these companies and has been steadily decreasing since 2012 (currently it is about 35 percent below the peak, and the rate of decline is increasing). This is a serious matter. Customer profitability is the transmission mechanism from investing to growth and from growth to valuation of capitalization. This key indicator has plummeted as more money is injected.
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Capitalization estimates collapsed 18 months ago

Exchanges are difficult, but realized this 18 months ago. Returning to the same public SaaS companies: the chart below refers to the top 25 percent of these companies ranked by their growth, and shows how the assessment of their capitalization has changed over time.
In March 2014, the capitalization of these rapidly growing companies was estimated at 12 potential annual revenues, but in the middle of that year it dropped to 6, where it remains to this day. The long-awaited crash has actually happened - almost 18 months ago.
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This couple is interconnected.

Either you believe in striking coincidences, or it is clear that these two graphs are related to each other. Unlike private capital markets, public markets have the ability to rethink investment decisions every day. Over time, an unlimited circle of investors explicitly or implicitly made the client’s profitability and growth quality lower and, therefore, the premium for increased growth decreased. Capitalism works.
Private capital markets, which make decisions only once a year, respond more slowly; therefore, the lack of IPOs and price regulators has led expensive private companies to enter public markets.

Now what?

In 2016, any private technology company, where the last percentage points of growth were obtained only at the expense of profit, will no longer be able to attract capital with a high assessment of capitalization. Prudent companies will respond by reducing marginal investment, thereby increasing sales efficiency - even lowering the growth rate.
Then we will see the work of the same feedback loop, but in the opposite direction. A lower valuation of capitalization will lead to a decrease in attracted capital, which will entail a decrease in growth and an even lower valuation of capitalization. In contrast to the increase, the decline will occur much faster. Bubbles grow slowly, but collapse quickly. Ultimately, after reaching the lower limit, recovery will begin, as the growth rate becomes stable at acceptable levels of customer profitability. Unstable growth time will end. Stable verified growth will return - at least until the next time.

Losses and sacrifices along the way

The new final state will be good, but the transition will be difficult. Some companies will leave the old way too late to have time to switch to another, and lose their money. Even for the vast majority of companies that manage to make the necessary U-turn, managers and investors devote one or two years to what they euphemistically call "growing into an assessment of capitalization." This, in other words, means that it will be necessary to work hard without any additional returns!
This is not 2008, which turned out to be very nasty for the business community as a whole, but rather merciful for technology; this is not 2001 — the year of the “bloody slaughter” for technology companies; and this is not Facebook 2012 - a panic out of nothing. The industry has clearly overpaid for fairly good companies and overestimated them. Now everyone involved in this process should heal their wounds and return to a world, albeit slower growing, but more healthy. But this is not the worst thing that could happen.

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