2023 was a taxing year in the venture capital markets. Dealmaking and valuation metrics have either plateaued or declined, the IPO market remains relatively frozen, and the investing climate favors the investor.[1] As valuation practitioners, we should expect valuation metrics to decline for early-stage businesses given the current market dynamics. However, are valuation discounts warranted if a start-up is achieving its growth metrics, profitability is close to realization, and regulatory approval or market acceptance has been realized? Is it fair that the value of a high-performing start-up should decline only because the company operates in a lackluster fundraising environment?
Systematic Risk & Venture Capital Market Risk
Systematic risk is the unavoidable external and macroeconomic factors that essentially affect all companies. Rising interest rates, a downturn in market sentiment, and increased cost of capital impact all companies whether it be a mega-cap enterprise or a pre-revenue business. Start-ups, however, are affected by additional risks that many publicly traded or earnings-positive companies are insulated from, including:
- Difficulty in Raising Capital: Start-ups often incur significant operating losses and require outside investment from venture capital, private equity, hedge funds, or other investors to finance operations. An environment of less capital deployment could lead to greater difficulty in securing funding to sustain operations.
- Liquidity/Exiting Issues: All investors want a return on their investment. Investors in an early-stage company can realize their investment by taking the company public, raising additional private capital to buy out existing stock, or shopping the company. If investors decide to force an exit in a languid IPO or M&A environment, the company may have to settle for a lower valuation.
Given the current venture capital climate and its impact on the risks above, it is reasonable to assume that early-stage valuations in the present should decline. For example, analyzing multiples from a comparable IPO or M&A transaction that occurred in 2023 would likely be lower than multiples from a robust IPO and M&A market in 2021 and 2022. Even if a start-up is operating efficiently and achieving milestones, the macroeconomic environment creates greater risk and thus justifies a lower value.
Intrinsic Value Drivers
However, even in stalled venture capital markets, an increase in value could be supported when analyzing a start-up intrinsically. If the company is achieving revenue and profitability targets, the growth expectations are revised upward, and market acceptance is occurring more rapidly, then an increase in value could be supportable, especially if those factors are considered in a discounted cash flow model.
Conclusion
Current venture capital market headwinds support the declining valuations among early-stage companies seen in 2023. Greater systematic risk, capital deployment constraints, and limited liquidity/exiting issues are all factors impacting the current market. Despite these current factors, start-ups can still be awarded higher valuations if intrinsically the company is operating exceptionally.
[1] Pitchbook Q3 2023 US VC Valuations Report
