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What Does the Flight to Quality Mean for Venture Capital in 2023?

 

Pandemic may accelerate the ILS investor flight to quality - Artemis.bm

 

TINA, the premise that “there is no alternative” to, in this example, the stock market, came to an end in 2022. For more than a decade, near-zero interest rates culminated in a speculative bubble that crashed last year. In a historic move, the global central banking system revived the long-forgotten idea of “discounting,” raising interest rates to resist the convergence of both demand- and supply-side inflationary tendencies. Money’s time value has returned: a dollar today is worth more than a dollar tomorrow. This rapid shift had the biggest impact on unprofitable technology companies based on projected cash flow. This group was harmed by both the discounting effect and a flight to quality, the belief that in times of uncertainty, capital will shift to safer havens.

 

What does this entail for those of us who work for or invest in failing businesses? A flight to quality does not exclude venture capital. A flight to quality may signify a shift from unprofitable technology to treasuries or gold, a shift from risky to riskless. However, there is an undeniable flight to quality taking place inside the tech sector. In our setting, “quality” simply takes on a new meaning.

 

The Flight To Quality Will Look Different This Time Around

 

The year 2021 served as a stark reminder that not all revenue is made equal. The public narrative frequently portrays technology as a monolithic entity, when in fact the industry spans a wide range of economic strategies. While tech stocks have been pounded across the board, some categories, particularly cloud software companies, have done significantly better than the rest of the industry.

 

Think about markets. Share values of digital marketplaces have declined by 78% on average over the last year, compared to a 65% drop for software businesses. At least six marketplaces* have lost 90% of their value or more. If the gap between 65% and 78% doesn’t seem significant, consider this: those six marketplaces lost an additional $12 billion in market capitalization as investors penalized them more harshly than software businesses. That further proof of the dislocation, a basket of markets was valued at approximately the same multiple as software businesses are today in December 2021.

 

Digital brokerages follow a similar pattern: a basket of tech-enabled brokerages has decreased by 78% year on year. Coinbase was valued at 9.2x LTM** revenue at its height; it is now valued at 1.3x LTM** revenue. Fintech companies have performed even worse than software companies, falling by an average of 73% year on year. Software-based fintech companies such as Flywire and Bill.com have outperformed pure-play payments or lending enterprises in terms of value retention. With the exception of fintech companies that monetize through software, the year-over-year fall for fintech companies is comparable to that of digital marketplaces and brokerages.

 

What is the significance of this? When venture capitalists dispersed capital like drunken sailors on the OpenSea in 2021, the nature of a company’s revenue lost importance. This thinking entered the lexicon: revenue was commonly referred to as “ARR,” or annual recurring revenue, regardless of whether the money was contractually recurring or billed in yearly portions. ARR came to be associated with “run-rate revenue,” or simply the annualization of a given month’s income. The combination of contractually recurring and annualized revenue permeated how revenue was perceived and ultimately valued by a corporation. The concept of income quality was subjugated to growth and other variables. As the values of technology companies became more scrutinized last year, investors no longer excused these imprecise classifications.

 

A “flight to quality” in the venture sector signifies a return to successful and predictable revenue streams. As investors look for companies to invest in this year, five fundamentals will receive renewed attention:

 

Profitability:

 

High margins are preferable to low margins! Investors compare gross and operational margins. Finally, estimated free cash flow determines valuation. Investors will focus on profitability of unit economics for the vast majority of businesses that do not produce free cash flow.

 

Predictability:

 

A dollar with a higher level of assurance is more valuable than a dollar with a lower level of certainty. A dollar that is contractual, recurring, and/or rising predictably should be worth more than a dollar that is not any of these things.

 

Companies that are neither profitable nor predictable will face the most severe consequences in 2022. In the future, the notion of excellence will extend far beyond a business model. There are also geographical and sociological implications. In the next phase of venture investing, which entrepreneurs and regions will be regarded safe? Until the FTX catastrophe, the Bahamas appeared to be an acceptable albeit unusual residence. Will this atmosphere disproportionately affect first-time founders or founders with unusual backgrounds or credentials? There is already evidence to support this.

 

The one certainty is that real and perceived quality is now more crucial to the investing process than it was previously. It will have a huge impact on which companies receive money.

 

*Carvana, Cazoo, thredUP, Vroom, TheRealReal, and Opendoor

 

**LTM stands for “last twelve months”

 

Source: Forbes

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