Why there is no bubble in true tech company valuations
Is a reckoning coming for us all? We don't think so.

Much has been made of WeWork’s calamitous NASDAQ IPO attempt and subsequent bailout from Softbank. When sceptics talk about tech bubbles and private market exuberance, this is exactly the kind of company they have in mind. Prior to its IPO attempt, WeWork had raised over $13bn, most recently at a $47bn valuation. For the six months to June 2019 it had net losses of $904m and was reliant on both the IPO getting away and an attached $6bn debt facility in order to continue on. Public market investors were further confounded by the corporate governance vacuum resulting from a dual-class share structure which afforded founder CEO Adam Neuman near-complete control of the board. It is hardly a wonder the IPO failed and that Softbank (and others) have had to take a $4.6bn bath on their investment.

The WeWork saga layered onto an already fomenting narrative that private tech companies are over-valued. Commentators cite high profile 2019 tech IPOs such as Uber (down 40% since listing), Lyft (down 40%) and Peloton (down 19%) as evidence for this. The argument seems to be mounting, both locally and internationally, that VC-backed, privately-held tech companies are not “real businesses” and that a reckoning is coming for us all.

This is not the case.

As usual, a tweet-sized explanation misses the nuance of what is happening in the technology sector. It is true that private markets have over-valued some venture-backed companies. Frankly, they will probably continue to do so. Part of this is due to structuring (late stage private investors will sometimes pay higher prices if they can mitigate part of their risk via terms like liquidation preferences and preferred payouts), but as prominent VC Fred Wilson noted recently, most of it is due to the fact that, as software eats the world, late-stage private-markets are incorrectly valuing the wrong companies as if they were software companies i.e. on a 10X+ revenue basis.

WeWork is the best example of this. Yes, it provides ping pong tables and beer on tap, but that’s about all it has in common with a software company. WeWork is a property leasing company dressed up as a technology company.

Let’s look at the basket of true software IPOs in 2019: Zoom (up 94%), Cloudflare (up 7%), Datadog (up 22%), Slack (down 21%, but a direct listing so unique circumstances), Pinterest (up 6%), Crowdstrike (up 39%) and Medallia (up 34%). Each of these companies is growing quickly and efficiently, is operating at 70%+ gross margins, and has highly predictable, recurring revenue streams. For the most part, they are not reliant on the markets for further funding in order to survive. Moreover, as McKinsey and others have pointed out, software products tend to reap greater benefits to scale than other companies — on average, 60% of the positive economic profit in a software market comes from the top 5% of players in that market. Investors buy ahead of that opportunity.

Ultimately, the public markets value a business based on their estimate of its future cash flows. Where companies have ‘software-like’ economic properties, a revenue multiple is sometimes used as a proxy for future profitability and the potential for outsized market share.

Contrast the economics of these businesses with WeWork which has ~20% gross margins, long term lease liabilities, high cash burn, and Buckley’s chance of taking the majority of the global property leasing market. You see that the public markets are doing exactly what they are meant to do: punishing lower-quality business models and rewarding great ones. Other underperformers tell similar stories. Peloton, Lyft and Uber each operate at 30–40% gross margins with less predictable, non-SaaS revenues and higher burn rates.

So what do the 2019 class of tech IPOs tell us about private tech markets? Are we in a bubble? Where investors are using software-like valuation methodologies (revenue multiples) for “technology” businesses with fundamentally different economics and market potential, yes absolutely. But by the same token, the majority of 2019’s technology IPOs have meaningfully outperformed the market, delivering their private backers even higher returns. The common trait among the winners is software-like economics. Opportunities abound in private market technology investing and the best companies are still woefully undervalued; you just need to know how to identify them.

This article was originally published in The Australian Financial Review on 11 November 2019

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