Are We Heading Towards a Reckoning of Startup Valuations?
Since I began working in the late ‘80s, I’ve weathered many market cycles. Some were mild, others devastating. Each time, however, similar mistakes and patterns emerged. Market cycles went south once greed led to lax vetting from banks, lenders, and investors. In today’s tech ecosystem, the same pattern has emerged; when cash is plentiful, entrepreneurs too often take the bait and fall into a trap that untimely leads to pain and suffering.
Now that I have worked in the real estate tech sector for nearly eight years, I sense similar patterns emerging in this very young sector. Similar to other non-tech cycles I have experienced, I am witnessing entrepreneurs too focused on maximizing their funding (and who can blame them when it's so plentiful), without focusing on long-term business fundamentals like sustainability, profitability, and viability.
There are increasingly concerning signs that we are heading into one of those cycles. By the midway point of 2019, venture capital funding in real estate tech companies reached over $14 billion in dollar volume, an astonishing 309% increase from the same period a year ago. Funding isn't limited to only real estate tech companies either. Built world innovation companies, which include innovation and technology companies spanning real estate, construction, retail and others, have raised over $25 billion, by Q3 2019. And yet, mass adoption, market traction, and correlated revenue growth are still lagging. The end result is that there are too many companies chasing too little market share: a red flag for me and a big bright flashing yellow caution sign for the markets.
Also, if you look at public markets as signs of what is happening in the investment markets at large, there are reasons for concern in the valuation model. “Only 8% of technology, media, and telecom companies coming to market last year were profitable in their first year,” according to James Mackintosh in the Wall Street Journal. That’s the lowest percentage dating back to 1995. Mackintosh also highlighted that “this year’s IPOs were notable for being loss-making, with only 25% expected to have positive net income in their first year ... the lowest since the dot-com bubble burst in 2000.”
Moreover, as Silicon Valley adjusts to the new reality as $100 billion evaporates, the plummeting values of companies like WeWork, Uber and other unicorns has prompted soul-searching amongst investors, as these companies and more have collectively lost about $100 billion in value this year, prompting some executives to talk up profitability over growth as venture-capital investors grow more cautious about spending.
In my opinion, investors have not been fastidious in their decision making — they invest in, how much, and at what terms—and as such, it’s not surprising that Goldman Sachs research found that “this year’s crop of IPOs is expected to be the least profitable since the technology boom.” What is less common place in the tech sector is the sense of profitability. However, tides are changing as cash is king (again).
In a recent NY Times article, some tech companies and their investors are preparing for a potential downturn by cutting spending and raising money earlier than planned, as several companies are raising unplanned “interim” rounds of funding to safeguard against a difficult environment.
But the tides may turn sooner rather than later as lock-up periods expire between now and year’s end for recent IPOs such as Uber, Pinterest, Zoom, and others. According to CNBC, “Lyft’s lock-up ended on Aug. 8. While shares held up that day, the stock has dropped roughly 40% since the lock-up expiration date.” And as a “stream of highly valued growth companies reported better revenue than forecast,” investors still “dumped the stocks due to disappointing earnings,” according to Mackintosh.
I don’t think the coming market cycle downshift will be anything like 2000 or 2008—or the three mid-’90s or the late ‘80s ones either for that matter—but the similarities do exist. The warning signs are in plain sight for those paying attention.
The Startup Mindset Must Change
Is the WeWork IPO debacle an isolated case of poor board oversight—a crazy valuation based on a cult-like culture and few business fundamentals—or is it instead reflective of a systemic problem in the venture community today? After all, Uber, Lyft, Slack and many others are following similar patterns. These businesses are kept afloat by venture and private equity firms throwing insane amounts of money at them, without any regard for whether the business is actually viable and can generate profits one day. Raise, raise, raise. Many startups are more focused on fundraising to offset continual losses rather than determining why their business model isn’t making any money in the first place. If a startup can raise more and more money and push its valuation higher, it’s sustainable—for now.
“The shock of WeWork’s failed initial public offering has helped awaken investors from the dream that easy finance will last forever,” says Mackintosh. It has also rejiggered WeWork’s priorities, making it an “extreme example of a company forced to dump its ambitions and focus on survival because investors would no longer finance a land grab of growth at any cost.”
“Recent market gyrations have helped bring IPO activity to a virtual standstill heading into what is traditionally one of the busiest times of year for new issues, as companies planning debuts wait for conditions to improve,” according to Maureen Farrell in the Wall Street Journal. Investors are reaching their breaking point and even revenue growth isn’t enough to turn the tide for startups chasing subscribers over profit. Look to Peloton Interactive for case in point. After the fitness startup posted both losses and higher-than-expected subscriber and revenue growth, the CEO admitted the company “could be profitable tomorrow” if it pulled back on growth—which it wasn’t going to do. Today, Peloton stock is trading “nearly 22% below its initial offering price in September, making for another example of investors shunning money-losing startups.”
In situations like the one facing Peloton, people often justify this insanity by bringing up Amazon, mentioning how it lost money year after year. Truth: Amazon raised less than $10 million before it went public. Once it was flush with revenue, it reinvested in building the business—not in stemming recurring losses. This huge differential cannot be overstated. “Investors might reasonably worry about whether and at what price the market will keep supplying cash to subsidize money-losing companies as they chase growth,” noted Mackintosh. Companies that raise funds to simply fund operations and overhead, and therefore recurring net operating losses year after year, are not sustainable.
For a second stop and think about two publicly-traded companies in our space,
CoStar and RealPage.
CoStar’s revenue for 2018 was $1.2 billion with EBITDA of $351 million and a current market cap of over $21 billion. RealPage’s total revenue in 2018 was $869 million with EBITDA of $231.2 million and a market cap of $5 billion. Say what you want about these two companies, but to me, these are the benchmarks: sustainable businesses with real revenue and profits. They have every right to feel “rationally exuberant.” Can they be challenged? Absolutely. Should they? For sure. But these valuations are what others will have to measure up to.
I have founded and acquired several businesses throughout my career, and I have always operated my businesses in a conservative manner. Of course I take risks every day, but with a relentless focus on top-line growth and bottom-line profit. My philosophy is simple: Think big and take risks, but with financial discipline. This has served me well and has rewarded employees and investors along the way. It’s not rocket science.
CRE Tech Needs Support
And what about our CRE Tech community? Though not many companies in our emerging tech sector are traded on the public markets, some of the valuations make you scratch your head. Sure, many of them are still pre-revenue, but it concerns me that many are not valued with that in mind. With a record $25 billion invested in the sector this year, we could be heading for a reckoning. If revenues and market share are not scaling for startups receiving high valuations, it will negatively impact the entire sector at large.
CRE Tech, and the broader proptech sector, needs patient capital, and early-stage startups need funding. The industry’s overall health and viability over the long term depend on it. The commercial real estate industry is the largest business sector in the world as measured by global GDP, but it also spends the least on innovation. The amazing entrepreneurs and visionaries in our emerging sector are doing important work—they need our support. And even at the $25 billion clip of investment this year, it’s a drop in the bucket for a multi-trillion dollar industry. Innovation is a must and will only accelerate in this industry, but we are still only in the first inning of this new marketplace.
Heed the Writing on the Wall
Rather than sound the alarm, let this instead serve as a cautionary flag. Startup valuations are out of hand and fear is outpacing greed. WeWork is not the only canary in the coal mine. Uber was valued at roughly $68 billion when it IPOed in May. “Since then, its stock has dropped 34%, putting the company’s market capitalization far below where it was last valued privately ($80 billion).”
Farrell also notes that “shares of technology startups and other companies that went public in the U.S. this year are trading roughly 5% above, on average, their prices at their initial public offerings, well short of the 18% gain in the S&P 500 index.”
And these are just the public markets. Every day I am seeing similar irrational exuberance in private sector valuations. We should be talking about market adoption, helping the industry build a tech infrastructure, and not instead looking for 100x returns in the traditional venture Hail Mary.
I have seen this movie many many times and it doesn’t have a happy ending. As a community, we must maintain our own sense of discipline for funding and valuations. We must ask the hard questions of ourselves and our businesses. Greed and hubris bring down entrepreneurs every time.
Think bold. Dream big. But keep a keen eye on financial discipline. Startups in this sector need patience and smart capital to support them for the long term. That might mean raising less capital than you need and keeping valuations in line with actual business fundamentals. Accept it. This is the real lesson gleaned from Amazon.