We have all been through a lot in the past four years. In early 2020, the Nasdaq was at or near all-time highs for much of January and February. Things felt so great. Then the novel coronavirus disease (COVID-19) occurred. Rapid technology adaptation, accelerated by remote work, sparked a massive technology boom that accelerated adoption, innovation, hiring, and evaluation from late 2020 through the first quarter of 2022. Then came war in Europe, rampant inflation, and high interest rates. Interest rates, uncertainty, the Great Reset in tech valuations, the banking crisis in the heart of Silicon Valley, and a lot of very difficult conversations for CEOs, management teams, and boards of directors.
At the beginning of 2024, we are now asking ourselves what to expect next from the technology ecosystem. I hope he comes to consider this year his first “normal” year since 2019.Although there are geopolitical risks that could always dash this hope, we should We have finally cleared our system of all pandemic-related distortions. And after six quarters of technology budget austerity, there is an opportunity to see improved demand signals.
The shift in mindset from the boom in 2021 to a return to normal in 2024 is important and healthy for the ecosystem. However, there are significant implications for founders and investors. At the highest level, the biggest changes can be expressed succinctly. The cost of failure has increased dramatically. This is due to a number of factors in the second half of 2021, including declining revenues regardless of demand, valuations remaining closer to 10-year lows than 2021 highs, and more expensive capital. This is the result of three major differences to date, and that is predicated on the availability of capital.
Demand may and will experience reduced revenues in the future
Software has many characteristics that violate the ideals of classical economics. Most companies do not benefit from high gross margins or high recurring revenues. Software, especially SaaS software, both. These are the ingredients for high growth and high profit margins, which can lead to the “50+ rule” where profit is the sum of growth rate and profit margin.
During the boom, high-tech companies reached astonishing levels of demand responsiveness to their sales efforts. This phenomenon differs from the traditional concept of price elasticity in that it was characterized by the market's response to an increase in sales force or sales activity, rather than to a change in price. As we expanded our sales operations and marketing efforts, our sales performance increased proportionately.
It was like a financial cheat code. To maintain stable customer acquisition costs (CAC), efficiency improvements must offset the diminishing returns from market penetration. This is reasonable if you want to increase your sales spend by 20%. But 200%? That's very difficult. Going from 200 salespeople to his 600 salespeople is a vastly different management model with advanced systems and a more serious need for leadership. But in a booming economy, companies tripled their sales expenditures and all the sales statistics looked great. What should I do? Part of the reason was that companies were increasing software spending in anticipation of their own hiring plans, but miscalculations were widespread about how quickly teams would scale their technology efforts, and the industry One example is that demand was exaggerated without the company's knowledge. That music stopped in his second quarter of 2022, and his CAC worsened momentarily.
The solution was to adjust spending to an acceptable CAC metric. By and large, that's the case, with SaaS public stocks starting to see net new average recurring revenue increase for the first time in many quarters. As we move forward with our modeling, we must be careful not to assume the same sales reactivity seen during the boom cycle. If you plan to scale quickly, ensure measurable results in short intervals. Adding too quickly can lead to attrition, so it's wise not to expand too much at first.
An obsession with efficiency, or at least an obsession with the path to efficiency, has always been in vogue, and the Great Reset reminded us of that. Perfecting sales efficiency is a great tool for maximizing value. All else being equal, a company with more efficient sales and marketing will be worth more than a company with less efficient operations.
Going forward, we will likely see more experiments in increasing spending with thorough and careful efficiency measurements. While you may have “waited” your way to efficiency by “growing” during a boom, you are much more likely to recoup some of your costs if you fail to meet your target metrics.
Valuations still closer to 10-year lows than 2021 highs
When demand shifted, as it did in early 2022, there were two painful effects. Worsening CAC means lower profits, and slower sales success means slower growth. This has led to significant changes in growth and expectations, which inevitably compressed valuations. Valuation is considered to be the present value of all future cash flows discounted. If growth declines and profits decline, valuations will fall further. This is why our valuations fell by up to 70% from high to low in our early years. Great reset.
One of the implications of lower valuation multiples is that founders and investors can no longer pull the lever to sell if things don't work out. Valuations are likely to rise slightly in the near term as net new growth gains momentum. However, the cost of failure will likely remain high, as it is unlikely that valuations will recover to the point that founders have the option to sell if things don't work out again.
Capital is more expensive – that is assuming capital is available
Capital is a fickle thing. It's either too much or too little. Interest rates are low or interest rates are high. Swinging up is a great thing. That's what created this boom. That's what will create the next boom. It hurts to swing down. We still feel it.
The Great Valuation Reset has led to a significant decline in exit activity. This means that limited partners backing new funds are delayed in making new commitments, as today's liquidity becomes tomorrow's commitments. Fund funding cycles are becoming longer.Appraisal value reset to lower value and Less capital flows into the ecosystem. In boom times, who cares if you try and fail? Please raise it more. Try it now and fail? Hmm.
The Great Reset applied to the availability of capital, and the threshold for “unfundable” was raised much higher. However, 2024 is likely to see more capital activity. However, the cost of failing to maintain an adequate cash cushion could still be catastrophic dilution or worse. My general rule of thumb is to tell the founder to assume he will raise in his 409A, which is the fair market value of the common stock. If raising with 409A is active, then by all means improve it. If the rise in 409A is determined to be too lean, the best course of action is to curtail the burn.
Looking ahead, I'm looking forward to next year. 2022 marked the Great Reset of valuation multiples. 2023 marks the Great Reset of performance expectations. Let's make 2024 the year that tech startups return to normal pre-pandemic growth.
Ryan Hinkle is a Managing Director at Insight Partners.
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