Tech start-ups have strength to weather tough times

Is tech overvalued? Are we heading for another painful bust? If you only read the headlines and looked at the numbers, you might believe that. After reaching record levels, some tech start-up valuations are falling. And with the global economic conditions looking gloomy again, those valuations might drop further.

Together with my partner Steve Schlenker, I established DN Capital 16 years ago and have spent over 25 years in venture capital and private equity in the US and Europe. I believe we are not in a new tech bubble the likes of which we experienced in 2000 and 2001. And I don’t think the wave of high valuations needs to end in a crash as it did back then. Eminent VC investors, including Marc Andreessen and Ben Horowitz, share that view.

The tech sector has come a long way from the dotcom bust, and the new batch of entrepreneurial companies is built on solid enough ground to weather stormy economic conditions. But there will be a price correction, particularly for some of the most mature start-ups because they just don’t have attractive enough revenues to justify their valuations, or the amount of cash they are spending to build their businesses. Others, meanwhile, are fully justified and may increase in value.

At the start of 2016, the number of unicorns – start-ups achieving valuations over $1bn – was 152 globally, valued at a collective $532bn, according to CB Insights. Last year, some achieved valuations running into many billions, including taxi service Uber and holiday rentals finder Airbnb, valued at $51bn and $25bn respectively in their last private funding rounds.

In Europe, 13 new unicorns were born in 2015, including German takeaway food group Delivery Hero, France’s ride-sharing service BlaBlaCar and German online car dealership Auto1. These companies are filling a real gap in the market and have big ambitions to expand both at home and abroad. It’s a testament to these industry successes and the efforts of Invest Europe that the European Commission wants to encourage more venture capital in its plan for a Capital Markets Union.

Yet, in the last few months, there have been increasing sounds of disquiet. China’s slowdown and the slump in the oil price are putting pressure on a whole range of businesses around the world. Tech companies are far from immune. In November, payments processor Square – led by Twitter co-founder Jack Dorsey – went public in the US at a price well below its last private funding round. The uncertainty has also led one of the world’s largest mutual fund managers Fidelity to cut into the valuations of some of the private tech companies it backs.

Part of the challenge for investors is placing a value on young companies that are growing quickly, but are yet to show a profit. In a volatile and interconnected world, this can be difficult to get right. Investors need to delve deep into sales forecasts, analyse the technology behind ideas, drill into sectors and subsectors, and be prudent about the valuations they place on businesses.

In their analysis, they’ll see many encouraging factors. Tech start-ups are private for longer, during which time they expand their customer bases. Those achieving billion dollar-plus valuations have built up impressive levels of turnover through strong and sustainable growth. What’s more, many still have huge potential to grow and weather any storms that may come.

It’s also important to understand that tech company valuations are a fraction of what they were in 2000. The top five tech stocks in the S&P 500 – including Apple and Facebook – traded at 26 times their earnings in 2015, while the top five of 2000 traded at an average of 125 times earnings. This is important because the leading investment managers who invest in stocks and shares for pension funds, amongst others, also invest in unicorns. They price sensibly, they buy sensibly, and they also protect their investments with tools to help make sure they – and the savers who back them – do not lose out if valuations drop. 

First published in City A.M.

Nenad Marovac is Managing Partner and Chief Executive at DN Capital (UK) and Chairman of Invest Europe’s Venture Capital Platform Council.