This month’s sell-off in publicly traded technology companies will spread to private markets, resulting in downward revaluations of enterprises that have relied on venture and growth capital to fuel their expansion, some top Canadian technology financiers warn.
“You’ll start to see this impact private market valuations,” said John Ruffolo, who led pension giant OMERS’ venture capital group for years until the end of 2018 and is now managing partner of technology-focused Maverix Private Equity. “They’re going to get hammered, especially those companies that are not profitable and will be needing capital soon.”
Sid Paquette, another OMERS Ventures alumnus who runs RBCx, Royal Bank of Canada’s innovation banking division, sees the tech market correction having a “trickle-down effect“ on private company valuations. When public companies trade at lower multiples than recent private company multiples, fundraising is more challenging “and if successful, is often done at decreased valuations to the last private round,” with early shareholders taking the brunt of any resulting share dilution, he said.
But not all in the private tech sector are as pessimistic. “Honestly, I don’t think it is going to have a huge impact” on private valuations, “certainly not in the near term,” said Carol Leaman, chief executive of training software provider Axonify Inc., based in Waterloo, Ont. “There’s just way too much private equity money and lots of competition for good deals. For companies with good fundamentals, there will still be tons of dough.”
Tech stocks have been hammered in recent weeks and gyrated wildly in recent days over concerns about rising interest rates to combat inflation. Shopify Inc., which became Canada’s most valuable company during the pandemic, has shed close to 50 per cent of its value from its peak just over two months ago.
Like their American peers, Canadian tech companies have dropped in value, with seven of the 10 largest publicly traded companies in Canada falling by 10 per cent or more in the past month as of Monday. The S&P/TSX Capped Information Technology Index had shed 16.7 per cent of its value in that time.
In addition, many Canadian technology companies that went public on the Toronto Stock Exchange from July, 2020, through the end of 2021 now trade at less than their issue price, although that was also mostly true more than a month ago, after many Canadian software companies went to market with a relatively weaker mix of revenue growth and profit margins than well-received tech offerings in the past. “The market is now simply reflecting that some of these companies should never have been public,” Mr. Ruffolo said.
Lesley Marks, chief investment officer, equities, with Mackenzie Investments, said investors were aware of macroeconomic concerns before the recent sell-off including inflation, rising rates and supply chain disruptions. She attributed the market drop to worsening sentiment that the pace of monetary policy tightening “will likely be faster than we thought.” Rapidly rising interest rates would translate into a higher discount rate on future cash flows, weighing on valuation, she said, with persistent supply chain issues adding to inflationary pressures.
“The market is going through rate-driven indigestion,” said Nitin Babbar, global co-head of equity capital markets for RBC Capital Markets. “Tech just happened to … have the loftiest valuations. In an environment where central banks are taking away cheap money … it is those that are the most highly perched in valuation that are impacted first.”
Data show one of the key dynamics behind the tech sell-off has indeed been a drop in vastly inflated multiples for software companies. For most of the 2010s, growing (and usually unprofitable) software companies commanded enterprise valuations of between three and seven times forecast revenues for the next 12 months. Top-performing companies commanded 10 times multiples.
But in the past few years, as capital flooded into private and public markets, forward valuations for cloud-based software companies shot up, peaking above 20 times sales about a year ago. At its peak in July, 2020, Shopify traded at 46.7 times forward revenues, according to National Bank Financial analyst Richard Tse.
With the sell-off, however, average software multiples have fallen back to around 10 times – closer to the historical range, but still above it. Shopify’s multiple, meanwhile, slipped to 17.8 times Monday, still high, but close to its pandemic-low of 15 times. “Is it a reversion to the mean? No doubt,” Mr. Tse said.
But Mr. Ruffolo said private markets “haven’t responded yet accordingly based on the activity I see now – but they will,” predicting valuations will be particularly affected at later stages when companies climb toward US$1-billion-plus valuations. Tomasz Tunguz, managing director with Silicon Valley-based Redpoint Ventures, predicted in a blog post last week that financing valuations for later-stage private companies “should flatten and fall in 2022″ given the steep drop in tech stock valuations, as happened during the latest three significant pullbacks for tech stocks, in 2014, 2016 and 2019-20.
Kim Furlong, CEO of the Canadian Venture Capital and Private Equity Association, agreed that “some of the valuations that were out there were highly inflated in the private market” and said the public markets sell-off “should have an impact on companies and what they believe their company is worth. If it continues, it’s not a blip.” She also predicted there would be fewer initial public offerings by tech companies this year than last year’s record crop. “Some people that may have had an exit on their radar will likely reconsider that.”
Still, if fourth-quarter earnings are strong for technology companies, “we’ll see investors get more comfortable that valuations can be supported, and as we’ve seen in the last 10 to 12 years, buying the dip has been a profitable strategy,” according to Mr. Babbar. That could continue to be the case despite higher rates if companies continue to post strong earnings, he said.
With a report from Josh O’Kane
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Sean Silcoff