No, Not That Inflation—Why Startup Founders Need To Focus On Fundamentals, Not Interest Rates

It’s no secret that valuations for startup companies—including those in my area of focus, enterprise technology—have been wildly inflated lately.

Now, as the public markets suffer a start-of-the-year swoon, startup founders seem to have another inflation problem: exaggerated concerns about the effect the market’s volatility, and the prospect of a sustained downturn, will have on their businesses. The constant ups and downs of companies like Meta and PayPal (whose shares sank last week) and Amazon and Google (whose shares are up), among others, are driving plenty of confusion, but mostly concern. The doom-and-gloom on Twitter about the startup markets in general is notable, and news outlets are breathlessly covering the issue.

Here’s my take: The recent market movement might lower some private companies’ valuations for now, and potentially even delay some technology IPOs. But enterprise-tech and cloud companies are still commanding valuations substantially higher than long-term averages, driven mainly by bigger-picture technology and societal trends that are propelling many companies’ annual revenues to $1 billion and beyond. Below, you can see a Battery analysis of recent valuation trends for over 100 software companies. It shows them being valued, as of yesterday, on average at just under 13 times forward revenues—that’s down from just over 23 times roughly a year ago, but still relatively in line with the average in pre-pandemic Q1 2020. Let’s also not forget just how dizzying and out-of-whack valuations became in the last 12 months in comparison to where software multiples used to trade prior to 2020 – an average of 7 times.

I realize the markets remain unpredictable. But there’s only so much founders can control here—and you need to keep your eyes on the prize. Fed policy, interest rates and Covid trends are not within your power to influence. What can you control? A focus on your customers, solving real problems that digitally transform your customers’ businesses and, above all, using the likelihood of higher interest rates as a wake-up call to use your capital more efficiently for growth.

Overall, despite the short-term noise and news coverage of the Nasdaq’s recent dive, I remain very bullish on the broader software and economic trends that are powering businesses related to cloud computing, data/artificial intelligence and cybersecurity, among other sectors. Here’s why—and my advice for adapting your business to harness those trends and build companies of lasting value in the current environment.

1.      Software continues to transform just about every industry—and you can harness it. Some people call this trend “digital transformation.” But it really just means that more organizations, across industries ranging from manufacturing to finance to healthcare to agriculture and others, are turning to software to run their businesses more efficiently and serve customers better. Technology has an industry has been around for only 50 years, roughly since the advent of Silicon Valley. But now, 100- to 200-year-old businesses have fundamentally started adopting technology and software in droves, driven by the reality of a hybrid world post-Covid. This might mean parsing data from factory-floor sensors to produce goods more efficiently, or leveraging analytics to get more food out of farm fields. The trend of hybrid work will also continue to drive the adoption of more collaboration and security software across industries.

In fact, I believe the overall software-spending pie of $672 billion in 2022, per Gartner, will grow as businesses globally buy and create more software to survive and thrive. It’s also possible that software could serve as a deflationary pressure driving higher GDP per capita, which could counteract inflation over the long term. Think about it: If Uber prices go up due to higher gas prices, software could be used to pool passengers and shuttle them around more economically/efficiently. If labor costs go up, cloud software could help compensate by reducing the cost of building and running companies. With organizations’ spending on software growing, and cloud-software companies growing ever-faster, we’re on the cusp, in my view, of creating more businesses with more than $1 billion in revenue—and these businesses will garner material value regardless of rising interest rates.

2.      Overall IT spending, and spending on the cloud specifically, continues to grow. According to Gartner, overall technology spending is likely to grow at a 6% compound annual growth rate from roughly $4.5 trillion today. Meanwhile, the major cloud-computing providers—AWS, Microsoft Azure and Google Cloud—are together throwing off more than $100 billion in revenue and still growing more than 40% YoY. (Earlier this month, as other tech stocks tanked, Amazon reported that AWS’s revenue for just the fourth quarter of 2021 grew 40% and hit $17.8 billion.) Our belief is that this trend will help create more new, $1 billion cloud software businesses than ever before.

Given this, it’s no surprise that more B2B technology companies are still achieving average values of over $10 billion today, up from just over $1 billion in the early-2010s, with some companies even being valued near $100 billion.

Many of these newer, public B2B and cloud companies saw their values increase somewhat slowly over time before they went public, with average value creation of $3 billion per year; however, today’s software companies are gaining value of more than four times that per year (see below). While this growth rate could slow, we don’t think the recent stock-market slowdown will fundamentally change this trajectory.

3.      Focus on efficient growth and spend your (more) expensive capital wisely. Subsidizing growth with venture dollars is likely not sustainable; investors will not be willing to offer more money at nosebleed valuations today if companies continue to post massive burn rates without even talking about a path to profitability. Given this, our advice is to focus on your user and, if you can, leverage more-efficient sales motions like product-led growth to qualify your prospects and streamline the sales process. Companies like Atlassian and many open-source companies that have learned to successfully monetize their offerings, like MongoDB, were trailblazers here, but now many more companies are leveraging PLG early on to drive growth at lower costs. You should also, of course, leverage a global workforce (over Zoom) to efficiently scale your business.

Ultimately the path to create a company with $1 billion in revenue valued at $10 billion is better than ever before – but the journey will require more focus on efficiency, and durable growth may be the name of the game. Higher interest rates/cost of capital may ultimately be the forcing function to balance growth and efficiency  and create lasting enterprise value.

4.      Get some perspective. I’m not a public-stock picker, and I have no idea where the current market volatility will take us. But I do know that we’re experiencing now, at least, is nowhere near the type of economic shock we felt in 2008, when Lehman Brothers went bankrupt and the federal government had to bail out the entire U.S. auto industry. The Great Recession of 2008-09 led to a loss of more than $2 trillion in global economic growth. The dot-com crash of 2000/2001 – which wiped out more than 75% of the Nasdaq’s value from its peak – is another much-worse-than-now scenario

The bottom line is that today’s stock-market volatility is certainly troubling, but it should not cause software/cloud entrepreneurs to lose hope. Instead this should be a wake-up call to entrepreneurs drive efficiency while riding the macro-growth trends outlined above. All over the globe, organizations are buying more software to engage customers, balance rising costs with software-driven automation and stay relevant. These same trends continue to drive once-unthinkable valuations for the world’s largest technology companies—four global companies are now worth over $1 trillion each. Don’t let this bump in the road keep you from striving to join them.