The recent sell off in public tech stocks has reverberated across the markets. The imminent threat of rising interest has caused many investors to shift from growth to value-oriented stocks. As a result, several well-known, high-growth technology companies have experienced a double-digit percent drop in their stock price in the last few months. Why are tech stocks selling off at these levels? What impact do tech stocks have on public market indices? And finally, how might this positively or negatively affect private market valuations?
At the onset of the pandemic, there was concern that both public and private markets would be negatively impacted. There were certainly industries that suffered (hospitality, restaurant, travel), but the broader stock market, especially tech stocks, continued to rally as society became even more reliant on technology to work, shop, and maintain social connections. Companies such as Zoom, Peloton, and Instacart seemingly surged over night.
As investors began to adjust to life in the pandemic, private market investing and company exits rebounded at an accelerated pace in the second half of 2020. See below the excerpt from the Pitchbook Venture Monitor Q4 2020 Report describing this shift:
“2020 set new US VC records in total deal value ($156 billion), exit value ($290 billion), and capital raised for VC funds ($ 73.6 billion). This trifecta of records, during a year characterized by a pandemic, demonstrates the resilience and long-term mindset of the VC industry at large (1).”
Fast forward to present day and it’s possible we could see a slowing of these trends. Why? One explanation is that the threat of inflation and rising interest rates puts pressure on growth/tech stocks because of the long duration of their earnings. Often, many tech stocks are unprofitable but their high growth rates and recurring revenue models are attractive to investors. However, as investors lower their growth expectations due to concerns of rising interest rates, inflation, and radical changes in consumer behavior, they will discount the future growth of these companies at a higher rate, which ultimately results in a lower present value (2). In addition, with bond yields rising investors can benefit from yields right now versus waiting for unprofitable companies to kick off distributions in the future (3).
The Standard & Poor’s 500 Index (S&P 500) is a public stock market index of the ~500 leading companies in the United States. The total market capitalization/value of the S&P 500 was approximately $40 trillion as of January 31, 2022. The top five companies in the S&P are tech stocks (Apple, Microsoft, Meta, Amazon, and Google) and account for ~20% of the value of the entire index. When these stocks experience large positive or negative price movements, they can have a meaningful effect on the index. Which brings us to the last point: If tech stocks can affect an entire index of public companies, how might public technology company prices impact valuations for late-stage, private technology companies?
To fully answer this question, it’s helpful to understand the relationship between public and private companies and the historic timeframe for how long a VC-backed company would stay private before going public. In the year 2000, the median age of a VC-backed IPO was five years. In 2021, the median age more than doubled to 12 years (4). This has happened for a couple of reasons. First, after the SOX Act of 2002 was passed in response to a number serious financial scandals at high-profile companies, the Securities and Exchange Commission (the governing body that enforces securities laws) increased filing and oversight requirements for publicly traded companies, it became more onerous and expensive for private companies wishing to go public. Second, there has been a surge in the last several years in the growth of non-traditional venture investors (sovereign wealth funds, hedge funds, family offices, and some private equity funds). According to Pitchbook-Venture Monitor Q4 2021, 77 % of venture dollars invested in 2021 ($254 billion) had participation from non-traditional investors (5). As a result, more later-stage growth companies are opting to stay private and raise more money from both traditional and non-traditional investors. This trend is not expected to change in the coming years.
The trend of staying private longer is likely to continue and if it does, late-stage, private technology companies may see some valuation compression as the tech sector pulls back due to changing economic conditions. While this isn’t necessarily great news, it does present an opportunity for venture investors to invest in the next wave of early-stage, innovative technology companies and potentially do so at lower valuations.
-KM
Sources
(1) Pitchbook-Venture Monitor Q4 2020
(2) MorningStar
(3) Business Insider
TheJCurve 