Navigating the New Private Equity Valuation Multiples

Instacart made headlines last week by slashing its valuation 40% after previously raising $265 million from top-tier VC firms at a $39 billion valuation. This increasingly appears to be a trend driven by inflation, rising interest rates, and labor shortages among other macro factors.

The latest episode of The All-In Podcast, E73: Late-Stage VC Markdowns and Mistakes, is a must listen for investors and founders. It includes Brad Gerstner, CEO of Altimeter Capital, who makes some great observations about the current investing climate. But it is David Sacks, cofounder of Craft Ventures and former founder of Yammer, who drops the big bomb. He says, “What we’re doing now is telling founders, ‘lengthen your runway, be more capital efficient…if you raised last year at 100X ARR [Annual Recurring Revenues], you need to understand the next time you raise might be at 20X ARR.’”

The Shifting Private Equity Investment Landscape

Sharply lower ARR multiples increase the likelihood of private companies facing a down round, where their valuation declines from their previous raise. A down round is something to avoid if possible. Sacks explains, “If you’re ever in a situation where you take a down round, it’s way worse than just the dilution because now the psychology of everyone in the company changes.”

I have been investing alongside my partners at HMG Ventures, the sister company to HMG Strategy for a little over two years. Because we typically help fund SaaS seed rounds, the changing investment landscape for later stage companies does not affect us directly. But it may eventually have huge implications on our existing investments as they mature. And it will impact how we value future seed opportunities.

The Burn Multiple

Sacks said, “In an upmarket or boom market, the three things that matter most are growth, growth, and growth. In a down-market the three things that matter are growth, burn and margins. It’s not that growth stops mattering, it’s just that burn and margins also matter…and now there’s going to have to be real tradeoffs. Before, the question was, ‘How much money do we have to spend how quickly to get growth?’ Now it’s, ‘Is this growth efficient and do we have enough money to get to the next round without having to take a down round.”

The Rule of 40, an assumption that a software or SaaS company’s combined growth rate and profit margin should be greater than 40%, has been a popular, albeit often complicated, metric for balancing growth vs. profitability. Sacks spoke about a different metric that Craft Ventures originated, the Burn Multiple.

You can read more about the ratio in Sack’s blog post, but the formula is Net Burn / Net New ARR. The idea is to measure how many dollars a company must spend to obtain a certain level of (subscription-based) ARR. For example, if a company requires $10M to obtain 10M in ARR, that is a ratio of 1 which is outstanding. If it requires $10M, that is still excellent. A ratio between 2.5 – 3 is cause for concern, and anything over 3 is bad.

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Late-stage private companies as well as startups can still thrive despite lower valuation multiples. This requires a different mindset, though, from the past decade where the focus has typically been on top line growth. Guidelines such as the Burn Multiple can help them navigate today’s more difficult money-raising environment.