Australia tech: Valuation conundrum

Canva looms large over Australia’s technology landscape as the leading example of a new generation of globally-minded B2B start-ups that swell the returns of a new generation of local venture capital firms. The eight-year-old design and workplace collaboration platform is a mainstay of early funds launched by the likes of AirTree Ventures, Blackbird Ventures, and Square Peg Capital.

Canva is also a posterchild for pandemic-driven uptake of remote working solutions, with a valuation that rose more than 12-fold over the course of two years to reach USD 40bn by September 2021. It remains to be seen to what extent this valuation adjusts following a sharp sell-off in listed technology stocks, driven in part by a reappraisal of the prospects for companies in a post-COVID-19 world.

T. Rowe Price and Franklin Templeton have recently marked down their positions in Canva. The latter imposed a 58.5% cut, implying a revised valuation of USD 16.6bn. Should this be interpreted as a conservative response to unprecedented recent volatility by crossover investors that are neither structured nor conditioned to think longer-term or as evidence of a more fundamental shift?

“The trap is: last year, valuations were wrong and today valuations are right. [But] last year, valuations were wrong, and today valuations are wrong,” Niki Scevak, a co-founder and partner at Blackbird, one of Canva’s earliest backers, told the AVCJ Australia & New Zealand Forum.

“To take a step back, Canva has grown from zero dollars to more than USD 1bn in annual revenue in under six years – faster than Zoom and faster than every software company, including Salesforce and Atlassian. It was cash flow positive from the beginning. It’s rare to find a business of such high quality, growing faster at USD 1bn in revenue than it was at USD 100m.”

This observation raises two issues that might prey on the minds of LPs as they await the next set of quarterly reports from portfolio GPs, which will formally document how public market weakness has filtered through to private markets.

First, there remains considerable uncertainty as to what represents a market bottom. Second, the most recent feeding frenzy that brought later-stage investors into tech start-ups was accompanied by more flexible valuation methodology. Does a correction warrant reversion to the norm or should companies that demonstrate an ability to sustain rapid growth be assessed differently?

On one point, though, everyone is agreed: for those with the resources and conviction to continue investing through the cycle, the current and coming vintages could be especially strong.

“All of us will be affected by these conditions and we must get used to the reality that the market is going to be different in the next couple of years. What matters is whether we are buyers or sellers,” said Tony Holt, a partner at Square Peg.

“We will be net buyers in the next couple of years and we have a great environment in which to be buying … The cycle had to turn, and the multiples have compressed more than the 70% we’ve seen [in the non-profitable listed technology indices].”

After the boom

One of those indices peaked nearly 18 months ago. Since the start of the year, technology in most markets globally has been characterised by weakness in listed equities, a paucity of IPOs, the departure of highly leveraged crossover investors no longer comfortable with illiquid positions, and a fall in growth-stage investment activity.

In 2021, more than USD 115bn was deployed in minority equity technology investments in Asia, up approximately 100% year-on-year. The early and growth-stage contributions were USD 69.4bn and USD 45.8bn, both record levels. For the first six months of 2022, those totals are USD 23bn and USD 20.7bn, with a steep drop-off in China somewhat counterbalanced by India and Southeast Asia.

Break it down by quarter and the impact of the tech sell-off, which began in April, becomes clear. Growth deals amounted to USD 7.8bn in the second quarter, a 50% drop from the first three months. Early-stage experienced a more modest decline, from USD 11.2bn to USD 9.5bn.

In Australia and New Zealand specifically, technology investment doubled in 2021, with USD 2.3bn going into growth and USD 2.1bn into early-stage deals, according to provisional data from AVCJ Research. Growth-stage activity collapsed in the first half of 2022, but the early-stage segment has proved more robust with USD 1.1bn committed in the first quarter and USD 638m in the second.

“Early-stage valuations have held up surprisingly well. Series B and growth-stage are down 20-25%, but we’ve had 14 follow-on financings over the last six months, and all were up-rounds,” said Matthew Koertge, a managing partner at Telstra Ventures. “Strong revenue growth has trumped valuation compression and multiple compression.”

The caveat – added by Koertge – is “so far.” Some of the downward drag already trickling back from pre-IPO rounds will inevitably be felt and, if historical corrections are anything to go by, it could be severe. This view was endorsed by Alister Coleman of early-stage specialist Folklore, who expects a divergence between high-quality companies that can control their burn rates and those that cannot.

“It will be an interesting dynamic that plays out in portfolios over the next 6, 12, 18 months,” he said. “For the first time in 10-12 years, liquidity preferences might start to mean something. We might see some of the downside protection that sits in the deal terms really play out in this market. It won’t be great for founders going through it, but it is almost certainly going to play out.”

LP exposure

For Australian LPs with considerable exposure to early and growth-stage technology – in most cases as part of global portfolios – assessments of business models with a view to discerning company quality began when the pandemic hit. They wanted to know whether COVID-19 was a tailwind or headwind and how long those impacts would likely endure.

With the market now repricing partly because of an easing in demand for technology-enabled services for at-home consumption, QIC, which has 40% of its AUD 8bn (USD 5.4bn) private equity portfolio in VC and technology, is revisiting those assessments.

“There will be mortality among investee companies, especially those that are customers to businesses you are invested in, so thinking through quality of revenue is critical,” said Stephen Whatmore, head of private capital at QIC, who is otherwise enthused by the investment opportunity arising from valuation resets and the departure of momentum investors.

Aware Super, which has just under AUD 9bn in private equity, has also been relatively conservative. An approximately one-third allocation to venture and growth pre-pandemic has been cut to less than 20%. Across all strategies, the portfolio remains highly concentrated – 70% in healthcare and technology, with software-as-a-service (SaaS) accounting for most of the latter.

Jenny Newmarch, head of private equity at Aware Super, observed that understanding nuances around recessionary resilience within different business models is not easy. SaaS, for example, should demonstrate resilience if it relies on recurring revenue streaming and is considered mission-critical by customers, but these models haven’t necessarily been fully tested in previous cycles.

“In the global financial crisis, there was a handful of listed software companies and they performed quite well, but adoption rates were low. We are going into a period now where adoption rates are high and customers that buy on a per-seat basis are making headcount reductions. There is going to be some impact. We are already seeing sales cycles slowing down,” said Newmarch.

“We are cautious about that; we are taking a wait-and-see approach. Given how much [exposure] we already have, we aren’t looking to load up on more.”

A SaaS story

SaaS, as part of a broader enterprise services offering, is integral to Australia’s technology ecosystem. Leveraging domestic technical talent as well as a common language and business culture with key jurisdictions like the US, entrepreneurs have much larger viable target markets in B2B than in B2C. Canva is one among numerous examples of start-ups that swiftly moved from local to global.

“If you look back 12-15 years ago, the total value of software companies started by Australians was about AUD 25bn. Absent any corrections over the last eight months, we had AUD 380bn in shareholder value created,” said Folklore’s Coleman. “Australian investors can build value, that’s not in question. And most of that is in B2B software.”

These companies are attracting global investors, including a slew of technology-focused US buyout and growth players. Vista Equity Partners is a relatively recent addition, having made a growth commitment to community and student housing software provider StarRez and helped portfolio company Pluralsight complete a bolt-on acquisition of skills development platform A Cloud Guru.

Adrian Alonso, a managing director responsible for Vista’s growth strategy, estimates that accelerated adoption of technology through COVID-19 took the industry 2-3 years ahead of where it was expected to be. Now, as the turbo-charging effect wears off, risk appetites are being reviewed.

“Over the next months and quarters, a lot of information will come out as to the effects of inflation and valuation changes,” Alonso said. “Many software companies are still driving tremendous value for their customers and industries, but the market is taking a step back to understand the trade on revenue growth and profitability and what multiple they are willing to pay for that.”

When valuing a software company that sells subscription-based products, average recurring revenue (ARR) and net revenue retention (NRR) are the touchstones. For Vista’s growth strategy, which focuses on proven businesses that have the potential to achieve massive scale, NRR is paramount.

The underlying logic is that a market leader able to hold on to its customers and maximise revenue from them by adding products and functionality is an inherently more stable growth proposition because relatively little incremental selling is required to stay on target. It is especially important given the challenge of maintaining high overall revenue growth as a company expands.

This gives context to Scevak’s description of Canva as a rare asset – even with a tenfold increase in the revenue base, growth continues apace. Investors must establish how many levers can be pulled to prolong the phenomenon. Salesforce is the go-to extreme example: it has generated compound annual revenue growth of 20% for more than 20 years.

“Technology companies are the most beautiful companies in the world. What people have got wrong about valuing them over the years is expecting the growth rate to decay over time. The mistake of DCF [discounted cash flow] models is the terminal valuation rate,” Scevak explained. “People can underestimate the compounding and durability of those growth rates.”

As larger investors pushed into growth-stage rounds, many had to get comfortable with valuations based on multiples of revenue. At the same time, a growth-at-any-cost mentality swept through the market, supported by an assumption that, ultimately, profit would come with scale.

“When you’ve got a 100% growth rate, you can talk about revenue multiples. When the growth rate drops back to 5-10%, people revert to more traditional valuation methods like earnings multiples, and that’s a very different story,” said Justin Ryan, co-founder and managing partner of Glow Capital Partners, which invests in consumer and technology-oriented businesses.

“It really is a perfect storm from a valuation perspective, and it stems from demand going through a lull, potentially, or growth rates experiencing a lull. The question is where does it go from here – can we look through the uncertainty?”

The new normal

Some start-ups are adapting to a changed reality, often through highly structured deals designed to avert doing a down round. Historically, these have included bridge rounds, debt instead of equity, and anti-dilution provisions whereby investors receive additional shares – by converting preferred shares to common stock at a higher ratio – if subsequent rounds happen at lower valuations.

Michelle Deaker, a co-founder and managing partner at OneVentures, said she is seeing the return of deal terms that fell away during the founder-friendly years. For example, investors are seeking downside protection by attaching multiples and coupons attached to preference shares.

Even if the next 12 months are dominated by down rounds, failed IPOs, and M&A transactions that fall over and get re-traded, one source of comfort is that Australia’s technology ecosystem is stronger and deeper than ever before. The positivity exuded by Square Peg’s Holt is based not only on anticipated buying opportunities, but also on a stream of distributions from early funds.

“Had the market dislocation we are seeing now happened 5-7 years ago, we might have had some existential concerns about the health of the industry because it was nascent. Now, we’re in good shape, we’ll get through,” he said, adding that the weighted average age of the capital pool in Australia VC is less than three years, which implies robust turnover.

In this way, the intense focus on Canva’s valuation – and the temptation to use it as a bellwether for the wider industry – is a source of frustration. As of early 2022, there were at least seven other unicorns that originated in Australia, including Airwallex, SafetyCulture, Culture Amp, Go1, Pet Circle, Judo Bank, and Zip Co.

“We must get beyond the discussion about Atlassian, about Canva and look at what we are building going forward rather than look at what was built 10 years ago or 20 years ago,” said Coleman of Folklore, which has no exposure to Canva. “It’s a power-law game, but the next power-law company is probably in a portfolio right now and there will be another one that comes from 2023-2024.”

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• Topics
• Australasia
• Technology
• Expansion
• Early-stage
• Australia
• Blackbird Ventures
• Square Peg Capital
• Telstra Ventures
• QIC
• Aware Super
• Vista Equity Partners
• Glow Capital Partners
• OneVentures