Charting a course for software companies over the coming quarters can be challenging. The lasting effects of COVID-19, including labor supply constraints, have caused significant inflation and led to uncertainty surrounding rising interest rates. The inflation rate has increased significantly, nearly doubling from Q2 2021 to Q2 2022. This prompted the Federal Reserve to raise the benchmark interest rate four times in 2022, including a 0.75% increase in June and in July.
Uncertainties have contributed to recent volatility in public markets, driving down broader stock market valuations and hitting the technology and software sectors particularly hard. This in turn limited public exit opportunities and dampened corporate acquisitions. According to the Nasdaq IPO calendar, in July 2022 there were only seven IPOs, while there were more than 100 in the same month in 2021, and the average deal size of $40 million in July 2022 was down considerably from $234 million the same month in 2021.
These public market conditions also affect private company valuations. Venture capital-backed early-stage software companies have been hardest hit by macroeconomic uncertainties. Given their proximity to a desired exit transaction, the decline in IPOs and acquisition activity has delayed anticipated liquidity events, and for those who need capital to bridge that delay, there has been a negative impact on round pricing.
According to PitchBook, in the first half of 2022, the median deal size was $14 million, a 7.1% decrease from the median deal size for all of 2021. The decline suggests investors are hesitant more to deploy capital in late-stage rounds if they don’t see the favorable prospects of a near-term exit.
PitchBook also highlighted some valuation trends. Assessments of venture capital cycles at an earlier stage in 2022 yielded mixed results, with deal sizes growing but pre-money valuations falling. The fall in valuations was likely due to companies possibly needing to extend their cash trail as the exit timeframe could take longer. Meanwhile, seed round valuations have been the least impacted as they are far enough away from their eventual exit. And finally, pre-money valuations continued to grow until the second quarter of 2022.
There has also been a noticeable change in the way private companies are valued. We are seeing investors place less emphasis on top line growth and a renewed focus on profitability and cash burn rates.
Recently, several public software vendors, in their second quarter earnings calls, also warned investors that they expect longer sales cycles and lowered their revenue and earnings targets. Uncertainty across the economy has undoubtedly prompted a refocus on cost containment, cost cutting and careful consideration of major new contracts.
We believe that in light of these headwinds facing the software industry, companies should make several adjustments to their business plans. They include the following:
Revisions to operating forecasts
Given longer sales cycles and cost-cutting exercises by customers, annual recurring revenue (ARR) projections should be adjusted downward in the forecast and estimated churn may increase as customers are looking for cost savings. Companies that have focused on growth may also find that the losses and cash burn resulting from these investments are less sustainable. Especially with the uncertainties surrounding available funding, companies should strive to become profitable to expand their runway and weather this economic storm.
Acceleration of financing plans
Companies are expected to start working on financing sooner than expected. Just as sales cycles can get longer, companies should expect the time to raise capital to take longer as well. Raising funds before you need them becomes essential in an environment like this. So when reassessing funding plans for the next year to 18 months, companies should accelerate the timing of targeted increases.
No one can fully predict the future. However, taking stock of current trends and preparing for future uncertainty will allow businesses to meet challenges more successfully.