📈 The Great Correction

Originally Published: March 27, 2022 (here)

It seems like every asset in the market is getting re-priced. By re-priced, I mean bleeding red.

Year to Date

Affirm down 50%

Snowflake down 25%

Uber down 20%

Welcome to The Great Correction

Actually, depending on how you see it, you may even call it The Great Normalization. In the past two years, the American economic engine was injected with trillions of dollars in stimulus. This led to two things:

1. An influx of capital into the markets

2. Too many dollars chasing too few goods

During this time, some even believed it was fine to stop working all together. Who can blame ‘em? The government was sending free money to anyone with a mailbox. This stimulus led to unforeseen valuations of companies in both the public and private markets. I mean if you parked your capital anywhere, you'd be green. Literally.

Companies took advantage of these favorable market conditions and raised astronomical rounds. It was as if unicorns went from being once in a blue moon to a daily occurrence.

Flying High

Before you accept a job, you go on Glassdoor and compare what your salary is to employees in similar roles. It gives you a good idea of what your expertise is worth. But what if every company is paying below market price? Then it’s a tragedy of the commons.

Green public market valuations, along with cheap capital, gave legitimacy to private companies to raise rounds at higher valuations. Surprisingly, companies didn’t realize they have to continue firing on all cylinders to grow into their new valuation.

A great example of this are the pandemic babies. Klarna (buy-now-pay-later) and Instacart (delivery service) wrongly assumed consumer behavior during the pandemic would continue (i.e. binge buying unnecessary products and home delivery due to the closure of indoor dining). Assuming that level of growth will continue into perpetuity caused a bad mispricing.

The Comedown

Over the last few months, the world has come to realize the second and third order effects of the massive injection the economy received. Let’s go through ‘em.

1. The cost of capital has dramatically risen. The Fed recently announced rate hikes which essentially means the cost to borrow capital is more expensive. This increases the discount rate in financial models causing the projected value of a company to decline. You can think of it as an inverse correlation between cost of capital and the enterprise value of your company.

2. Inflation is rampant. There's two reasons for this:A) Supply was not keeping up with demand. In response, companies have to raise prices. Not only does this affect the cost of your groceries, but it also impacts the input costs of many services companies use (i.e. Facebook and Google Ads).B) The war between Russia and Ukraine is further emphasizing the importance of de-globalization. If you've filled up your tank recently, you probably understand. If we, as a country, decide to bring everything in-house, there will continue to be a ramp up in prices.

3. The public equity market is in decline. One of the major benefits of the public market is that it is an immediate feedback loop. As public market comparables fall, private companies begin to question their valuation. The cycle of pricing goes, public market correction first, early-stage second, and late-stage third.A) Think about it. Since Affirm's valuation went from ~$30B to ~$10B, how can Klarna justify its private market valuation of ~$45B? If Klarna decides to go public this year, it will almost certainly have to IPO at a down round.

Symptoms of the Comedown

Equity is a representation of ownership in a firm. If you own equity, you are effectively a partial owner of a business. As an employee, many firms offer compensation packages to be awarded in the form of equity. This is an effective way to align the incentives of an employee with the goals of the firm.

Employee perform well, firms does well, equity goes up.

It's a win-win situation.

Until it’s not.

In recent news, Instacart slashed its valuation by almost 40% to $24B. This is an enormous problem for startups that raised large rounds. While getting knocked over the head with rising costs of everyday expenses, some employees may even go under water if they elected to take their salary in equity. In the face of macro pressure cratering a company’s valuation, the morale of the organization will also wane. It can be especially disastrous for a company if talent begins to go elsewhere.

What Happens Next

The correction continues to affect many.

Once private companies begin to need access to capital again, we’ll see how it impacts their fundraising rounds. Nonetheless, this could also be the best time to join your favorite startup. If a company is slashing their valuation and you believe it has long-term value, go for it. You’ll get in while the company is at a discount.

We'll see how this all plays out.

Till next time.

This post and the information presented are intended for informational purposes only and are not a reflection of my employer. The views expressed herein are the author’s alone and do not constitute an offer to sell, or a recommendation to purchase, or a solicitation of an offer to buy, any security, nor a recommendation for any investment product or service. While certain information contained herein has been obtained from sources believed to be reliable, neither the author nor any of his employers or their affiliates have independently verified this information, and its accuracy and completeness cannot be guaranteed. Accordingly, no representation or warranty, express or implied, is made as to, and no reliance should be placed on, the fairness, accuracy, timeliness or completeness of this information. The author and all employers and their affiliated persons assume no liability for this information and no obligation to update the information or analysis contained herein in the future.