Is 2016 the year tech valuations return to earth?

How much longer can sky high tech valuations last? Evidence suggests a closing of the valuation gap in 2016. 

In the midst of 2016s first quarter, venture capital database CB Insights launched Downround Tracker – a tool which keeps a running tab on the latest failures and disappointments in the valuation sphere, with a special focus on tech valuations. Four months in, the list of companies selling for under previous valuations continues to grow. In a sense, it’s an affirmation of Firmex’s latest mid-market M&A report on the valuation gap. According to its interviewees and data, the number of mid-market deals (US$10 million to $250 million in value) fell sharply in North America in 2015. This year continued the trend, with January 2016 having the worst showing for mid-market deals in 25 years.

One of the key catalysts for the decline is the looming valuation gap between buyers and sellers. With high-quality targets in the mid-market becoming fewer and farther between, sellers looking to leverage that scarcity have inflated their valuations, leaving a sour taste in the mouth of buyers.

In Firmex’s mid-market report, Andrew Lucano, a partner in the New York office of Seyfarth Shaw LLP and Vice Chair of Seyfarth’s Mergers & Acquisitions practice group – points to the technology sector as one of the areas seeing the biggest valuation gap.

“In the tech world, you frequently see companies being sold on unrealized potential – certain buyers are willing to gamble that what they are purchasing is going to be the next Google or the next Uber, which can result in very high sell-side valuations,” he writes.

Sometimes, they ignore the fact those tech companies may not have the financials to back up the valuation.

“Some mid-market tech companies look at the big tech companies that have gone public, or have gotten swallowed up by a company such as Facebook at some extremely high valuation, and think that’s going to work for every technology company out there,” he says.

Of the 2,025 mid-market deals worth a combined US$160 billion in 2015, 23 per cent of the North American deals were in the technology, media and telecommunications sphere.

“The valuation gap is not as wide for companies engaged in industrial, brick-and-mortar-type industries, and in the energy industry right now, because of all the turbulence due to the low price of oil and gas,” Andrew Hulsh, a partner in the Corporate and Securities Practice Group of Pepper Hamilton LLP in New York, wrote in the report. “The industries where the valuation gap is very pronounced are those that I would refer to as ‘transformative’ industries, involving companies that have substantially higher financial upside.”

And that’s where the headline-making down-valuations were.

Currently topping Downround is Onefinestay, a London-based short-term vacation rental company, which was acquired in early April by hoteliers AccorHotels for US$169 million. According to the Downround tracker, it’s US$57 million shy of a previous valuation.

But perhaps more publicly edifying of overvalued startups coming down to earth in 2016 is Fourquare’s embarrassing downgrade in January to less than half of its $650 million valuation in 2013, prompting CEO Dennis Crowley to step down.

According to corporate documents obtained by the Wall Street Journal from private-company research firm VC Experts, the social media company sold shares in its most recent round at US$4.01, a 69% free-fall from the previous round.

Look to the unicorns

Outside the mid-market, the spike of unicorns – those startups with billion dollar plus valuations – has sent out its own series of red flags, even prompting some cries of another tech bubble bursting at the seams. A report by Upfront Ventures issued last year found that five out of seven exits for tech unicorns earned a lower valuation than previous estimates versus three out of 12 exits the previous year.

“The market is rapidly correcting,” Mark Suster, managing partner at Upfront Ventures and co-author of the report, told the San Francisco Chronicle. “Valuations have gotten out of control. By any definition, I don’t think you can say what’s happening is anything other than a bubble.”

It seems the kid siblings in the mid-market want to play too.

“A high-flying technology company may trade at 5x or 7x revenue if it’s early in its age and is growing very rapidly. But what acquirers are usually paying for is technology that can be monetized and expanded upon,” muses Richard Herbst, a partner at Sikich Investment Banking in Chicago. “It’s not just unique technology – what they care about is how your technology has been adopted in the market and what sort of momentum you have in the commercialization of it.”

Herbst points out that it often leads to competing tech companies saying: “Well, I have better technology!”

“But that’s not what acquirers are paying for,” he writes. “Usually, they’re paying because the market has found a certain technology and has been really receptive to it.”

Will there be a reality check?

While there’s some grumbling in the analyst community to suggest the valuation gap is in for some sort of tightening or correction, what that looks like can only be half-baked prognostication at this point.

One factor that could help it along is a slight decrease in the availability of credit.

“Many acquisitions are dependent upon the availability of debt financing, and valuations are often driven by the availability of credit at reasonable terms and rates,” writes Herbst. “In the past two months or so, we have seen a decrease in the availability of credit, and my sense is that this decrease will lessen the valuation gap we saw for most of 2015, because sellers just won’t have the same level of interest they previously had when credit was easier to obtain.”

On the flip side is the need of private equity firms to deploy their capital.

“Many of these PE firms have substantial assets under management, they’ve raised new funds recently, and there is a need to deploy that capital within a defined investment period,” he adds. “I would also say that as long as there are strategic buyers willing to grow through acquisitions rather than organically, I think there’s a fair chance that valuations will remain extremely high and that the valuation gap we’ve been seeing in the market will continue.”

If the past year has taught us anything, it’s to expect the unexpected. But whatever happens, tech companies with ambitions of selling high should keep a careful eye on the market.

Andrew Seale

Andrew Seale is a Toronto-based business writer who contributes frequently to Yahoo Canada Finance, The Globe and Mail's Report on Business and The Toronto Star.