To understand when private market valuations will reach similar levels to what we’re seeing in public markets, there are a few factors to consider. As there are generally fewer “crystallization events” for early-stage companies, it takes longer for private markets to adjust than public markets. Public companies are generally required to report their updates quarterly and sometimes more frequently (such as when management has information that causes them to believe that there will be a significant deviation in results from their previous forecasts).

This means there is still a relatively large delta between the valuations that we’re seeing in public and private markets. Public market valuations have come down substantially, but private market valuations, especially in the early-stage space remain buoyant. There are a couple of reasons why it has taken the founders of early-stage ventures longer to adjust their expectations.

Firstly, private companies last raised capital in a more ebullient times and they have continued to operate as if that was the status quo unless they have been given some guidance to do otherwise. This means that the first data point that private market companies receive is going to happen when they go back to market to raise additional capital.

Any companies that raised in 2021 or 2022, likely had sufficient capital to get them through 12-18 months, which was probably extended recently as Boards became aware that the funding market is more challenging and encouraged companies to operate on a leaner budget. This means that most companies that require additional funding are only now starting to get feedback on market sentiment. As the founders have likely anchored their expectations on the valuation that they were able to achieve on their previous raise and misguided rules of thumb, which no longer apply (e.g. “We should be able to raise at 10x revenue”). It takes time for those founders’ expectations to adjust in line with the market.

Secondly, there’s also the possibility that some early-stage companies raised a “bridge round” from existing investors. Sadly, there will be a number of these rounds that will likely prove to be bridges-to-nowhere. This could further extend runways 6-12 months, which also extends the amount of time that it takes for founders to face reality. Existing investors are more likely to continue to support a company because of the endowment effect, attributing a higher value to something that it already owned. This means that even if they objectively asked the question “If we didn’t own this already, would we invest in it now?” they likely wouldn’t invest but they could justify investing in a bridge round using some other leaps of logic. However, objectivity is in short supply in financial markets, especially at turning points.

When will things change?

There were a number of tourists that entered the early-stage space over the past few years, both on the entrepreneur-side as well as the investor-side (undisciplined investors). It’ll likely take another 6 to 12 months from here for early-stage market valuations to be more in line with public market valuations.

There still needs to be some pain felt by founders and undisciplined investors who were too bullish when markets were being driven by excess liquidity. The existing funding needs to run out, internal funding rounds need to be exhausted, and companies need to speak to external investors to find that the environment is markedly different from a year or more ago. Some funds are reducing their investment pace because of a more uncertain environment and others were tourists that had no interest in supporting a company through the ups and downs of an economic cycle.

We likely need to see the tourist-founders, who joined or created start-ups for “market salaries” with the added upside of equity, leave the market for more stable roles. It was a no-brainer to take this path if you had the capacity to do so previously because early-stage founders had more control over where and when they worked and gave up little in terms of monthly cash flows but also created upside optionality through equity ownership. This will leave the more resilient founders to deal with the fallout.

Moral Hazards

The past few years have also created a real moral hazard for the more disciplined investors that are willing to stick with their portfolio companies. While they might want to invest in and support some of the companies that are coming to market for funding, they are hamstrung by high caps created by the investors that bought into the hype of the previous cycle.

If a company previously raised capital with SAFE with a cap that a disciplined investors perceived to be too high, they likely didn’t participate. Now if that same investor was to invest with a convertible instrument at a lower cap, there are two issues.

Firstly, there will be a lot of capital that has been raised at different cap valuations sitting on the cap table. Some investors have rules of thumb related to how much should be outstanding in convertible instruments prior to a priced round, one investor recently told me that they don’t like seeing more than 25% of what will be raised in a priced round sitting on the cap table in convertible instruments. While we could quibble about what a reasonable level is, something less than 50% is likely appropriate (we can discuss the rationalize around this in another post). If a company has a number of convertible instruments, then it makes it more and more likely that the convertible instruments will represent more than 50% of a priced round, which makes that company less desirable to disciplined investors subsequently.

Secondly, the disciplined investor will be supporting the decisions of the undisciplined. This creates a moral hazard because then it would always be in the interests of undisciplined investors to write notes at ever increasing caps to be able to position in a round because they know that eventually a disciplined investor will “bail them out” if the market turns. Poor investment decisions have consequences. Those consequences are usually delayed in private markets because of the long feedback cycles. However, we’re getting closer to a point where the undisciplined investors are going to need to reassess their positions in light of the current market information.

Conclusion

There are a number of issues with the current early-stage funding market in Southeast Asia and we’re only slowly working through them. It will likely take another 6-12 months for the issues that we’re currently seeing to resolve. At that point, we’ll be looking at a far more resilient early-stage eco-system, where the winners of the next generation will likely be hiding in the weeds.