Now, what could go wrong in Tech financing?

After setting records in 2021, PE deal making has throttled back in 2022.

We’re not witnessing a total collapse of the market. Instead, it’s a subtle slowing that makes it difficult to read the terrain and the overall mood of investors. Amid this uncertainty, there are a few signposts that we can see clearly.

The threat of higher interest rates has put pressure on deal activity (and valuations). The geopolitical tensions in Europe have complicated the financial picture. The Russian invasion of Ukraine caused dealmakers to push the pause button for several weeks. While that pause is still in effect for Europe, particularly for late-stage funding, the market is moving again in the U.S. (source: Pitchbook, Q1 2022 US PE Breakdown).

Meanwhile, tech continues to see capital flowing into GPs, for both Venture Capital (Per Pitchbook, record-level of VC fundraising in Q1 2022) and Private Equity. Even so, some investors are rotating out of high valuation tech stocks as investors see attractive growth prospects elsewhere and the possibility of better valuations.

The bottom line is that it’s hard to know the bottom line when some indicators are pointing up and others are pointing down. So rather than a definitive diagnostic of this snapshot in time, let’s imagine what could go wrong for Tech as we move through Q2 in order to be better prepared. Here are 3 risk factors for investors and entrepreneurs to break things down and ask the right questions to help make critical strategic and funding decisions.

1. Global Economic Growth

The Context: Forecasters on Wall Street and at central banks have lowered their projections of economic growth for nearly all regions of the world, with the steepest adjustment for Russia (i.e. — 9% for this year per S&P Global estimates). In the US, the Federal Reserve cut its annual growth forecast from 4% to 2.8%. According to Goldman Sachs, there’s a 20–35% chance that the US enters recession this year.

Impact on Tech companies: As growth slows or falls, not all Tech verticals will feel the same impact. But only “sticky” software solutions will escape the full brunt of this shock. This is true across all segments of software.

To understand whether a particular company is indeed “sticky,” look at their Net retention rate and customer churn metrics. If these metrics were not good enough prior to FY22, then steer clear of these companies for now.

In our view, the HR Tech vertical will be one of the most resilient Tech verticals. The global shift to remote work and the need for a more efficient workplace will continue to drive deals in business and productivity technology.

Indeed, this sector produced one major PE deal in the US in Q1 2022. In January, Vista Equity Partners and Evergreen Coast Capital announced the acquisition of digital workplace solutions provider Citrix (NASDAQ: CTXS) for $16.5bn in a take-private deal. Citrix will merge with TIBCO Software, which provides enterprise data management to help navigate a hybrid workplace. The deal showcased opportunities in the space of digital workplace transitions.

In Europe, Paris-based Lucca raised €65m in March from London-based One Peak. Lucca, which makes an HR automation platform, was founded in 2002 but had bootstrapped until taking this outside funding to accelerate its growth.

2. Inflation Across the Supply Chain

Context: The rising costs that emerged in 2021 have persisted in Q1 2022. After a half century of falling inflation rates, the global annual inflation rate has now climbed above 6%. The inflationary pressure the global economy is facing from rising food and oil prices has been compounded by Russia’s invasion of Ukraine.

Impact on Tech Companies: Wage rate increases and inflation could have a materially adverse effect on the financial condition and operating results of Tech companies in three important ways.

First, this is particularly true for the labor market where inflation will add to the wage increases Tech companies should forecast in their FY22B budgets. For example, let’s zoom in on Sales & Marketing, a core component of a Tech company’s OPEX). It is estimated that the cost of replacing a sales rep could reach 150% of the previous employee’s cost. If, that is, the company can find such a replacement.

Companies should be more conservative in their budgets and build in an additional buffer for estimated payroll costs to avoid surprises.

Next, inflation could boost customer acquisition costs, a key element in a Tech company’s path to profitability. On top of buffers on the actual people costs involved in Sales & Marketing, the surge in paid acquisition costs should be factored in as well (+30% on average for Facebook ads compared to 2021, for example). This inflation concerns all Tech companies, from traditional software players (and especially those using an SMB playbook in which these companies rely on inbound leads) to DNVBs which heavily rely on digital marketing.

Finally, DNVBs specifically face the risk of increases in component costs, shipping costs, long lead times, supply shortages, and supply changes that could disrupt their supply chain. The war in Ukraine has started to have major consequences in this sector, which will become clearer in disclosures for this quarter’s performance. It’s critical to monitor operational risks and the financial consequences that result from them.

3. Covid

Context: Amid all these other variables, Covid remained the main disruptor of the global economy in 2021. Today, much of the world is starting to shrug off the pandemic. Hospitalizations are falling thanks to a combination of vaccination and immunity from previous infections in most of the world. The exception is China which remains committed to its zero-covid policy and lockdowns despite backlash from fed-up Chinese citizens. And yet, the continued return to normal could be further delayed if another variant pops up.

Impact on Tech companies: On one hand, many Tech companies benefitted from Covid. We noted the favorable trends in HR Tech above, but COVID has allowed for the growth of many new economic models based on digitalization of traditional parts of the economy across BtoB and BtoC.

However, as the tide shifts on Covid, we are going to see a sorting of companies that built a durable and viable model during the pandemic and those were simply artificially boosted and are now undergoing painful valuation revisions this year. Peloton may be the poster child for the latter. The darling of the pandemic thanks to its bikes and subscription model for sports-from-home, the company appears to be crumbling amid falling demand and over-production that led to massive losses and firing 20% of its employees. And yet, its digital subscription business continues to grow. The new CEO faces a daunting task of recalibrating this business model.

Likewise, many EdTech players are likely to find themselves at a crossroads. Despite big growth during the pandemic, the path to profitability for companies like Coursera or Udemy will be interesting to watch. Such companies must find a way to maintain the massive numbers of users they acquired during Covid and convert them into long-term cash-generating customers.

As with all these issues, there are not simple right or wrong answers. Instead, the smart leaders and investors will have conducted a rigorous and honest due diligence of a company’s strengths and vulnerabilities to fully understand their position. That kind of insight is the best way to make preparations that will serve to help successfully navigate a period where turbulence and uncertainty may continue to increase.