New study reveals correlation model between startup valuations and macroeconomic market conditions
New research by Benjamin Le Pendevin and Max Berre at Audencia’s ‘Finance for Innovation’ chair finds that business cycles have both a direct and indirect impact on startup valuations. In the current challenging economic environment, the authors wanted to establish a new model conceptualizing startup pre-money valuation.
In 2020 and 2021, venture capital (VC) markets reached all-time highs in terms of both value invested and number of deals worldwide. The number of unicorns in the world also peaked, rising from 45 in 2014 to 1,058 in 2021. However, as shown by a new study by Audencia’s ‘Finance for Innovation’ Chair, many young companies in the process of raising funds are likely to experience more difficult rounds of financing due to current market conditions. Recent macroeconomic troubles have concrete consequences for startups valuations.
This is why Benjamin Le Pendeven, holder of Audencia’s ‘Finance for Innovation’ chair, and Max Berre, PhD candidate within the chair, investigated the impact of the macroeconomic factors hich determine startup valuation. They were then able to create a model linking startup valuations to macroeconomic market conditions.
Some macroeconomic factors strongly influence startup valuations
In their study, Benjamin Le Pendeven and Max Berre built a database of 1,089 observations representing 1,042 deals across 675 European startups between 2000 and 2020. This enabled them to find to what extent market conditions and macroeconomic factors influence startup valuations. Specifically, they uncovered that the business cycle (i.e., the continual economic movements that take place in a country over a given period) is the most influential valuation driver. However, business cycles not only drive startup valuations through direct impact, but also through macroeconomic and macro-financial factors that have an indirect impact on startup valuations. This indicates a double-impact: direct and indirect.
In terms of direct impact, business cycles influence companies’ revenues, asset valuations, business relationships and market demand, all of which affect the business of a company. In terms of indirect impact, they influence country risk premiums (used for example in DCF valuation methods) and the amount of money invested by domestic VCs.
In fact, it appears that domestic VC is the strongest factor, being itself influenced by business cycles and tax rates among others.
While ‘dry powder’ (the quantity of money collected by VCs but not yet invested) is statistically significant, it only has a minor effect on the valuation model. This means that a large increase in this money to invest at the country level will only lead to a relatively small increase in startup valuations, and vice versa.
This result can seem counterintuitive: while data show that tax-rates have a negative impact on this ‘dry powder’, this study reveals that tax rates are actually positively associated with startup valuations. So higher valuations lead to higher taxes, not the other way around.
The direct and indirect effects of macroeconomic factors on startup valuation
The study shows that relationships between startup valuations and macroeconomic market conditions can be modelled as a complex, multistep and partially indirect relationship.
The authors found that the impact on startup valuations is primarily driven by business cycles. Even though other macroeconomic market conditions such as country-risk premium and money invested in VCs influence startup pre-money valuations, they appear to act essentially as distribution channels transmitting business cycle impact rather than as valuation drivers in their own right.
Read the working paper online.
Methodology:
Benjamin Le Pendeven and Max Berre built a dataset of over 1,089 observations representing 1,042 deals across 675 startups between 2000 and 2020 on which the model was tested. They were helped by Early Metrics (a ratings agency for startups and Audencia’s ‘Finance for Innovation’ chair)
The main parameters to consider in the model are the business cycles, the country risk premium, cash on market and other financial indicators like the CAPM-Beta (a measure of the volatility, or systematic risk, of a security or portfolio compared to the market as a whole) and the revenue of the startup. The authors used a structural equation modeling approach which allowed them to consider various parameters while analyzing complex indirect relationships, assessing both direct and indirect effects on the startup valuation process.
To represent the contraction and expansion phases of an economy that form the business cycles, they use output gap as the key variable. The output gap is the difference between the actual output of an economy and its potential output.
Running the model on the dataset provides information both on the explanatory power of variables on the pre-money startups valuation and on their statistical significance.
