There’s a wave of pre-IPO startups with pandemic-era price tags stuck in limbo right now

• A slew of pre-IPO startups with lofty valuations are currently in limbo.
• Late-stage investors are waiting for their pandemic-era bets to mature and justify their exorbitant prices.
• However, some may never reach those heights, resulting in hidden deals and bankruptcies.

A wave of pandemic-era startups is currently in limbo.

They have been hampered by a drop in growth-stage funding and volatile public markets, where recent debutants Klaviyo and Instacart have seen their share prices fall by double digits as of November 21.

More importantly, they’re being held back by the same investors who slashed their valuations during an extremely frothy period fueled by cheap capital and widespread FOMO.

According to PitchBook’s Q3 IPO market report, late-stage investors prefer to wait for their portfolio companies to “grow into their valuations” rather than take them public and incur a significant loss. If they wait, the company will grow into its high valuation, and investors will recoup their investment.

According to the report’s author and PitchBook analyst James Ulan, revenue growth at most startups has also slowed, which means valuations will take even longer to achieve – and some may never come to fruition.

For example, the buy-now-pay-later company Klarna saw its valuation fall to $6.7 billion after raising $45.6 billion the year before.

“You have to promise the moon, otherwise the valuation is even more crazy,” Ulan said of Karna’s late-stage rounds. “And it just turns out that you can’t grow that fast for a long period of time.”

The days of seeing 80% to 100% year-on-year revenue growth are over, according to Hussein Kanji of early-stage fund Hoxton Ventures.

In this market, a good enterprise software company will grow by 40%, with 50% being exceptional, he claims. “A lot of them are guiding to 20% to 30% growth,” he said.

Startups can maintain their prices while there is plenty of cash in the bank, but money will eventually run out and they will need to find new funding. According to a Q3 Morgan Stanley report, most unicorns have less than two years of cash runway, while the desire to hold onto legacy valuations has led to hidden and unannounced deals where valuations are typically flat to down, according to PitchBook’s Ulan.

According to Hoxton’s Kanji, one way to avoid haircuts is to add structure to deals. Various terms can be added to financing agreements to allow startups to access new funds while maintaining high valuations while protecting investors if the company fails. However, this disadvantages earlier investors because structure can “eat up economic returns” when an exit occurs.

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Structure does not hold when a company goes public, so some pre-IPO companies may be forced to merge. However, it makes no sense for large tech companies to acquire unprofitable startups when their own growth has slowed, according to Kanji.

“So you have this wall of unicorns that aren’t going anywhere – they’re not getting acquired, they’re not getting IPO’d,” said Kamil Mieczakowski, partner at Notion software fund.

“Maybe they shouldn’t have ever been called unicorns in the first place, right?”

Investors typically base their assessment of a company’s readiness for an IPO on the rule of 40, which is revenue growth plus EBIT margin. According to the Morgan Stanley report, only about 150 of the 1,200 private unicorns “actually have a rule of 40 that you would be looked at favorably by the public markets.”

At current growth rates, funds holding their position could be waiting for five years inside a typical 10-year fund, which could be three years into the cycle at the time of investment.

“So that’s like year eight before you get parity,” chimed in.

“They should draw a line in the sand and say, ‘We’ll just get rid of these things,’ or ‘We’ll forget about them, close that chapter, or sell them at a discount and move on.” But doing so is extremely difficult emotionally.”

Indeed, after doubling down over the last two years, some investors will cut their losses. Bankruptcies “are kicking in” with companies that are unable to secure funds and thus lose investor support, according to Fabian Heilemann, CEO of impact fund Aenu.

Graphcore, touted as Nvidia’s AI chip rival, is one such startup rumored to be for sale after Sequoia sold its stake last year.

Kanji went on to say, “This is a lesson for a lot of people – if the IPO window opens up, take the company public.”