2023 Outlook – Technology Sector

Entrepreneurs have all been managing businesses through an uncertain and challenging social and economic period. Challenges included Covid business restrictions, leveraging access to government support programs, managing a remote workforce and the changing expectations of employees, the bust/boom of our economy that dropped painfully during the worst Covid period only to bounce back vigorously as social restrictions relaxed and discretionary spending increased. These challenges combined with supply chain shortages and rising energy costs have driven inflation and interest rates to levels not seen in generations contributing to significant wage price escalation and predictions of a recession in 2023.

The technology sector in general performed very well during this period as Covid accelerated digital transformation. The technology sector has benefited during the past several years from growing enterprise valuations that recognize the value in the broader economy’s leveraging of technology to improve productivity and outputs. While valuations had risen, technology companies struggled with their main input – access to skilled team members and the related cost. With the growing demand for technology solutions came the increased demand for skilled labour, a workforce that was becoming more transitory and competitive driving significant wage price inflation. The demand for talent with material wage price inflation was last seen at this level during the technology bubble in the early 2000’s. 

Higher inflation, growing borrowing costs and predictions of a recession creates continued uncertainty for 2023. The technology sector has not recently faced such headwinds which raises questions on the impact to the technology sector. These headwinds as it relates to inflation, particularly wage price inflation, and the threat of a recession definitely impact directly on technology companies. Those companies accessing variable interest rate debt funding will feel the cash flow impact of rising borrowing costs. Separately and as importantly the physiology of a potential recession can drive business and consumer behavior well before a recession materializes resulting in service/product pricing pressure or reductions in product/service demand.

Technology executive teams need to continue to adapt to these headwinds. We expect that the impact in 2023 could include the following:

  • Public markets will likely continue to be unsettled with inflation concerns, impact if higher interest rates, Ukraine uncertainty coupled with energy cost uncertainty, supply chain risks, wage price inflation risk and risk of reduced corporate and individual discretionary spending.  Generally, uncertainty in the public markets drives slower IPO activity which can constrain access to capital.
  • The lens through which capital gets deployed is likely to change with expectations of consumer and business consumption changes resulting in more scrutiny on financial modeling and related assumptions such as sustainability of margins and margin forecasts, customer churn, sustainable growth rates and costs assumptions regarding wages.
  • Creditors may be become more cautious resulting in operating lines not getting renewed or with changes to terms and conditions including security, borrowing costs or adjusted covenants, less tolerance with non-compliance with terms and conditions and increased oversight
  • The challenges recruiting and retaining your workforce will continue. There have been some notable employee workforce reductions recently that are likely to continue into 2023 that may provide some relief, however, it would be prudent to continue to operate with a view that wage price pressure will continue and that the demand for talent will outpace the supply.
  • Conversion of amounts invoiced to cash may slow (accounts receivable turnover) as customers face increased financial pressure with a desire to be more cautious with their own cash flow. Supply chains may also impose more pressure related to adhering to agreed upon payment terms.
  • Valuations will be impact, coming off of a period with high valuations, the uncertainty that we enter 2023 with may drive lower valuations. This will in turn result in a return to share issuances where tranche financings are more common and the issuance of shares that provide preferential terms to the new investors, such as liquidation preferences, are more prevalent.
  • M&A activity may slow with relatively fewer accretive exits. We have seen numerous exits over the last several years where the exit price was very accretive to the founders and investors – in most cases significant returns to all investors. This was a result of very positive capital markets supporting strong valuations. With lower valuations and constrained capital we will see a change in the mix of exits in 2023 with more distressed exits by entities that are unable to fund the business models and fewer exits that provided the same multiples on exit that we have seen more recently.  We may see strategic investment activity increase as valuations drop or if distressed companies look for life lines to continue.

Executive teams should anticipate the above when communicating with investors, lenders and future debt and equity sources of capital. Generally, we would expect more scrutiny from their existing creditors and shareholders and more detailed financial model due diligence when looking to access new debt or equity financing. Whenever there is the fear of an economic slow down there is generally a tightening of capital as the perception of risk increases which will involve more discussions and likely slow the deployment of capital and introduce perceived risk mitigation strategies like tranche financings and more complex terms and conditions.

The active management of your business model and how it translates into cash flow and reported results will continue to be critical to navigating 2023. We expect that there will be a need to build budgets with various scenario’s including different growth rates and margin expectations, conversion of amounts invoiced to cash as customers may slow payments if they are under more financial pressure, with a clear view on the sustainability of the business under various funding scenarios.  In the absence of creating these budget scenario’s completing a detailed quarterly review of operating results compared to budget is helpful to monitor results and identify trends that may need to factored into go forward operating activities and updates to budget assumptions. A key input to most technology budgets is the cost of wages. With the workforce reductions witnessed recently is there an opportunity to address wage price pressure through more emphasis on variable compensation that ties input costs to cash inflows or achievement of other KPIs. To the extent you have accessed debt, understand the covenants and your ability to be compliant. Understand other terms like the renewal of operating facilities and what conditions are needed for renewal.

It is worth noting that the supply of capital has not changed with significant equity and debt looking for the right entrepreneurs/teams to generate the required returns. What may be different in 2023 is that the capital may be more selective, result in more dilution, come with more conditions and therefore slower to deploy. Early data is suggesting that the amount of capital deployed is slowing. Having the right mind set when approaching capital is key to making a first positive impression.

It is important to highlight that what won’t change in 2023 is that investors and lenders invest in people and businesses. These stakeholders are banking on your ability to manage these headwinds. They will be looking to gauge your ability to do so. Demonstrate to them your awareness of the economic factors impacting your business and how you are actively managing. Don’t wait from them to reach out, proactively connect with lenders and investors including potential future sources of capital to share your plans – ensure before reaching out that you are prepared.

Finally leverage your business partners to help – if you have the right business partners they should be there to help particularly during more challenging times. The Welch tech sector team has extensive experience supporting entrepreneurs from start-up through to exit. If there is a situation we cannot directly help with we are supported by others in the communities that we serve that can help. We take pride in our accessibility and look forward to helping. Reach out and lean on us for support as you manage though 2023. We will also do our best to reach out and connect to ensure we are accessible.

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