I just listened to this podcast with Marc Andreessen, Chris Dixon, and Benedict Evans. And since the post I was going to write today is now delayed until tomorrow, I will simply run the podcast as my post of the day. Lot’s of great stuff in here. I particularly liked the bit (about 17.5 mins in) where Marc says “there’s no public market bet on bitcoin, there’s no public market bet on crowdfunding, etc, etc”. We’ve got those bets and I hope we can share them with the public markets someday
Posts from stocks
Everywhere I go, everywhere I speak, I get asked this question. Are we in a bubble?
I’ve been getting asked that question for at least four years now. It’s hard to sustain a bubble for four years. But we are also not in a normal valuation environment for high growth tech companies and we have not been in one for a while.
Here’s how I have been answering the question.
I learned in business school that the multiple of earnings one should pay for a business is roughly the inverse of interest rates. The reason for that is if you buy a business that makes $10mm a year and pay $100mm for it, then you are effectively getting a yield on your investment of 10% (annual earnings/purchase price). This math is terribly simplistic but fine for the purposes of this post. If interest rates are 5% instead of 10%, then you would pay $200mm for the business ($10mm/$200mm = 5%). So the math here is interest rates = annual earnings/purchase price. Again this is very simplistic because it does not deal with the important questions of what interest rate you use, how you deal with earnings that are growing or declining, and a host of other issues. But at the end of the day, this math [annual earnings/purchase price = yield] is fundamental and everything about asset values, capital markets, and valuations stems from it.
Since the financial crisis of 2008, policy makers in the developed world have kept interest rates at or near zero. They have flooded the market with cheap money in an attempt to heal the wounds (losses) of the financial crisis and incent business owners to invest and grow their businesses. That has not worked particularly well but it has worked a bit. Though their words have changed in recent years, their actions have not changed very much. We still are in a policy framework where money is cheap and interest rates are near zero.
If you go back and apply the formula [yield = earnings/purchase price] and use zero for yield/interest rate, then one would pay an infinite amount for an earning stream. Of course that doesn’t make sense and it has not happened. But valuations are at extreme levels because you cannot get a decent return on your money doing anything else.
At some point this will change. The yield on the 30 year treasury yield has been sub 5% since the financial crisis. If (when?) it gets back to the 6-8% range where it was for most of the 1990s, we will be in a different place. Here’s a 40 year history of the 30-year treasury yield. You can see that we have been in a very low rate environment for a while now.
The other thing we have noticed is that this low rate environment has caused asset value/earnings ratios to be non-linear. What you normally see is the value/earnings ratio grows linearly with earnings growth rates. If earnings are growing 20% per year you get a value/earnings ratio of X. If earnings are growing 40% per year, you get a value/earnings ratio of 2x. But what we are seeing is you get something that looks more exponential than linear when you start modeling this out at higher earnings growth rates. When earnings growth rates get to 50-100% per year and look like they can continue to grow at that rate for a number of years, you get value/earnings ratios that are eye popping. It seems that investors are so starved for returns that they are willing to pay that much more for earnings that can grow quickly.
It is the combination of these two factors, which are really just one factor (cheap money/low rates), that is the root cause of the valuation environment we are in. And the answer to when/if it will end comes down to when/if the global economy starts growing more rapidly and sucking up the excess liquidity and policy makers start tightening up the easy money regime.
I have no idea when and if that will happen. But until it does, I believe we will continue to see eye popping EBITDA multiples for high growth tech companies. And those tech companies with eye popping EBITDA multiples will use their highly valued stock to purchase other high growth tech business and strategic assets at eye popping valuations.
It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.
So RIM has decided that it is time to make Blackberry Messenger (BBM) cross platform. They announced yesterday that by this summer BBM will be available on iOS and Android.
The time to do this was in 2008/2009 when BBM was huge and everyone was on it. The core users were beginning to leave for iOS and eventually Android and if RIM would have let them take BBM with them, they would now own the biggest cross platform messenger out there. BBM is great and everyone knew how to use it and was comfortable with it.
But RIM execs waited four years to make this move. When BBM hits iOS and Android this summer, they will face dozens of cross platform apps that people use to message each other, one of which is in the USV portfolio. My bet is this won't help RIM or BBM much at this point.
This is a classic case of the innovator's dillemma. RIM felt that letting BBM out in the open would make it easier for Blackberry users to leave. So they kept it proprietary. For way too long. Now they no longer have a dominant smartphone franchise or a dominant mobile messenger franchise.
You cannot fight innovation and opening markets. You have to go with the flow and adapt to the new reality.
I sat next to Jim Cramer last night at a dinner put on by some mutual friends. I hadn't seen Jim in a while so it was a great opportunity to take a trip down memory lane. In 1996 or early 1997, my prior firm Flatiron Partners led the first round of outside financing for TheStreet.com. I joined the board and eventually became Chairman before stepping down a decade ago.
When I first met Jim, he was running a hedge fund and blasting posts from his trading desk. This was 1996 and what he was doing was unprecedented. He was publishing in real time his thoughts on what was going on in the markets. On some days, Jim would post three or four dozen times.
As Jim and I reminisced about those days last night, I said to him "you were tweeting and blogging a decade before anyone else was doing that." He nodded, "yeah, that is what I was doing".
But we didn't know that. The money our firm invested went to hiring a team of journalists and we saw ourselves as the Wall Street Journal of the web. That was a mistake. The Wall Street Journal is the Wall Street Journal of the web. What Jim was doing was something way more native, way more powerful, and way more important. But we missed it.
TheStreet.com has gone on to build a niche financial publishing business that is a solid and profitable company. But it could have been the Twitter and Blogger of Wall Street. That's what it was at the start. But we didn't know what we had.
Ron Lieber has a column in today's New York Times called "A Financial Plan For The Truly Fed Up" where he lists some alternatives to investing your savings with the banks and brokerages that make up Wall Street.
His roadmap is basically what the Gotham Gal and I have been doing since the aftermath of the financial market meltdown in 2008. We invested pretty heavily in the stock market as the market was melting down in 2008 and I blogged actively about that here at AVC. But we took our gains early, in the first half of 2009, and then have more or less stayed out of the stock and bond markets since then (we do use our portfolio company Covestor's service).
We are in cash, real estate, venture capital, and private investments centered around our neighborhood and city (retail, restaurants, etc). Other than cash, we are invested in things we can touch and/or impact and understand.
As Ron talks about at the start of his piece, the never ending blowups on wall street are eroding confidence in that system. It certainly has eroded our confidence in that system. So we are staying out of it for the most part.
We do have our cash at a large money center bank. Ron advises credit unions instead. We haven't made that move and I am not sure we will.
Ron also advises people to check out peer to peer lending markets and mentions our portfolio company Lending Club. I was very happy to see that Ron has come around on peer to peer lending. Our firm is a big fan of these markets, having invested in two of them and looking at others.
And he describes a movement he calls Slow Money described in this way:
“Let’s just take some of our money and invest it near where we live in things we understand, starting with food,” as the movement’s founder, Woody Tasch, puts it. He describes returns as being in the “lowish single digits,” ranging from roughly 3 percent to a few percentage points higher.
The Gotham Gal and I are big fans of this approach. We have invested in a number of busineses in our neighborhood and city with expectations properly set for the occasional loss and in general low returns on the portfolio. But we are helping folks start their own businesses and create establishments we can use and that we want to see in our neighborhood. It feels good and I think it will turn out to be as good an investment as cash in the bank. At least I hope so.
As one system seems to be failing on a regular basis, it makes sense that there are new systems that operate differently that are emerging. We are seeking to invest in the ones that can scale at USV and the Gotham Gal and I are also looking to support these efforts in our personal investing. I am optimistic about this emerging movement and I am pleased to see mainstream media starting to talk about it.
A few months I threw a public hissy fit and declared on this blog that Yahoo is dead to me. And they were.
But in four months since I wrote that post, they did some good things.
1) they asked the CEO who led them down the patent troll route to leave the company
2) they invited some smart shareholder activists on the Board
3) they settled with Facebook and abandoned the patent troll route
4) and yesterday they selected Marissa Mayer as their new CEO
That's a string of good decisions culiminating in the wooing of Marissa. As Marc Andreessen said in this interview yesterday, "I didn't think they could get someone like Marissa".
The Yahoo! board went out and got Marissa to lead the company. And they kept their mouths shut in the process and the news surprised everyone. That's how you run a company, a board, and a process. Well done.
It feels like a new leaf has been turned. Marissa has a tough job turning around a company that has had failed leadership forever. I have not worked closely with Marissa but I have seen her up close. She is serious, intense, crisp, data driven, and opinionated. When I think of Marissa, I think of this Jim Barksdale quote:
"If we have data, let’s look at data. If all we have are opinions, let’s go with mine."
That approach should serve her well. I wish her and Yahoo! luck and I am rooting for them.
I don't disagree with PG when he says that Facebook's IPO performance (or lack thereof) has the potential to impact valuations in startup land. I think it will be particularly impactful on the late stage and secondary markets where most of the IPO valuation speculation is happening.
But let's put Facebook's current valuation in perspective. At the closing price of $26.90, Facebook commands a valuation of $57.5bn (according to Google Finance). Facebook had around $4bn of cash prior to going public and raised about $10bn so let's assume they have $14bn in cash on the books. That means Facebook has an enterprise value of roughly $43bn.
In its last quarter Facebook had $1bn of revenue and 40% pre-tax operating margins. If we annualize those numbers, that would be $4bn of annual revenue and $1.6bn of annual pre-tax operating margins. Let's use pre-tax operating margins as a proxy for EBITDA, because this whole post is back of envelope quality analysis and please take it for what it is.
That means that Facebook's enterprise value is greater than 10x current revenue run rate and greater than 25x EBITDA. These are big multiples folks. I am happy to take those numbers for any company out there.
Clearly Facebook is a premium company and commands a premium valuation and entrepreneurs should not expect to get 10x revenues and 25x EBITDA for their companies in a sale or an IPO. But even at half those numbers there are fantastic returns for investors and entreprenuers to be had.
If speculators are disappointed with the performance of the Facebook IPO it is because they had ridiculous expectations of what rational investors would pay. The market has put a premium valuation on a great company and we should be happy about all of that. I certainly am.
I guess this will be online learning weekend. Yesterday I talked about MBA Mondays Live and the fact that it will be available via livestream and via archive.
Today, I'd like to tell you about an online conference being put on by our portfolio company Covestor. It is called the Next Invest Conference and it takes place this tuesday and wednesday (3/20 and 3/21). The conference partners include Motley Fool, Stocktwits, Seeking Alpha, Benzinga, TedX Wall Street and many of the biggest names in online investing.
Best of all, it is free to attend. If you are into online investing, either personally or via your startup, you should check this conference out. Details are here.
For those who won't take the time to read it end to end, I'll summarize it.
Many high growth companies can be profitable. They have enough revenue to cover their essential costs and could easily decide to show a profitable income statement. But they don't make that choice. Instead they invest heavily in the business with the expectations that those investments will produce more revenue (by hiring salespeople), or additional products (by hiring engineers and product managers), or additional geographies (by hiring an international team), or any number of other value enhancing aspects of the business. The result of that decision is that the business loses money or simply breaks even (I prefer the latter approach).
There was a discussion of profits (or the lack of them) in the comments to the IPO Market blog post I wrote last week. A number of commenters pointed out that many web companies lack profits. I don't think that is actually true (certainly not for many that have gone public), but it is true that most, if not all, web companies are not optimizing for profits this year or next year. They are optimizing for the ultimate size of their businesss and the total amount of cash flow they can ultimately expect to generate when the business gets to maturity.
This is tricky stuff. If you are going to take all of your potential profits and reinvest them in the businesss in search of higher growth and greater profits in the future, you had better be right about those investments. And it is often hard for investors to see how those investments are going to pay off, so at times you can be penalized for making those choices. Right now the public markets seem to be paying companies more for long term growth than for near term profits, so it seems that public market investors (and VCs) are aligned in this respect. But that is not always the case. Markets are fickle. But the best entrepreneurs are focused on the long term vision and will invest in their businesses without paying too much mind to what investors want at any point in time.
We have an IPO market for web companies again. I don't have all the names in front of me, but this year has brought IPOs for Pandora, LinkedIn, Groupon, Zynga, and TripAdvisor. These five companies are all trading for north of $1bn market cap. Pandora is at ~$1.5bn. LinkedIn is at ~$6bn. Groupon is at ~$15bn, Zynga is at ~$7bn, and TripAdvisor is at ~$3.5bn.
We can (and surely will in the comments) argue about these valuations. Some will say they are too high. Some will say they are too low. That's what makes a market. But in the aggregate, these valuations do not seem ridiculous to me. The public market investors are valuing these companies at prices that have some rationality to them.
What is possibly more interesting is that the public markets are valuing these companies at less than the late stage private market might value them at. Again, I don't have the data in front of me (I'm on vacation), but I believe that some of these companies had private financings at our above these current market caps.
The past decade (post Internet bubble, post Sarbox) brought a new normal to the late stage venture capital market. Companies are staying private longer. They are doing multiple rounds of growth financing privately. And they are doing multiple rounds of secondary liquidity for the founders, angels, and early investors. Mike Moritz calls these financings the "new IPOs".
This "new normal" is allowing these companies to stay private and develop into real businesses. With a lot of revenue. The five companies I mentioned at the top of this post will have close to $5bn in revenue this year. The company with the least amount of revenue is Pandora which, as of its last quarterly report, is operating at a $300mm annual revenue run rate.
These companies also have built sophisticated management teams that are highly capable of managing a business to meet the expectations of public market investors. They have strong operating executives, strong financial executives, and strong product and engineering leadership. They should be well run public companies.
The five companies I mentioned at the top of this post are carrying a combined market cap of $33bn. So they trade at an average of 6.6x revenues. And that is not including the cash they have on their balance sheets. I am not going to do the math, but I would bet if you back out the excess cash, you might see revenue multiples of less than 6x for this cohort. These are full valuations in a historical context, but these are not crazy valuations. If these companies can continue to grow at the rates they are currently growing, and if they can generate significant cash flow from their businesses (some of these companies already are doing that), then they should be more valuable in the next couple years, generating gains for the public market investors who hold the stock.
When Zynga was pricing its offering last week and getting ready to start trading its stock, I got a note from a friend who said "let's hope for a '99 style first day pop." I responded that was the last thing I wanted to see. And thankfully we did not get that.
It is not healthy for companies to trade at prices well beyond what they are worth. It puts incredible pressure on the team to deliver results that can't be delivered. And when the stock inevitably comes back to reality, the team feels like they somehow failed. Morale is impacted. The whole things is madness. And who benefits from that first day pop? Only the best customers of the banks who led the offerings. Why should they get a windfall when they did nothing to build the company and when they will be out of the stock so fast it will make your head spin?
The IPO market for web companies we have right now is rationale. We can argue whether it is pricing thse offerings correctly. But it feels about right to me. I believe we will see a bunch of IPOs next year, led by Facebook, which is the poster child of this whole "stay private longer" movement. If we as an industry can be patient, keep our companies private longer until they are truly IPO ready, then we should have a sustainable IPO market. That's where we seem to be headed. Let's not get greedy and screw it up.
Disclosure: USV has a significant holding in Zynga therefore I am long that stock through my interest in USV.