Reckoning Reflections
The post I wrote yesterday generated a lot of discussion. I followed it on Twitter and engaged with much of it there.
One of the best things about writing is all of the feedback you get. It helps to sharpen your arguments and also makes you rethink them too.
Here are some of the takeaways:
- Some readers interpreted the post as arguing for only investing in high gross margin businesses. I don’t believe that is the right takeaway. The better takeaway is that high margin businesses are often less dependent on capital markets because they can internally generate cash more easily. That is not the case with low margin businesses. So how you value and how you finance low margin businesses becomes very important. They can’t be valued too highly or you risk a financing crisis.
- Bill Gurley tweeted his blog post from 2011 that “all revenue is not created equal.” That is a great way of saying what I was trying to say.
- Apple and Amazon were put forth as great lower margin businesses. Amazon is a roughly 25% gross margin business and trades at a little over 3x revenues. Apple is a roughly 40% gross margin business and trades closer to 4x revenues. I think that emphasizes the point that revenue multiples ought to reflect gross margins.
- Many people argued that operating margins and growth rates should be the two numbers that matter most in valuing a business. I totally agree. But it is hard to have 40% operating margins if you have 40% gross margins. The truth is that operating margins will be highly dependent on gross margins. But there will be edge cases where that is less true.
- I got a lot of people saying “isn’t this totally obvious?”. To which I say “it should be but clearly it is not.”
The most important takeaway for me is that the public markets are showing us in tech/startup/VC land that the economic fundamentals of a business, even those that are driving massive disruption in their markets, really does matter and that we need to pay attention to them when we finance these companies.
Comments (Archived):
But is disruption deterministic?
Contribution margin is a leading indicator for gross margin is a leading indicator for net margin.I’d imagine when you’re investing before a business and it’s P&L matures, you’re looking for those leading indicators or even trend lines that show expansion of those leading indicators. (Or when very early in a business, at least a narrative as to how there will be expansion of those indicators.)
exactly
Many will get lost in the details of the last two posts, but my favorite part is the humility. VC has been the favorite child for some time now, and VCs have learned some bad lessons over the last cycle enabled by LPs, the press etc. Here’s one who’s still trying to learn the right lessons after a lifetime of achievement. Love it.
Isn’t much of this a simple by-product of private companies staying private for longer and raising money at more obscene private valuations? (You have written about this before.) In order for the IPO event to make money, by definition the thing will be over priced. Of course there will be reckoning when operational reality is exposed.
But doesn’t that often turn into a form of “pump and dump” (post lock-up)?
Of course. If the IPO wasn’t a rigged game for the private investors, there would be no need for a “lock up” period would there?
Very true. Lock ups vary between 3-6 months. Companies can still prob play it loose for a quarter or two w/ creative accounting, even w/ audits.
Look at the macro environment. The cost for capital has never been cheaper. Hence, the cost to stay private vs the cost to go public weighs in favor of staying private. In the last 20 years, the number of public companies is about 50% less. Part of that is cost of capital, part of it is rules/regulations/disclosure. I don’t blame companies for staying private longer, they are responding to incentives. I do blame boards of directors for not ensuring that the structure of the company mirrors standard public company structure
I LOL everytime I see Fred write “low margin” followed by 30%-40% GPM. You guys live on a crazy planet.
Re: “The most important takeaway for me is that the public markets are showing us in tech/startup/VC land that the economic fundamentals of a business, even those that are driving massive disruption in their markets, really does matter and that we need to pay attention to them when we finance these companies.”This is where I get lost with crypto-“currency” investments. Bitcoin et al have been looking for the killer app for (more than?) a decade now, a solution looking for a problem: isn’t that the core issue? The problems it seems supporters/investors believe they solve are societal issues, but that isn’t done through a platform – it’s done by rules set by a stable democratic system.Re: “One of the best things about writing is all of the feedback you get. It helps to sharpen your arguments and also makes you rethink them too.”Assuming you actually engage to write out and reply – if not, why not, and is it because being stuck – and if that’s the case, why is that?it’s also interesting the choice of responding to short-form arguments vs. long-form, which presumably the writer at minimum has more thoroughly thought through their argument(s), and more likely are better at articulating it to argue clear counterpoint(s).
Speculation and trying to envision the future…
Fair enough – however they’re not envisioning very far or very broadly then, along with conflating societal rules with technology being a fundamental error in thinking as part of their speculation; this conflation is certainly a large part – perhaps the largest, in competition with greed-profit potential – of the underlying reasons for the hype train though – “it’ll solve ‘all’ societal problems if we just get everyone on Bitcoin!”
I don’t know about your last point – “it should be but clearly it is not”.I don’t think this is un-obvious at all to any of the involved players. I used a term here a few months back – “Wilful Blindness” and used that term deliberately….that is the best description I can think of what is happening, whether on private business valuations or in the crypto space.You linked to Bill Gurley’s post from 2011. Here is a link to Bill Gurley’s post from three years later where he rebutted Aswath Damodaran’s argument on Uber’s valuation.http://abovethecrowd.com/20…Gurley focuses on a couple of things – (1) The TAM and (2) – Achievable Market Share of the TAM to size Uber’s opportunity.But is there a discussion of Uber’s profitability in this post ?Here is what happened since that 2014 post on Uber’s valuation.1. Uber has demonstrated increasing losses as its business grows, and there is no line of sight to show how it can be profitable anytime in the near future.Meanwhile…2. Benchmark has had one of the all-time great VC exits in Uber.Regarding the gross margin, you are right of course that you don’t get 40% operating margin from 40% gross margin.The point there was simple and one I used with my team in the past, viz – You can’t take gross margin% to the bank.If you have a healthy gross margin with a low operating margin business, you have a lot of opex that makes you vulnerable.Especially, if you are using a high opex structure to support a high gross margin.So, the Bridge from gross margin to operating margin, and net mgn matters, that’s all.
If you have a healthy gross margin with a low operating margin business, you have a lot of opex that makes you vulnerable.Also a good indicator that a company has putting a lot of time and effort into financial /management engineering over core innovation and product engineering. IBM is a prime example — they kept eroding their core productization skills over decades …and eventually ended up paying $$$$$ and praying that RedHat will make up for the 15-20 years of atrophy to the innovation and product growth engine. Of course this is not always a bad thing – depends on the industry one applies it to.
High gross margin and high growth holds a lot of potential because once the fixed cost is covered, every additional customer translates directly to profits.The real questions to ask are:1. At What point is fixed cost covered and what does it take to get there?2. How is CAC calculated? How is it allocated to COGS?3. How much of the growth is organic vs paid and how much is it net new vs existing and how much is it compensating for churn?If the gross margin is calculated correctly, includes the right CAC, and is still high (>70%) and growth is high, you can usually see a clear way to operating profitability assuming you can make the profit to growth trade offs.But if companies obfuscate these numbers ( as they increasingly do) it is hard to know which is what. Real estate companies spinning themselves up as tech and software companies is what the state of the market is. And most people bought into it until the shit hit the fan.
A former entrepreneur said “Software is eating the world”.A bunch of folks said – Hey, we got software too. We can play this game too.I am not sure most people bought into it, but they played the game anyway.Smart people who wrote smart posts about quality of revenue talked about market size instead when it suited to talk about that.Remember Uber wanted to get to the market at a $120 billion valuation earlier this year. Its all good fun to watch :).https://www.bloomberg.com/n…
Thanks Fred, I think this is a problem that shows up in market sizing a lot in pitch decks. Time and again I see $ market size used as a proxy for the size of an opportunity in a market and its really lazy analysis. The size of an opportunity is a guess at the free cashflow the market leader can extract from that market at scale not just the total value of products sold.I wrote a bit more on that here a few years ago.. https://medium.com/mmc-writ…
A ‘British cuisine restaurant in Palo Alto’ has to be a runaway success. The restaurant market is HUGE, JUST HUGE. 021.
Well stated.
When looking at mature business (including those like Apple and Amazon), the use of “multiple of revenue” is no longer the best, or even a very good way to calculate value. All things being equal, a company with $1 billion dollars in earnings and the same projected future earnings growth is worth the same amount whether its revenue is $5 billion or $25 billion.
Yes indeed. Oversimple rules of thumb on multiples is a big inefficiency. We can all take advantage of it by really exploring how market expectations may change for all the aspects of outlook–market size, odds of an edge in that market, margins, capex and working cap needs, etc–and use our new SaaS to quantify how that may change multiples, as just happened for WeWork. Here’s how: https://lisa-dolan-ebpl.squ…
Fred,Some additional observations:High gross margin businesses are attractive but opX is important – marketing costs come to mind in order to sell the high-margin stuff.While high op margins are important as is growth, two additional factors are important – the sustainability of margins and growth and return on invested capital.Finally, the quote “The public markets are a lot different than the private markets” is so true. Consider for a moment those companies that do not have a ramp to the public markets or for that matter to PE capital. Access to private capital markets will be much more limited and all the more reason for strategies that capture value, sustain it and provide for a transition.
This is a beautiful set of important points and the richness of your posts is what makes me return to this blog so frequently.Coming back. I think the public markets are just saying – “You better give us a business which has worked out its economics. We do not understand your world of ‘scale at any costs'”.Perhaps, private investors should take their own sweet time working around with the managements on the businesses before rushing for a public offer. This is also a result of the times we live in – where barriers to start a business are lowest ever, and barriers (read years) to turn profitable are the highest.