Posts from VC & Technology

Not All Gross Margin Is The Same

I wrote a blog post in September of last year arguing that gross margins and operating margins really matter when valuing companies. I argued that “software companies with software margins” are better businesses than tech companies that are not really software companies but a tech-enabled version of some other business.

But gross margins, in particular, can be tricky to compare. In some cases, a software business is in the middle of the revenue flow, takes the revenue, and then passes on a lot of it, and is left with what looks like a low margin, but is in fact a high margin.

An example of that is the Dutch payment processing company Adyen. Here is a screenshot of a part of Adyen’s income statement from Yahoo Finance:

So Adyen operated in the last twelve months with an 18.7% gross margin. Many would think that was a “very low margin business.” But the truth is Adyen is simply passing through that $2.1bn of revenue to financial institutions in the form of interchange and other fees. They do very little with that money.

Let’s compare that with the big retailer Macy’s. Here is a screenshot of a part of Macy’s income statement from Yahoo Finance:

So Macy’s operated at a 40.1% gross margin over the last twelve months, more than double what Adyen operated at.

That $15bn cost of revenue on Macy’s Income Statement is the cost of purchasing everything you might find in a Macy’s store, the inventory costs associated with that, and the cost and effort of displaying all of that inventory in the stores.

So while it is the case that Macy’s has more than double the gross margin of Adyen, I believe Adyen has a much more attractive business from a margin perspective than Macy’s.

That is because Macy’s expends enormous amounts of working capital and operating expense and effort in its $15bn cost of revenue where Adyen expends very little working capital and operating expense and effort in its $2.1bn cost of revenue.

The trick, I think, is to wrap your head around the cost of revenue or cost of goods sold line item in the income statement and think about what is going on there. If it is very little to no effort, and largely just an accounting entry, then you may have a “low margin business” that is actually a high margin business. On the other hand, if it is a lot of work and capital investment to produce those margins, well then you have what you have and that is often a low margin business.

#stocks#VC & Technology

The AVC Cap Table Template

I woke up to this tweet this morning:

I went to that blog post and clicked on the link and sure enough someone had swapped out my cap table template from 2011 with their own cap table. I am not entirely sure how that happened and for how long that has been the case, but I was not going to let that stand.

So I went to my google drive and searched and found the cap table that I had built for that post back in 2011, made a copy, made it public on the web but view only, and fixed the link.

Phew.

If you want to see a cap table and waterfall template in the style that I have become accustomed to over the years, here it is. Hopefully, nobody will hack it again. I will be super careful not to permission anyone to have edit capabilities (which is what I think I may have done accidentally).

#entrepreneurship#hacking education#VC & Technology

Still Open For Business

I wrote a blog post on March 12th called Open For Business and thought I would return to the topic.

If you search for “vc open for business” on Twitter, you will see almost universal scorn for the idea that VCs are open for business right now.

But our experience doesn’t match that scorn. Since writing that post, we have watched a bunch of our portfolio companies close financings, some on the same terms as provided before the pandemic and some on slightly adjusted terms. We have mostly seen VC firms live up to the commitments they made pre-pandemic and in the cases where terms changed, it has not been not gratuitous.

On our side, we have signed three or four term sheets since I wrote that post, closed on a few of them already, are currently engaged in several processes.

We have had to step up to the plate in a few situations and provide interim financing, and we are certainly working very closely with our existing portfolio companies during this challenging time for many of them. But our focus has not moved dramatically away from looking at and investing in new companies and we don’t see a dramatic change in that regard among many of our peers in the venture community.

David Kelnar sent me a blog post he wrote addressing some of these trends this morning and I saw this chart in it.

I don’t think new investment activity has shrunk from 40% of the industry’s time to just above 20%. From what I see, it has shrunk a bit, but not cut in half.

There certainly are funds who are focused on sectors that have taken a bath in the pandemic and in those cases it is natural and appropriate for those funds to be more focused on their portfolios. But I don’t see that across the entire VC landscape.

It is always easy to talk yourself into the idea that the door is currently shut for you. But before you do that, I suggest you knock on it. It may in fact be open.

#VC & Technology

Startups and SBA Loans

Last week Congress passed the CARES Act which provides a vast array of financial relief provisions to people and businesses in the US.

Congress is providing relief to small businesses via a forgivable loan program administered by the Small Business Administration (SBA). The SBA has long been in the business of making small business loans, but the loans under the CARE Act are very different. Here are the primary provisions of these CARE Act loans (cut and paste courtesy of my friends at KE Law):

  • Loan Program Eligibility.  Any business concern (including franchises) as well as non-for-profit organizations, with no more than 500 employees are eligible to receive a single loan under this Act.  The maximum amount of the loan is the lesser of (1) $10M, and (2) 2.5 times the monthly payroll costs determined over a specific testing period.  No personal guarantees or collateral will be required for loan eligibility under this Act.
  • Loan Proceeds Usage.  Loan proceeds can be used for payroll and other compensation costs, health benefits, insurance premiums, mortgage interest, rent, utilities and interest on other outstanding debt.
  • Loan Forgiveness.  Perhaps the most important element of the Loan Program is its loan forgiveness element.  Pursuant to the Act, borrowers under this Act will be forgiven a specific sum equal to the sum of (1) certain payroll costs, (2) mortgage interest payments, (3) rent, and (4) utility payments that were incurred during an 8-week period beginning on the loan borrowing date.
  • Forgiveness Penalties.  Given the intent of the Act to save American jobs and salaries, the amount of the foregoing loan forgiveness will be reduced by certain factors.  These factors include a reduction in the average number of full-time employees as well as substantially reduction (beyond 25%) in employees’ salaries.
  • Other Terms.  The maximum loan term under the Act will be 10 years (for amounts that were borrowed that are not subject to loan forgiveness), and the maximum interest rate is 4%.  The first payment on any loan under this Act will be for at least six (6) months, but not longer than a year.
  • How to Apply.  Eligible business should seek competent counsel immediately to work on the application, as the loans will begin to be available likely by the middle of April 2020.  Required information for the application will include payroll documentation, tax filings, unemployment insurance filings, proof of payment of payroll taxes, mortgage applications and the like.

So this sounds great for startups, right?

Well not so fast.

The law as written requires “affiliates” to aggregate their employees into a total and that must be below the 500 employee threshold in order to qualify for these loans. And most of the lawyers that I have talked to over the last few days read the affiliate provision in the CARES Act such that any venture capital-backed startup would need to affiliate with all of the other startups that are backed by the same venture capital firm or other kind of investor.

There are many folks in startup land (lawyers, investors, CEOs, lobbyists, etc) who are working with Congress and the SBA to address this issue. Many of the largest employers in small businesses in the US are backed at some level by investors who back many startups, including angels, seed funds, VC firms, and corporate investors.

From what I can tell, based on some work but not exhaustive work, this was not intentional on the part of Congress and there seems to be a willingness to figure this out.

If you are planning on accessing these loans, I recommend talking to a lawyer who is well versed in venture capital and startup law and make sure you are looking carefully at the affiliate provision. And if you have a relationship with your elected officials in Washington, you might want to reach out to them and explain that the Cares Act affiliate rules are problematic.

It is my hope that this “bug” in the law will get fixed over the next week or so. It may be possible for the SBA to address this issue without the need for any more work by Congress and that would be ideal in my view.

#VC & Technology

New Faces At USV

We onboarded our new analyst team over the last few weeks at USV.

As is our tradition, they have each written a “hello world” blog post on usv.com introducing themselves.

They are:

David

Hannah

Hanel

I can’t imagine how hard and surreal it must be to join a new firm just as we are all starting to work from home. So they are going to be challenged getting out of the gate more than prior analyst teams, but I am confident that each of them will rise to the challenge and we are learning some new tricks on how to remotely onboard too.

I hope that many of you will get the chance to meet or engage with them. They are a great group of analysts and I am excited to work with them.

#VC & Technology

Open For Business

I got an email from a well known journalist who covers the VC sector today. He was asking a bunch of VCs a few questions that basically can be summed up “are you open for business?”

I answered him with these facts:

1/ We are working on two term sheets for new investments by USV this week and hope to sign them by end of this week

2/ We are closing on several existing term sheets as well

3/ At least one of our portfolio companies received a term sheet this week and hopes to sign it shortly

4/ We have seen a few deals that were in negotiations get put on hold in our portfolio.

It will be interesting to see where his informal survey of the VC business shakes out.

But from where I’m sitting it seems that much of the VC industry is still open for business and USV certainly is.

#VC & Technology

The Venture Capital Math Problem Revisited (aka How Could You Be So Wrong?)

Back in 2009, I wrote a post called The Venture Capital Math Problem.

I was reminded of it yesterday when I saw this tweet:

In that post, I argued that the venture capital business could not sustain more than $20bn a year of new capital coming into it and continue to produce good returns to the investors in VC funds.

The venture capital business has been raising north of $50bn per year for much of the last decade and so far, the returns continue to look quite good.

So what did I get wrong in my attempt to solve the venture capital math problem?

I think it set the problem up correctly but I got one assumption very wrong and it was this:

And I assume that the biggest exit each year is $5bn. Yes, it is true that some venture investments turn into businesses like Apple, Google, Microsoft that are worth $100bn and more. But it is also true that most VCs are long gone from those deals before the valuations get to that level. So for the sake of solving this problem, I’d assume the largest exit each year is $5bn and then you have a power law distribution of another 999 deals.

……..

I’ll assume that the biggest deal, $5bn, represents 5% of the total value of all 1000 exits and that the total value of all exits is $100bn per year.

That was off by maybe an order of magnitude or more. Uber IPO’d at $70bn and still trades at north of $50bn. Zoom is now trading at $32bn. Out of the USV portfolio in the last decade we have Twitter at $26bn, Twilio at $16bn, and MongoDB at almost $10bn and a number of high quality public companies trading in the single digit billions.

I suspect that last paragraph that I quoted should read “the biggest deal, $50-100bn, represents 5% of the total value of all exits (likely north of 2000, possibly a lot more) and the total value of all exits is $1-2 trillion per year”

By that math, keeping all other assumptions, formulas, and math the same, the max that can be invested in VC is maybe as much as $100bn per year and we are still well below that level based on the numbers I am seeing.

So what did I learn from this mistake?

I learned that you can’t assume that the past is a predictor of the future. And I learned that it is helpful to ask yourself “what could go right?” instead of “what could go wrong?”

It is also true that the last decade has been one of incredibly low interest rates/cost of capital, and conversely very high PE and revenue multiples on growth stocks. And we have seen companies like Uber, Facebook, etc stay private much longer so the VCs have exited at much higher valuations than was once the case.

We cannot assume that will continue either and it may well be true that the $50bn-$100bn that is going into the venture capital business right now will not get the same returns that the $20bn that was going into the venture capital business in 2009 has gotten.

But regardless, I was dead wrong in that post back in 2009 and I have learned from it. As I have aged, I tend to underwrite to the upside not the downside. That has not been my nature but I have learned that it works better, particularly in the VC business.

Finally, I do not regret writing that post one bit. As I replied to Ben’s tweet when I saw it:

#economics#life lessons#VC & Technology

Being In The Flow

I have been investing in developer tools since the earliest days of my VC career. The first investment I led in the late 80s was a financing that provided the funds to acquire a programming editor called Brief. It was a text-based editor for PCs. That investment worked out but we didn’t make a lot of money on it. Brief was eclipsed by other better editors.

But that did not cool my interest in developer tools. I have always believed that supporting the people who build software is a great business and it is.

At USV, we have made developer tools a key area of investment and some of our most well-known successes like MongoDB, Twilio, and Stripe are developer tools.

But as I learned from my Brief experience, all developer tools are not equal in terms of creating business value.

Last week, I was discussing this in a texting session with my partner Nick. And he observed that the tools that have produced the most value for the founders and investors, including USV, are the tools that are “in the flow” and not on the side.

That was quite an “aha moment” for me as it clarified something that I have longed felt intuitively but could not articulate. Now I can.

I think this is true for many other areas of software. If you build software that sits in the flow of something important (mission critical, recurring, etc) then it will increase in value over time, and sustain its value, much more significantly than something that “sits on the side.”

So when thinking about what to build or what to invest in (it is the same thing, just depends on if you are investing time or money), try to be in the flow.

#entrepreneurship#VC & Technology

Entertainment vs Utility

The news this week that HQ Trivia has finally called it quits reminded me of this post I wrote back in 2012 about the difference in sustainability (and thus value) between entertainment and utility apps.

What is interesting to me is if you could use a social app or an entertainment app to get to another place (distribution, platform, blockchain, financial services, etc, etc). That feels like a much more sustainable place to be.

But very few social apps and games have been able to do that. And the result has been a predictable boom/bust cycle that has not produced a lot of value for founders or investors.

#entrepreneurship#VC & Technology

Tech in 2020: Standing On The Shoulders Of Giants

Our friend Benedict Evans posted his annual “macro trends” deck this weekend.

You can also download the PDF here.

In the deck, Benedict poses the question “what is the next S-Curve?”

And while he doesn’t exactly answer that question, these two slides are revealing:

There is a lot more in the deck, particularly around regulatory issues in tech and it is well worth a quick skim this morning.

#mobile#regulation 2.0#VC & Technology#Web/Tech