A few IPOs make like pears and all of a sudden the VCs are getting wonky again.
If you’ve been on Twitter the past few days and take part in the venture capital parts of the social media service, you’ll have seen a link or two from Fred Wilson (Union Square Ventures) discussing revenue quality. What he’s talking about, and why now, are good things to understand if you want to be current with the world of private companies.
Let’s take a minute and understand what Wilson is discussing. He’s right as well, as we’ll see. So listen up, this stuff matters if you are in the startup game.
Quick Digression On Revenue
Revenue comes in varying levels of quality. That’s important to understand. It’s also a fact that becomes obscured when discussing startups, a market in which revenue growth is far more discussed (and championed!) than revenue quality. This makes some sense, as the former is easy to understand, the latter more tricky to grok, and growth is something inherently easier to calculate and brag about than revenue quality.
Let’s see what Wilson wrote. Here’s the key section from his first post on the subject of revenue (condensed, formatted):
A narrative in the late stage private markets [is] that as software is eating the world, every company should be valued as a software company at 10x revenues or more. And that narrative is now falling apart.
If the product is software and thus can produce software gross margins (75% or greater), then it should be valued as a software company. If the product is something else and cannot produce software gross margins then it needs to be valued like other similar businesses with similar margins.
If that doesn’t make sense, let me help. Wilson, a venture capitalist with a pretty good track record and, more to the point for us, a propensity for writing correct things about his industry on the Internet, is arguing that revenue quality is a key factor to the value of your business.
That may sound incredibly obvious, but often firms are valued more on revenue scale (current top line) and revenue growth (pace of current top-line expansion), than what sort of gross margins that revenue generates. In case some of this isn’t making sense, gross margin is the portion of revenue that is left over after the revenue pays for itself.
The higher gross margin a company’s revenue is, the more that revenue is worth.
That is why software companies (returning to Wilson’s first paragraph) are often awarded high revenue multiples by public markets, while other industries are valued at lower revenue multiples.
Wilson’s post hit a nerve. Why? Because a number of recent IPOs that were expected to be huge successes wound up flopping (Lyft, SmileDirectClub, Peloton), pricing lower than expected (Uber) or not happening at all (WeWork). In each case, Wilson highlighted, the struggling companies had margins lower than those usually generated by software companies.
And the public markets weren’t buying at the prices that private investors had hoped for. Wilson returned the next day to add to his point, writing about the connection between valuations and margins:
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.
Polygamy is banned in the United States, but I’d marry those two paragraphs if I could.
There should be a direct correlation between revenue quality, and a company’s constituent revenue multiple. And, the idea that a result further down in an income statement is more important than one higher up is silly (more on income statements here).
More Market Examples
Shares in Peloton, a recent IPO, fell over 10 percent today to $22.51 per share. Peloton’s IPO price was $29 per share, valuing the firm at $8.1 billion. Today it’s worth $6.25 billion. At its IPO price, Peloton was trading for 8.8x trailing revenues (its fiscal year ended June 30, 2019). Today that same revenue multiple compressed to 6.8x.
Why? Because the company’s blended gross margins are just over 40 percent. That’s miles from a software company’s 70 to 85 percent gross margin range.
Notably, both Peloton’s original IPO revenue multiple and its current revenue multiple are higher than the range that Wilson doodled out for SaaS companies (i.e. companies with better gross margins) years ago. So it’s not like Peloton isn’t well-valued today; it is, and you could argue that even its new revenue multiple is rich for its margins.
But what about growth? That impacts revenue multiples as well, right? Yep. Indeed they do! You can think about a company’s revenue multiple in the following way:
Correct revenue multiple = (revenue growth + revenue quality + operating margins)
How much weight to give to each is different for each company; a firm with faster revenue growth can get away with a lower level of revenue quality (to some degree, for a short period of time) and secure a similar, correct revenue multiple as a company that had higher revenue quality and lower growth. A firm with high revenue growth and good revenue quality could still be dragged down (in a multiple sense) if its cost structure made its operating margins insidiously negative, and so forth.
All Wilson is arguing is that the middle term in our little faux equation should be taken into account by private investors, because public investors are going to pay it mind. It’s the opposite of an intemperate point. It just seems odd counter-narrative as there are so many unicorns out today that like to talk growth, but not margins.
We need to wrap as we’re over 1,000 words which means that I am in danger of talking to myself. To sum, then, the recent IPO issues we’ve seen from unprofitable companies with slimmer-than-software margins and slowing growth, or expensive growth, should not surprise.
They should, instead, be reminders that the basic fundamentals of business adapt to new models over time. But they never go away.