The Profit Imperative

With the markets crashing around us and the sky once again falling I thought it was time to revisit a few fundamentals and perhaps more importantly share some what what we’re now seeing in the private funding markets.  

Growing Profitably. Let’s start with what I labeled the Growth Imperative a few months ago in a post, where I pointed out 1) that investors were (over) valuing growth and 2) that when this changed it was going to change quickly (and in a separate post said: “when the growth imperative shifts to a profit focus, companies with high burn and weak operating metrics can get stuck in the lurch.”).  It always amazes me how quickly the markets can shift and how rapidly investors change their mind set. But they do, and they are right now. We’re seeing lots of market data points that suggest that the private markets have shifted dramatically to a Profit Imperative, overnight eschewing high growth/high burn with no line of site to profitability and favoring companies that are growing more slowly but doing so profitability or with a clear path to profitability. There’s an increased focus on key metrics – especially those core metrics that drive the spend/growth curve such as LTV/CAC and months to pay back CAC. 

Valuations are Down. As the public markets have fallen, so have the private markets. No surprise here, but the drop has been rapid and it’s been dramatic. In the public markets public SaaS valuations (EV/Revenue) are down 33% since January and 66% since their high in January 2014. This is true across other markets and has quickly worked its way down into the private markets (btw, the current EV/Rev multiple for public SaaS is 3.2x). Different sectors of the market have seen varying levels of decline, but overall the private markets are off similarly to the public markets. I’d point out that this is especially true for companies in the Series B stage.

Flight to Quality. Just as we’ve seen this in the public markets (with Google, Facebook and a few other giants suffering stock losses much less than their smaller peers), the private markets are quickly differentiating true market leaders from the rest of the pack. And while there are plenty of markets that aren’t necessarily winner take all, investors aren’t buying the story for why a 2nd or 3rd player can break out.

Product vs. Company. There seems to be a growing realization – especially in the B2B SaaS market, but also across others – that many of the companies that have been funded and have seen reasonable growth are really products, not companies. And that at some point their growth will flatten out as their product saturates the market. I think this is coming through in subtle ways as investors evaluate companies (I’m not hearing people talk about it explicitly) but behind some of the comments is clearly this question and all companies that are in the market to raise capital should recognize this bias.

There’s no silver lining with which to end this post (other than that I personally think the markets – public and private – are overreacting; but that doesn’t mean they’ll necessarily correct back any time soon). Hopefully you took the opportunity in the past few quarters to shore up your balance sheet. If you didn’t it’s time to be careful. Plenty of companies will continue to get funding, but beware of the market dynamics that I describe above.

  • Chris

    Seth – As always, thanks for the insight.

    I asked for clarification on one of your previous posts and never got a response, but I’ll try again: what makes you think markets are overreacting? In the other post you claimed we weren’t in the midst of a bubble bursting, but I think it’s clear now the days of easy money (and sky-high valuations) are ending–and fast.

    I don’t have the private market visibility that you do, but if it’s anything like the public markets (and I suspect it’s worse), then there are some very worrying signs out there right now. I actually agree with most of the points you made in this article, but my conclusion is different. I think we have much further to fall.

    Anyway, I’m just curious to hear your reasoning for why you think markets have overreacted. I have a hard time envisioning any scenario that doesn’t equate to a painful correction over the next 12-18 months. I’ve been shorting tech companies that have IPOed in the last few years, and have profited phenomenally in the last two months. I just don’t see an end to this trend and still see at least another 50%+ fall ahead for public markets. I have to think that will have serious follow-on implications for private markets.

    A great article I read the other day outlining all the reasons why I think a massive correction is still on the horizon: http://www.bothsidesofthetable.com/2015/10/18/venture-outlook-2016/

    Hope I don’t sound too critical. I’m really just looking for some insight into your conclusion.

    • Hi Chris. Spent 45 minutes this morning writing up a detailed response, which Disqus apparently lost. I’ll try to recreate it when I have a few minutes later. Sorry about that!

      • Chris

        Seth – Thanks for the response. I’m seeing your reply so don’t spend any time on rewriting. I’ll write a reply when I have a minute later on.

        • I figured out how to recover it! Let me know your thoughts after you have a chance to dig through.

    • Not critical at all Chris. It’s a good question and I’m sorry I somehow missed it last time you asked about it.

      There are clearly headwinds in the markets – I’m not at all suggesting that there aren’t. And we may be in a period of strong negative pricing pressure in both the public and private markets. As you know, markets tend to perpetuate themselves and pendulum. This cycle of overreacting is how business and market cycles seem to work.

      There’s no functional definition of an asset “bubble” that people seem to agree on, but let’s at least agree that they’re caused by a fundamental imbalance between the actual “value” of an asset and the way the markets are pricing that asset. We saw this clearly in the housing market when the access to cheap capital created run-away housing prices that weren’t sustainable by any historical measure of actual underlying value. We’ve certainly seen this in the public and private markets as well (for example in the 2000 crash where truly unsustainable levels of funding were driving too many bad ideas into the market and the perception of market value and future growth and profit potential was completely out of balance with reality).

      I’d differentiate this from what we saw in 2008 in the private markets where prices (somewhat) contracted). The private markets in that case were reacting to the larger trends in the public markets (the US consumer was in a painful process of shedding debt and readjusting their balance sheets after the housing bubble broke) and to a supply and demand change in the availability of capital. That so many great companies were started in this period suggests that the venture capital markets over reacted to what was taking place in the public markets (and that’s just one measure of the over-reaction).

      When I look at the fundamental value of public comps, we’re already well below historical averages (and weren’t even at the top of those averages when the markets started correcting). When I see the drastic proclamations of arageddon I think they’re unjustified by the current actual market conditions. When I look at the US economic data I don’t see anything justifying the wide sell-off in the market. When I see companies announce 1-time tax hits and drop 40% of their value overnight, I see a market that’s overreacting.

      You bring up a good point about some of the data that Mark posted last week – which really goes to more to sentiment than to data (the rise of seed rounds is nothing like the overfunding of Series A and B that we saw in 99′ – and some might argue is good for the overall ecosystem as more ideas get enough legs to test whether they have merit and those that do go on to raise their A rounds). This is a bit of an oversimplification but to some extent we live in a bifurcated world. There’s a big difference in market behavior at the high end of the markets where there has been a “bubble” around so called unicorn companies who were chasing that billion dollar valuation. This led to aggressive valuations, to aggressive terms and to aggressive expectations on growth that I think are about to come home to roost in that market segment. But to be clear, I thought this long ago and well before the public markets started reacting. More on this last point perhaps in a full blog post.

      Would love your reaction to this.

      • Chris

        I think I understand your position a little better now. It sounds like our differing outlooks come, at least in part, from our different positions in the market–you’re involved in early stages of funding, whereas I’m only involved on the tail end in public markets. I think we both agree that valuations among unicorns needed a correction. When I said I anticipate more painful corrections, I was referring mostly to those companies.
        I should also clarify why I believe some tougher times are ahead for funding, and why I believe there’s more correction to come:
        1. Rising interest rates. When interest rates are zero, money is very easy to come by. As rates go up, people pull back on speculative investments as the risk/reward equation starts to change. I assume most everyone agrees on that point.
        2. Risk-off mentality. I always hate this term when I hear it on CNBC, but I think it applies here (and it plays into point #1). The rapid change in sentiment on fresh IPOs has been surprising, and the effects could be compounded when coupled with rising interest rates. We’ve had a great run, and people seem ready to take some money off the table. The 40% drops you mentioned, to me, are a sign that investors know they’ve been playing the “greater fool” game and were ready to sell.
        3. If public startups stop being the “it” investment to have, then suddenly all startup valuations get called into question. Part of the rationale on the way up has been that Company X has an EV/R (or P/S) of 10x, so Company Z should be valued accordingly. I would think that on the way down, the converse would apply. (I should mention I’m not a fan of benchmarking against assets in the same class because it causes exactly this valuation paradox)
        4. Unforeseen economic events on the horizon. We’ve had unusually smooth sailing for the last several years. Risks from China (a big unknown, might be nothing), bank exposure to oil debt, real estate correction, and so on all play into my 2nd point above.
        #1 and #2 seem to be inevitable, and I would assume their impact on the private startup world will be noticeable, with unknown severity. The question is how big of an impact. #3 and #4 would have more substantial impacts, in my opinion.
        I actually thought your point in the last paragraph was the most interesting: less crowded, and therefore lower valuated, seed rounds means more companies get funded, which means more ideas get tested, which means the ones that make it to IPO are going to be the most “battle tested” and proven. Great insight that I hadn’t considered.
        One last point: the economy seems to be chugging along reasonably well and I don’t foresee any true economic shocks. Bank failures from oil debt would change my outlook, but right now the main risk I see is a severe correction of runaway valuations in many asset classes (real estate, tech, biotech, etc). It’s more of a money supply issue than an economic one in my opinion. I don’t really think private funding is evaporating altogether, it just seems the landscape is changing–and rapidly.

        • Very helpful to better understand your lens here Chris. I think we’re generally on the same page. I think the challenge for the Unicorn class is going to be doubly challenging because many ended up with deal structures that were significantly unfavorable in down market scenarios (all in trade-off for that billion dollar valuation). There are going to be some painful recaps and some very painful sales where investors pull all the money out of a previously high flying company).

          Your last paragraph in particular resonated with me. While there may be an external shock to the system that we’re not seeing yet, fundamentally the US economy is doing reasonably well all things considered – certainly better than the rhetoric would suggest at the moment.

      • Chris

        PS – The topic of your article is spot on. Profitable growth is the key… I hear so many conversations among friends, on public transportation, online forums, etc about “growing at all costs” which I fundamentally disagree with.

  • Jim Franklin

    See Bessemer’s Cloud Index for a good history of cloud SaaS metrics. EV/R has a long term median of 6x; has traded as high as 12x, but is now at 4x TTM and 3x FTM. So the ‘over reaction’ would be the difference between a 6x long run median and the current 4x market valuation. https://www.bvp.com/strategy/cloud-computing/index

    • Chris

      Thanks for the response.
      I have to ask though: is this really a relevant time frame for comparison? 2011 to 2015 was one of the longest, strongest bull markets in history. That’s like saying midway through the crash of 1929 that stocks were cheap based on average prices from the previous 4 years.
      Obviously there isn’t really a better, more “relevant” time period to look at since we’re talking about new technologies. EV/R of 6x is pretty rich, though.
      Anyway, thanks again for the link.