Venture Capital

The Dangerous Seduction of the Lifetime Value (LTV) Formula

Posted on September 4, 2012. Filed under: advertising, Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , , , , |

Many consumer Internet business executives are loyalists of the Lifetime Value model, often referred to as the LTV model or formula. Lifetime value is the net present value of the profit stream of a customer. This concept, which appears on the surface to be quite benign, is typically used to compare the costs of acquiring a customer (often referred to as SAC, which stands for Subscriber Acquisition Costs) with the discounted positive cash flows that will come from that customer over time. As long as the sum of the discounted future cash flows are significantly higher than the SAC, then people will argue it is warranted to “push the accelerator,” which typically means burning capital by aggressively spending on marketing.

This is a simplified version of the formula:


The key statistics are as follows:

  • ARPU (average revenue per user)
  • Avg. Cust. Lifetime, n (This is the inverse of the churn, n=1/[annual churn])
  • WACC (weighted average cost of capital)
  • Costs (annual costs to support the user in a given period)
  • SAC (subscriber acquisition costs, sometimes refereed to as CAC = customer acquisition costs)

The LTV formula, when used correctly, can be a good tactical tool for monitoring and comparing like-minded variable market programs, especially across channels. But like any model, its proper use is entirely dependent on the assumptions used in that model. Also, people who have a hidden agenda or who confuse a model with reality can misuse it. For many companies that subscribe to its wisdom, the formula slowly takes on more importance than it should. Seduced by the model, its practitioners often lose sight of the more important elements of corporate strategy, and become narrowly fixated on the dogmatic execution of the formula. In these cases, the formula can be confused, misused, and abused, much to the detriment of the business, and in many cases the customer as well.

Here are ten reasons to avoid worshiping at the LTV altar:

  1. It’s a Tool, Not a Strategy.  Heavy LTV companies forget that the LTV model does not create sustainable competitive advantage. You shouldn’t’ confuse output with input. The LTV formula is a measurement tool to be used by marketing to test the effectiveness of their marketing spend – nothing more and nothing less. If one asserts that buying customers below what they charge them is a corporate strategy, this is in essence an arbitrage game, and arbitrage games rarely last. Too many of the variables (specifically ARPU and SAC) are outside of your control, and nothing would prevent another player from executing the exact same strategy. It’s not rocket science; it’s a formula that any business school graduate can calculate. Do not fool yourself into believing it creates a proprietary advantage.
  2. The LTV Model Is Used To Rationalize Marketing Spending.  Marketing executives like big budgets, as big budgets make it easier to grow the top line.  The LTV formula “relaxes” the need for near term profitability and “justifies” the ability to play it forward – to spend today for benefits that are postponed into the future. It is no coincidence that companies that put a heavy emphasis on LTV are also the ones that have massive losses as they scale, frequently even through an IPO. Consider that most companies limit any “affiliate fee” they would be willing to spend to 5-10% of sales. Yet when they are marketing, they use different math. They use LTV math, and all the sudden it’s acceptable to spend 30-50% of revenue on customer acquisition. Find the most boisterous executive recommending excessive spending, and you will usually find a loyal servant of the LTV religion.
  3. The Model is Confused and Misused. Frequently the same group that is arguing for more spending is the same one that “owns” the LTV calculation. (This is a mistake – finance should monitor LTV).  As a result, it is not uncommon for one to see shortcuts taken that allow for greater freedom. As an example, marketers often divide spend by total customers to calculate SAC rather than just those customers that were “purchased.” If you have organic customers, they shouldn’t be included in the spend calculus. They would have arrived regardless of spend. Also, many people discount “revenues” rather than marginal cash contribution. It is critical to bundle all future variable costs of supporting the customer in order to fairly estimate the future contribution. As an example of the sloppiness that exists around the formula, consider this blog post ( from KISS metrics, a company whose aim is to “help you make smarter business decisions.” Not only do they include a version of the model that specifically ignores future costs, but also they recommend taking an average of three different results, two of which are clearly flawed. This voodoo-math has no place as part of a multi-million dollar marketing exercise.
  4. Business Isn’t Physics – The Formula Is Not Absolute. LTV zealots often hold an overly confident view of the predictive nature of the formula. It’s not “hard science” like say predicting gravity. It’s at best a “good guess” about how the future will unfold. Businesses are complex adaptive systems that cannot be modeled with certainty. The future LTV results are simply predictions based on many assumptions that may or may not hold. Yet the LTV practitioner often moves forward with a brazen naiveté, evocative of the first time stock buyer who just found out about the price/earnings ratio, or the newcomer to Vegas who has just been taught the basics of twenty-one. LTV models win arguments because executives perceive them to be grounded in science. Just because its math, doesn’t mean its good math.
  5. The LTV Variables “Tug” at One Another. This may be the single most important issue and it lies at the heart of why the LTV model eventually breaks down and fails to scale ad infinitum. Tren Griffin, a close friend that has worked for both Craig McCaw and Bill Gates refers to the five variables of the LTV formula as the five horsemen. What he envisions is that a rope connects them all, and they are all facing different directions. When one horse pulls one way, it makes it more difficult for the other horse to go his direction. Tren’s view is that the variables of the LTV formula are interdependent not independent, and are an overly simplified abstraction of reality. If you try to raise ARPU (price) you will naturally increase churn. If you try to grow faster by spending more on marketing, your SAC will rise (assuming a finite amount of opportunities to buy customers, which is true). Churn may rise also, as a more aggressive program will likely capture customers of a lower quality. As another example, if you beef up customer service to improve churn, you directly impact future costs, and therefore deteriorate the potential cash flow contribution. Ironically, many company presentations show all metrics improving as you head into the future. This is unlikely to play out in reality.
  6. Growing Becomes a Grind. Let’s say you have a company that estimates it will do $100mm in revenue this year, $200mm the next, and $400mm the year after that. In order to accomplish those goals it is going to invest heavily in marketing – say 50% of revenues. So the budget for the next three years is $50mm, $100mm, and $200mm. How realistic is it to assume that your SAC will drop as you 4X your spend? Supply and demand analysis suggests the exact opposite outcome. As you try to buy more and more of a limited good, the price will inherently increase. The number one place on the planet for marketing spend is Google Adwords, and make no mistake about it, this is an increasingly finite resource. Click-outs are not growing at a meaningful pace, and key word purchases are highly contested. Assuming you will “get better” at buying while trying to buy more is a daunting assumption. The game will likely get tougher not easier.
  7. Purchased Customers Underperform Organic on Almost Every Metric. Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend. LTV heavy companies are in denial about this point. In fact, many of them will argue until they are blue in the face that the customer dynamics are the same while this is rarely the case. A customer that “chooses” your firm’s services will be much more staisfied than one that is persuaded to buy your product through spend. Find any high-marketing spend consumer subscription company, and I will show you a company with numerous complaints at the Better Business Bureau. These are companies that make it almost impossible to terminate your subscription. When you are scheming on how to trap the customer from finding the exit you are not building a long-term brand.
  8. The Money Could Go to the Customer.Think about this. If you are a company that spends millions and millions of dollars on marketing, wouldn’t you be better off handing that money to the customer versus handing it to a third-party who has nothing to do with the future life-time value of the customer? Providing a better value-proposition to the customer is much more likely to endure goodwill than spending on marketing. A heavy marketing spend necessitates a higher margin (to cover the spend), and therefore a higher end user price to the customer! So the customer is negatively impacted by the presence or “need” of the marketing program. Plus, a margin umbrella now exists for competition that chooses to undercut your margin model with a more efficient customer acquisition strategy (such as giving the customer the money).“More and more money will go into making a great customer experience, and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people find out.” – Jeff Bezos
  9. LTV Obsession Creates Blinders. Many companies that obsess over LTV, become overwhelmed by LTV. In essence, the formula becomes a blinder that restricts creativity and open-mindedness. Some of the most efficient forms of marketing are viral, social, and effective PR (public relations). Most companies that obsess about LTV are less skilled at these more leveraged techniques. Ironically, it’s the scrappy and capital starved startup with absolutely no marketing budget that typically finds a clever way to scale growth organically.  I love this historic slide from Skype comparing their SAC with that of Vonage, an iconic disciple of LTV analysis.


10. Tomorrow Never Arrives.  The Utopian destination imagined by the LTV formula is a mirage. It almost never works out as planned in the long run. Either growth begins to slow, or you run out of capital to continue to fund losses, or Wall Street cries uncle and asks to see profitability. When this happens the frailty of the model begins to appear. SAC is a little higher than expected. You met your growth target, but the projected loss was bigger than expected. Wall Street is hounding you for churn numbers, but you are reluctant to give them out. The lack of transparency then leads to cynicism, and everyone assumes the worse. It turns out that the excessive marketing spend was also propping up repeat purchase, and pulling back to achieve profitability is increasing churn. Moreover, a negative PR cycle has ensued as a result of your stock decline, and the press’ new doubts about your model. This also impacts results, and customer perception of your brand. The bottom line is that “one day we can stop spending and be remarkably profitable” rarely comes to fruition.

It is not impossible to create permanent equity value with the LTV approach, but it’s a dangerous game of timing – you don’t want to be the peak investor. Let’s say a new business starts with an early market capitalization of A (see graph below). Through aggressive marketing techniques, and aggressive fund raising, the company is able to achieve amazing revenue growth (and corresponding losses), but nonetheless creates a rather sizable organization. At this point, the company is value at point B. Eventually, however, gravity ensues and the constraints outlined herein raise their head, resulting in a collapse to point C.  For early founders and investors at point A, they may do OK (as long as C>A), but it will be accomplished on the backs of later stage investors that helped fund the unsustainable push to point B. This is the story of many a telecom and cable provider expansion history, as well as a few recent Internet companies.


This should not be misconstrued as a eulogy for the LTV formula. It has a very important place in business as a way to contrast and compare alternative marketing programs and channels. It is a tactical marketing tool that requires candor and thoroughness in its implementation. The fundamental reason that it is so amazingly dangerous and seductive is its simplicity and certainty. Generic marketing is conceptual. LTV marketing is specific. Building a plan to grow to a million users organically is an order of magnitude more difficult than doing it with the aid of the LTV formula. There is comfort in its determinism, and it is simply easier to do.

Some people wield the LTV model as if they were Yoda with a light saber; “Look at this amazing weapon I know how to use!” Unfortunately, it is not that amazing, it’s not that unique to understand, and it is not a weapon, it’s a tool. Companies need a sustainable competitive advantage that is independent of their variable marketing campaigns. You can’t win a fight with a measuring tape.

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Social-Mobile-LOCAL: “Local” Will Be The Biggest of the Three

Posted on June 25, 2012. Filed under: android, Internet, iphone, Uncategorized, Venture Capital, Web/Tech | Tags: , , , |

“Well I was born in a small town
And I live in a small town
Prob’ly die in a small town
Oh, those small – communities”
— Small Town, John Mellencamp

While “Social-Mobile-Local” is certainly an overused buzz phrase, most of the attention has been placed on the “social” and “mobile” parts of the phrase. In social, the spectacular rise of Facebook and Twitter is clearly a disruptive and critical trend. In mobile, the adoption of the smartphone (led by Apple’s iPhone and now catapulted forward by Android) is also a fundamentally important platform transition. Much less attention has been paid to the third concept, “local,” which is ironic since it may be a much larger real business opportunity than either social media or Smartphone application revenue. Over the next five years, this massive opportunity will come into focus as local businesses embrace the Internet and adopt new interactive technologies that increasingly automate the connections between their customers and themselves.

A Huge Opportunity

The attached slide will look familiar to readers in Silicon Valley. It appears to be a disruptive, up-and-to-the-right graph that we normally associate with break-out technology companies. This slide, however, maps the rise of the Yellow Pages industry in North America from 1920 to 2007. As you can see, the Yellow Pages business saw incredible revenue growth as the phone became the key point of connectivity for interaction with local business. At its peak in 2007, the North American Yellow Pages business topped out somewhere between $14-16 billion, depending on the source.

Total local advertising and promotion is much larger than just the Yellow Pages. A separate analysis done by Advertising Age, suggests that in 2007, local U.S. businesses spent around $123 billion annually on local media. However, starting in 2008, this market began to materially erode. Why? Newspapers, magazines, local radio, and Yellow Pages represent about 80% of this spend, and the rise of the Internet is unquestionably undermining the  core structure of these industries. Since 2007, Yellow Pages revenues have fallen in half in five years, after taking 87 years to reach their peak. Many newspapers have closed, and others teeter on the edge of bankruptcy. This is not at all shocking. We  know that consumers are using these products less frequently every day. The Yellow Pages business itself suffers from a terminal disease.

If you think back to five years ago, the small business owner was clearly an Internet skeptic. People would say things like “you should have a web site,” but for most local business owners — like a pet-shop or a locksmith — this didn’t mean anything. They had a phone, it was listed in the Yellow Pages – and people could find them. And if the potential consumer went online, the phone number could be found there as well. No problem. For those that did put up a web site, it was, in many cases, a non-event. Some customers might find it, but only the ones that were already looking for them. What’s the big deal?

An Online Awakening

Two things then happened. The first is the critical success of Yelp. Local merchants were suddenly profiled in an environment where the consumer, not the business owner, controlled the copy and the narrative. At first, it was easy to disregard this thing called Yelp as a passing fad. But the voices  got louder and louder – both the happy and the unhappy ones. Accountability and transparency had arrived at the local level. One has to suspect that Facebook’s pervasiveness played a roll in awakening the small business owner too.  By 2011, Facebook had reached 71% penetration of all 221mm U.S. Internet users. Regardless of  industry, when the small business owner now went home, his or her family was constantly on the Internet – playing games, doing research, connecting with friends. The Internet’s pervasiveness could no longer be denied.

Today, the small business owner’s attitude has shifted from denial to anxiety, and, as a result, these local business owners are rushing to the Internet in droves. In Benchmark’s own portfolio, we have eight companies (OpenTable, Uber, Zillow, Yelp, DemandForce, GrubHub, 1stdibs, and Peixe Urbano, *) that generate the majority of their revenue directly from local businesses. Based on estimates, these companies will represent approximately $735mm in revenue in calendar year 2012. Four of these companies have already seen a liquidity event (OpenTable, Zillow, and Yelp have had successful IPOs, and DemandForce was recently purchased by Intuit for $425 million). As small business owners embrace the Internet, the local Internet is firing on all cylinders. Not bad for a customer segment that was once considered a “do not enter” zone for venture capitalists.

The Smartphone as a Catalyst

If the decay of the Yellow Pages was a catalyst for the local Internet, then the rise of the smartphone is an accelerant. Smartphone adoption is staggering. Today, there are over 1 billion smartphone users worldwide, and in the U.S., smartphone penetration recently passed 50%. Google has announced that Android is activating over 850K new users a day. These mobile devices are frequently the preferred device (vs. a personal computer) when a consumer looks to interact with local businesses. For the eight companies mentioned above, mobile usage already represents between 25-50% of overall customer usage depending on time of day and day of week. And mobile usage looks destined to increase from here: DigitalBuzz predicts that mobile Internet users will pass desktop Internet users within the next 3 years.

The rise of the Smartphone as a new platform is a huge benefit for entrepreneurs. Simply put, large incumbents are typically slow to make shifts to new platforms. This is either because they are overly focused on their current strength, or simply too large and bureaucratic to move quickly. Often, it is a combination of both. Startups on the other hand are eager to find a point of leverage or advantage, and rush to new platforms. New platforms typically have  “hooks” that enable features that never existed on the previous platform, further differentiating the startups offerings. A great example on the Smartphone is using GPS for one button local search. New platforms also require new distribution techniques, and in such a “jump ball” scenario the incumbent’s advantage evaporates. One could argue the incumbents are even at a disadvantage as they are less likely to have the cutting edge technical employees who understand the new platforms.

Changing the Game: Going Deep

But there is an even greater limitation on the power of incumbents than their discomfort with new platforms. As the market moves away from Yellow Pages-like listings and directories as a proxy for advertising, many young companies, taking a page out of the playbook of data-driven software-as-a-service companies, have created deep vertical integration within their spaces in order to drive traffic and enable services. By organizing small business owners, supplementary service providers, and customers on a single canonical set of data, these companies are not only providing new ways for customers to discover local businesses: they are creating new ways for local businesses to interact with customers. They are moving from “listing” services to “automation” services, and they are stitching these Internet services deep into the nervous system of the target industry.

For example, a company like OpenTable provides, on a stand-alone basis, a premises based computer that is an extremely effective tool for restaurants to manage their tables — a digital version of the reservation book on the maitre d’s desk. By connecting that same data on the Internet, and aggregating that data from other restaurants, you have OpenTable’s incredible online reservation system. Along that same data spine, customers can add reviews, limousine services and florists can enhance the dining experience, and a location-aware Smartphone app can tell you what restaurant within walking distance of where you are has a table available right now. The “offering” is the complete network, not just one specific piece, and the pieces alone are less compelling.

Going “deep” like this is a significant challenge for larger incumbents. The playbook requires a deep understanding of the industry, access to all the key content and its structure, a targeted and experienced sales structure, and a willingness to invest in a market that may seem “niche” to the broader service provider. You have to be willing to get your hands dirty. These large companies favor a horizontal, one-size-fits-all approach, offering a widget that all local companies would potentially use (such as virtual loyalty cards). But these lightweight offerings from the incumbents will fall well short of the “automation” features and functionality enabled by the innovators digging deeper into the vertical.

We’ve already seen a couple of recent examples of this with Google. In mortgages, Google launched a product but ultimately retreated, citing prioritization concerns and “taking a hard look at products that haven’t been as successful as we had hoped.” A seemingly simple category like mortgages proved difficult to nail within the overall Google strategic framework. Likewise, in order to gain a foothold in travel — a space where deep verticals thrived for many years —Google ultimately realized they had to pay $700mm for ITA Software in order to acquire the vertical tools they needed to be successful.

The Real Winner: The Customer

If you look closely at many of the leading companies developing these deep verticals, like Zillow or OpenTable or Uber or AirBnB, they are providing far more than just advertising opportunities for local businesses. These companies are using new technologies like mobility and location to improve communication, interaction and overall customer experience.

The amazing thing about these new local Internet companies is how much value the consumer gets from this data-driven, vertically-integrated experience. Watching your Uber driver approaching your location on GPS forever alters your experience of taxis and limos, while at the same time providing total transparency up and down the value chain, from dispatcher to driver to fleet manager.

But the really exciting part is that we are still really early in this process of transformation away from listing/directory advertising to a local Internet.  By way of comparison, in the fourth quarter of 2011, Southwest Airlines reported that 86% of its revenue was booked online.  By comparison, only 12% of US restaurant reservations are booked online. Only 15% of dentists are connected to customers through services like DemandForce.  Only 3% of takeout orders are processed through online offerings like GrubHub. And less than 1% of realtors are premier agents on Zillow.

We all know intuitively where those numbers are headed in the future.

*Benchmark Capital is also super excited about its investment in Nextdoor, the leading social network for local neighborhoods and communities. Join 3,000 other local communities who have revolutionized how neighbors interact online. Check it out at

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Intuit to Acquire Demandforce for $424MM

Posted on April 27, 2012. Filed under: advertising, Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , |

This morning, Intuit announced its agreement to acquire one of Benchmark’s portfolio companies, Demandforce, for $424mm. As with Instagram, Benchmark Capital is the largest institutional investor in Demandforce. Unlike Instagram, which is a consumer application and is extremely well known, Demandforce focuses on local professional businesses and has chosen to keep an intentionally low profile – a strategy that has served them well.

Great entrepreneurs often blaze their own trails, and the founder and CEO of Demandforce, Rick Berry, is no different. In a day and age of social media, where many companies project a persona much larger than reality, Demandforce chose instead to focus on its customers and its products. We never even announced Benchmark’s funding of the company, which I believe is unprecedented. The Demandforce team always felt that the attention should be focused on the customer rather than the company.

Demandforce’s customer mission has always been the same – to help small businesses thrive in an evolving and increasingly complex connected world. Today, they are the leading provider of interactive “front office” SAAS services to thousands and thousands of professional small business owners. The Demandforce product is a powerful web-based application that seamlessly integrates with existing workflow systems, works automatically, and delivers guaranteed results. Through this, Demandforce provides local businesses – like salons, auto shops, chiropractors, dentists, and veterinarians – with affordable and easy access to the tools and platforms that large enterprises use to communicate with customers, build a strong online reputation and leverage network marketing. It you have ever received an automated communication from your dentist, it was likely sent through Demandforce.

Demandforce’s success puts it at the forefront of the burgeoning “Local Internet” wave. The combination of Internet pervasiveness and smartphone penetration has led to a complete reconfiguration with regard to how local businesses interact with their customers. These local businesses have traditionally spent over $125B/year on traditional media, and this is only in the U.S. But the channels they have historically used, such as the newspaper and the yellow pages, are increasingly compromised. These business owners know they need new solutions, and these dollars will be reallocated to these exciting new platforms. Benchmark believes this “Local Internet” wave is many times larger than the “social” and “mobile” themes with which it is often contrasted. In addition to DemandForce, Benchmark is fortunate to have backed such “Local Internet” market leaders as OpenTable (OPEN), Zillow (Z), Yelp (YELP), Peixe Urbano, GrubHub, Uber, and Nextdoor.

It has been an honor and a pleasure to work with Rick Berry, Patrick Barry, Hoang Vuong, Mark Hale, Sam Osman and Annie Tsai at Demandforce. This is truly one of the best teams ever assembled. It was also a pleasure to work with Steve Kostyshen as well as Mike Maples of Floodgate and Peter Ziebelman of Palo Alto Venture Partners, all of whom preceded us in their investment, and all of whom are passionate fans of the company.

It is certainly thrilling to see a team of entrepreneurs reach a significant milestone such as this.  That said, it is equally bittersweet as it means we will no longer be working directly with them on this incredibly compelling mission. Our loss is unquestionably Brad Smith and Intuit’s gain. Combining the leading “front office” small business SAAS vendor with the iconic Silicon Valley small business company is an incredibly compelling combination.

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Why Youth Has an Advantage in Innovation & Why You Want To Be a Learn-It-All

Posted on March 26, 2012. Filed under: Internet, social networking, Uncategorized, Venture Capital | Tags: , , , |

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A few relevant scenes from the recent blockbuster Moneyball:

Peter Brand: Billy, Pena is an All Star. Okay? And if you dump him and this Hatteberg thing doesn’t work out the way that we want it to, you know, this is…this is the kind of decision that gets you fired. It is!
Billy Beane: Yes, you’re right. I may lose my job, in which case I’m a forty four year old guy with a high school diploma and a daughter I’d like to be able to send to college. You’re twenty five years old with a degree from Yale and a pretty impressive apprenticeship. I don’t think we’re asking the right question. I think the question we should be asking is, do you believe in this thing or not?
Peter Brand: I do.
Billy Beane: It’s a problem you think we need to explain ourselves. Don’t. To anyone.
Peter Brand: Okay.


Grady Fuson: No. Baseball isn’t just numbers, it’s not science. If it was then anybody could do what we’re doing, but they can’t because they don’t know what we know. They don’t have our experience and they don’t have our intuition.
Billy Beane: Okay.
Grady Fuson: Billy, you got a kid in there that’s got a degree in Economics from Yale. You got a scout here with twenty nine years of baseball experience. You’re listening to the wrong one. Now there are intangibles that only baseball people understand. You’re discounting what scouts have done for a hundred and fifty years, even yourself!

These two scenes from Moneyball illustrate something that may be essential to modern business: the incredible value of youth and innovative thinking relative to traditional experience. It turns out that the Moneyball character Peter Brand’s real name is not Peter Brand (played by Jonah Hill), but rather Paul DePodesta. And he didn’t go to Yale, but instead Harvard. He was indeed young – twenty-seven when he went to work for Billy Beane – and he did have an actual degree in Economics. What’s more, as you can see in the interaction above, Billy valued Paul’s (Peter Brand’s) opinions and decisions – despite the fact that he was a complete novice with respect to baseball operations.

A month or two ago, I had the unique opportunity to share the stage with Billy Beane at a management offsite for one of the leading companies in the Fortune 500. We were both fielding questions about innovation, and what one can do to keep their organization innovative. I talked about how many of the partners that have joined Benchmark Capital have been extremely young when they joined, including our most recent partner Matt Cohler who joined us at the age of 31. At Benchmark, we believe that young partners have many compelling differentiators. First, they will ideally have strong connections and compatibility with young entrepreneurs, who are frequently the founders of the largest breakout companies. They are also likely to be frequent users of the latest and greatest technologies (all the more important with today’s consumer Internet market). Like the “Moneyball” situation described herein, young VCs are open to new ways of doing things. This form of “rule-breaking,” or intentionally ignoring yesterday’s doctrine, may in fact be a requirement for successful venture capital investing.

When I mentioned this intentional bias towards youth, Billy Beane abruptly concurred. He noted that injecting youth into the A’s organization is also a key philosophy of his. Paul DePodesta may have been the first young gun that Billy hired, but he was far from the last. Billy continues to recruit young, bright, talented people right out of college to help shake up the closed-minded thinking that can develop with an “experience only” staff. Also noted was the fact that if a certain “experience” is shared by all teams in the league, then it is no longer a strategic weapon. You can only win with a unique advantage.

The impact of youth on the technology scene is undeniable. The included table lists the founding age of some of the most prominent founders of our time. The facts are humbling and intimidating, especially for someone who is no longer in their twenties or early thirties. Can someone in their forties be innovative? Or, do the same things that produce “experience” constrain you from the creativity and perspective needed to innovate?

Lets look at some of the specific advantages of youth. First, as mentioned before, without the blinders of past experience, you don’t know what not to try, and therefore, you are willing to attempt things that experienced executives will not consider. Second, you are quick to leverage new technologies and tools way before the incumbent will see an opportunity or a need to pay attention. For me this may be the bigger issue. The rate of change on the Internet is extremely high. If the weapon du jour is constantly changing, being nimble and open-minded far outweighs being experienced. Blink and you are behind. Youth is a competitive weapon.

The point Billy raised regarding the fleeting value of experience is also important to consider. As the world becomes more and more aware of a trick or a skill, the value of that experience begins to decay. If word travels fast, the value of the skill diminishes quickly. Best practice becomes table stakes to stay-afloat, but not to get ahead. We see examples of this every day with Facebook application user acquisition techniques. Companies find a seam or arbitrage that creates a small window of opportunity in the market, but quickly others mimic the same technique and the advantage proves fleeting.

Back before the Yahoo BOD hired Carol Bartz, there was much speculation about the important traits for Yahoo’s next CEO. Most of the analysis honed in on two key traits for the company’s next leader – the ability to lead and the ability to innovate. I remember trying to think about leaders that I thought would have a chance at having a measurable impact. On one hand, you could put a very young innovative executive into the role, but it is hard to imagine handing a $15B public company over to someone remarkably inexperienced. The other side of the coin is equally difficult – thinking of a seasoned executive who has the ability to dramatically innovate Yahoo’s products and business model.

There were only a handful of people (as few as three) that I could think of at the time that fit this second profile. Thinking back now, they all shared the following characteristic: despite being experienced CEOs, these individuals all “thought young” i.e. they were open-minded and curious. And they did not believe that experience gave them all the answers. These type of executives love diving head-first into the latest and greatest technologies as soon as they become available.

If you want to stay “young” and innovative, you have no choice but to immerse yourself in the emerging tools of the current and next generation. You MUST stay current, as it is illusionary to imagine being innovative without being current. Also realize that the generational shifts are much shorter than they were in the past. If you were an innovative Internet company five short years ago, you might have learned about SEM and SEO. Most of the newly disruptive companies are no longer using these tools as paths to success – they have moved on to social/viral techniques. The game keeps changing, and if you are not “all-in” in terms of learning what’s new, than you may be falling rapidly behind.

Consider these questions:

  1. When a new device or operating system comes out do you rush out to get it as soon as possible – just because you want to play with the new features? Or do you wait for the dust to settle so that you don’t make a mistaken purchase. Or because you don’t want to waste your time.
  2. Do you use LinkedIn for all of your recruiting, or do you mistakenly think that LinkedIn is only for job seekers? How many connections do you have? Is your profile up to date? (When Yahoo announced Carol Bartz as CEO, I did a quick search on LinkedIn.  She was not a registered user.)
  3. When you heard that Zynga’s Farmville had over 80MM monthly users, did you immediately launch the game to see what it was all about, or do you make comments about how mindless it is to play such a game? Have you ever launched a single Facebook game?
  4. Do you have an Android phone or do you still use a Blackberry because your Chief Security Officer says you have to? I know many “innovators” who carry an iPhone and an Android, simply because they know these are the smartphones that customers use. And they want exposure to both platforms – at a tactile level.
  5. Do you use the internal camera app on your iPhone because it’s easy, or have you downloaded Instgram to find out why 27mm other people use that instead?
  6. Do you leverage Twitter to improve your influence and position in your industry or is it more comfortable for you to declare, “why would I tweet?,” before you even fully understand the product or why people in similar roles are leveraging the medium? Do you follow the industry leaders in your field on Twitter? Do you follow your competitors and customers? Do you track your company’s products and reputation?
  7. How many apps are on your smart phone? Do you have well over 50, or even 100, because you are routinely downloading each and every app from each peer and competitor you can to see how others are exploiting the environment? Do you know how WhatsApp, Voxer, and Path leveraged the iphone contact list for viral distribution?
  8. Do you know what Github is and why most startups rely on it as the key center of their engineering effort?
  9. Have you ever mounted an AWS server at Amazon? Do you know how AWS pricing works?
  10. Does it make sense to you to use HTML5 as your mobile solution so that you don’t have to code for multiple platforms? Does it bother you that none of the leading smartphone app vendors take this approach?
  11. When you are on the road on business, do you let your assistant book the same old car service, or do you tell them, “I want to use Uber just to see how it works?”
  12. When Facebook launched the new timeline feature did you immediately build one to see what the company was up to, or did you dismiss this as something you shouldn’t waste your time on?
  13. Have you been to to see what employees are saying about your company? Or have you rationalized why it’s not important, the way the way the old-school small business owner formerly dismissed his/her Yelp review.

The really great news is that being a “learn-it-all” has never been easier. With the Internet, high-speed broadband, SAAS, Cloud-services, 4G, and smart-phones, you can learn about new things, 24 hours a day, no matter where you are or what you do. All you need is the internal drive and insatiable curiosity to understand why the world is evolving the way it is. It is all out there for you to touch and feel. None of it is hidden.

There are in fact many “over 30” executives who can go toe-to-toe with these young entrepreneurs, precisely because they keep themselves youthful by leaning-in and understanding the constantly evolving frontier. My favorite “youthful” CEOs are people like Marc Benioff and Michael Dell, who frequently can be found signing up for brand new social networking tools and applications. Reed Hastings has more than once answered Netflix questions directly in Quora.  Jason Kilar frequently communicates directly with his customers through Hulu’s blog. Rich Barton, the co-founder of Expedia and Zillow is one of those people carrying both an Iphone and an Android, and is constant learning mode. I would also include Mark Cuban, whose curiosity is voracious. The other NBA owners never saw him coming. And lastly, there is Jeff Bezos, who seems to live beyond the edge, imagining the future as it unfolds. Watch the launch of Kindle Fire in NYC, and you will have no doubt that Jeff plays with these products directly and frequently.

Our last table highlights the stats from the Twitter account of some of these “youthful,” learn-it-all executives (sans Mr. Bezos – we all wish he tweeted). If you don’t find this list interesting, think about the thousands and thousands of executives out there who are nowhere to be found with respect to social media. They take the easy way out, likely blaming their legal department. They intentionally choose not to learn and not to be innovative. And they refuse to indoctrinate themselves to the very tools that the disrupters will use to attack their incumbency. That may in fact be the most dangerous path of all.

[Follow Me on Twitter]

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Why Dropbox Is A Major Disruption

Posted on February 23, 2012. Filed under: android, Apple, Internet, iphone, Mobile, Uncategorized, Venture Capital, Web/Tech | Tags: , , , |

Back in October, Techcrunch announced that Dropbox had raised $250mm at a seemingly absurd valuation. Many firms, including my firm Benchmark Capital, participated. When this happened, many people asked us why this was a special company that would cause us to break our standard investment paradigm. They didn’t quite understand why this was a company that deserved once-in-a-generation special attention.

The first answer to this question is rather straightforward, but not earth shattering. Drew Houston and his team had taken a hard problem — file synchronization — and made it brain dead simple. Anyone that had used previous file synchronization programs, including Apple’s own iDisk, constantly encountered state problems. Modifications in one location would get out of synch with those in another, ruining the  entire premise of seamless synchronization. It wasn’t that these other companies did not understand the problem, it was just that they could not execute on the solution. The Dropbox team solved this, which was a critical innovation.

Although this was critical, nailing technical synchronization would not necessarily warrant outsized valuations. In order to be worth $40B one day (which is 10X the $4B reported round, the objective return of a VC investment), the company would need to hold a place in the ecosystem that is far more strategic than that of a simple high-tech problem solver. So what is it Dropbox does that is so special?

This evening, TechCrunch reported that Dropbox would automatically synch your Android photos. Once again, someone could suggest “so what, how hard is it to do that?, and why is that worth billions?”

Here is why. Once you begin using Dropbox, you become more and more indifferent to the hardware you are using, as well as the operating system on that device. Dropbox commoditizes your devices and their OS, by being your “state” system in the sky. Storing credentials and configurations of devices, and even applications are natural next steps for this company. And the further they take it, the less dependent any user becomes of the physical machine (HW and SW) that is accessing that data (and state). Imagine the number of companies, as well as the previous paradigms, this threatens.

That is a major, major deal. And it comes at a time where there are many competing platforms on both desktop and mobile. This “unsure” market backdrop ensures the need for a cross-platform solution and plays right into Dropbox’s hand. You can lose your desktop computer, you can lose your smartphone. It doesn’t matter, because all you really care about is in the Dropbox cloud.

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Why Facebook Clearly Belongs in the 10X Revenue Club

Posted on February 1, 2012. Filed under: Facebook, Internet, IPO, Uncategorized, Venture Capital, Web/Tech | Tags: , |

Attached are my thoughts on the Facebook S-1 along with some quick stabs at valuation.  Brief disclosure, Benchmark Capital has a minority position in Facebook as a result of the acquisition of FriendFeed, a company that was incubated in our offices.

I thought it would be useful to look at Facebook using the scorecard from our May 24 blog post, “All Revenue is Not Created Equal, the Keys to the 10X Revenue Club.” For those that want to save time, the key point of this piece is that there is a broad disparity of Price/Revenue multiples for global Internet stocks, and that only a very small fraction of these companies achieve a multiple over 10X. We also created a list of 10 factors that public investors consider when trying to qualify if a company is deserved of such a prestigious and lofty valuation.

On a roll, these factors are:

1. Sustainable Competitive Advantage – how big is the competitive Moat?
2. Presence of Network Effects – does the model tip to a single vendor?
3. Visibility/Predictability – is the revenue consistent
4. Customer Lock-in / High Switching Costs – is it expensive to leave?
5. Gross margin levels – How much leverage exists is the business?
6. Marginal Profitability Calculation – is the leverage still expanding?
7. Customer Concentration – are there key dependencies?
8. Major Partner Dependencies – are there key dependencies here as well?
9. Organic Demand vs. Marketing Spend – is customer acquisition expensive?
10. Growth – how big will the future be?

So how does Facebook score on these metrics? As you would expect, pretty well.

Metric: Comments: Grade:
Sustainable Competitive Advantage It would be extremely hard to launch a direct-on competitor to Facebook.  Look at what has happened to Friendster, MySpace, Bebo, and is happening to Orkut in Brazil.  Google+ as a FB competitor is a tough slog. A+
Presence of Network Effects These are about as strong as you could design. All current non-US Facebook users have immediate connections if they log-in. A+
Visibility/Predictability This is fairly strong as well, simply because there is no lumpiness.  There is a small dependency on Zynga that could cause variability. Also, a premium product would offer more consistency than pure ads.  That said, this is not an issue. A
Customer Lock-In / Switching Costs Leaving Facebook is possible, but finding an alternative with all your friends on it is not really possible.  Obviously, the inclusion of Timeline works to increase this even more by creating a permanent dependence on past content. Also, Facebook’s DAU number is staggering. Over half of all users check-in daily. That is uber lock-in. A+
Gross Margin Levels Gross margin has hovered between 75-80% for the last several quarters.  This is a fantastic overall gross margin. It would be great to think they have more leverage here, but as the largest Internet site in the world, this probably represents peak margins. A
Marginal Profitability Calculation On this one Facebook doesn’t score so well.  Peak profitability (on a margin % basis) was in Q4 of 2010, and since then spending has kept pace with revenue growth. It is likley that the team would argue they are “investing for the long-term,” but if the long term is forever, than EPS growth is permanently tied to revenue growth. B-
Customer Concentration Zynga is 12% of revenues, but this is fairly low and they are the only company over 10%. Plus, if Zynga stopped competing for these ad purchases, there are many, many Zynga look-alikes that would rush to fill that void. So even if they left tomorrow (which they won’t) the number would not go away completely. A
Partner Dependency Facebook has grown to be the largest site in the world with the help of no one. No partners. No dependency. A+
Organic Demand All of Facebook’s customers are organic. This is as good as it gets.  The pure stuff. A+
Growth Facebook grew the top line 88% in 2011. That’s quite amazing. Q4 of 2011, however, was only 55%.  People will definitely be watching this number in Q1. If growth rate hurts the company, then it’s a direct result of waiting too long to go public – past peak growth. B

The bottom line is that these scores are fantastic. Facebook is a shoe-in for the 10X+ revenue club. Perhaps the only question is which years’ revenue you consider. If the company grows 50-60% in 2012, you end up with roughly $5.5-6B in revenue. With all the hype, assume a 12x multiple on the $6, and you end up right at $72B. You can double-check this with earnings. As operating margin is stable, 60% growth would result in $1.6B in after-tax earnings. At $72B, this is a 45 PE ratio for a company growing at 60%. At a 60 PE, you would have a $96B market capitalization. The bottom line is that the banker range looks right to me. Of course, overt and ecstatic demand for the hottest IPO of the past 10 years could easily lead to much higher speculative valuations. But it’s hard to argue that the $70-100B range is wrong. Feels quite right to me.

Here are a few other interesting things from the S-1:

  1. Tax Rate. Warren Buffet’s secretary would be happy. Facebook’s tax rate is already north of 40%. Other multi-national companies typically have found a way to reduce this. Facebook is paying full-boat.
  2. Model appears set. With gross margin relatively fixed, and peak operating margins over 5 quarter ago, investors should get comfortable that bottom-line growth is limited by top line growth. Management could change their attitude later, but experience suggests that founders like Zuckenburg want to invest for the long term. As a result, one shouldn’t expect these super healthy margins to go any higher.
  3. Sales > R&D. It is somewhat surprising that sales expense is greater than R&D expense. The ad units clearly are not self-serve. Interestingly, this ratio is very similar for Google.
  4. Seasonality. The company has more seasonality than I would have expected (geared towards Q4). The prospectus says this is tied to traditional advertising seasonality.
  5. Facebook’s unique RSU program. In an effort to avoid the restrictions of 409A, Facebook long ago created an RSU structure whose shares vest on a liquidity event.  As a result, a large amount of stock (close to $1B in value) will all “vest” on the IPO. This will result in an enormous one-time, non-cash charge. What I still can’t figure out, is how this will effect the overall share count. If you know let me know, and I will append the post. If auditors and the SEC are happy with this RSU structure, I would expect to see other startups adopt it, as it avoids the restrictions of 409A.
  6. Cash. Over $3.9B in cash already. And they will raise $5B more. That’s a lot of cash.

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You Don’t Have to Tweet to Twitter

Posted on November 15, 2011. Filed under: advertising, Facebook, Internet, IPO, social networking, Twitter, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , |

Frequent comparisons to Facebook leave many confused about the true value of Twitter.

[Follow Me on Twitter]

“In a brand new direction
A change of perception
On a brand new trajection”

[Disclosure: Benchmark Capital is a major investor in Twitter, and my partner Peter Fenton sits on the Twitter BOD.]

Twitter is having a remarkable year. Active users have soared to over 100 million per month, with daily actives now above 50 million. Tweets per day are over 250 million. Most top actors, athletes, and artists are all active on Twitter. Every news and sports program proudly advertises its Twitter account handle. No one would consider running for public office without a strong Twitter presence. Global news in any region breaks first and spreads fast on Twitter. Even uber-socialist Hugo Chavez of Venezuela has 2.24 million followers (which puts him slightly behind Mandy Moore, but just ahead of Queen Latifah).

So, Twitter’s traffic has been growing in leaps and bounds. It has become an indispensable tool for managing personal and corporate brands. And Twitter, along with its verb form “tweet”, have become words in everyday usage all over the world. Yet despite these impressive strides, Twitter’s upside is far, far greater and its user base will expand by an order of magnitude – as soon as the service can overcome a major perception problem.

Twitter suffers from two key misperceptions that need to be resolved before the business can reach its true potential. The first misperception is that Twitter is simply another social network, like Facebook. People commonly think of Twitter as a variant of Facebook. The press frequently positions the two together as “leaders in social networking.” This pairing erroneously implies that the two services are used for the exact same thing, even though the two platforms are very different. Facebook is a few-to-few communication network designed for sharing information and life events with friends. Twitter, on the other hand, is a one-to-many information broadcast network. The only way magic happens on Facebook is through reciprocity: I friend you and you friend me back – then information flows. But on Twitter, I can get something out of following Shaquile O’Neil who has no social obligation to follow me back.

As its roots are in communication, a key part of the Facebook value proposition is sharing information. Any potential anxiety with regards to Facebook sharing is reduced by the fact that these communications are generally seen only by one’s friends. In fact, users react quite negatively when this information is unknowingly shared more broadly. For the people who view Twitter as a Facebook variant, they immediately assume the platform’s core purpose is for the user to broadcast his or her own thoughts and personal information (like Facebook), but to a much broader public audience. For those with this perception, the notion of potentially exposing their own private thoughts to the broad public Internet is overwhelming and uninteresting.

The second, and more critical, Twitter misperception is that you need to tweet, to have something to say and broadcast, for the service to be meaningful to you. For many non-Twitter users, Twitter is an intimidating proposition. “Why would I tweet?,” and “…but I don’t want to tweet” are two common refrains from the non-adopter that highlight this key misperception. But this completely misses the point as to why Twitter has become such an amazingly powerful Internet destination for 100 million others. For the vast majority of Twitter’s next 900 million users, the core usage modality will have very little to do with “tweeting,” and everything to do with “listening” or “hearing.”

Twitter is an innovative and remarkable information service. While it is amazingly democratic and allows literally anyone to broadcast publicly as a “tweeter,” the core value in today’s Twitter is the amazing flow of curated and customized information that emanates from its crowd-sourced user feeds. Other Internet networks like to keep the user “inside.” Much like Google, Twitter points out to the world. It’s a “discovery engine” and an “information utility” rolled into one. With Twitter, you get news faster, you see updates from your favorite artists, you hear directly from key politicians, and gain insights from influencers in a wide variety of specializations. Just as Facebook is symmetric in terms of its poster-reader relationship, Twitter is highly asymmetric. The majority of the tweets on Twitter are posted by a small sub-set of the users. And the majority of the users get value from “reading” or “listening” to the tweets from these core influencers. Once again, for most users it’s more about what you hear, learn, and find than the fact that you can tweet.

In many ways, Twitter is much more of a competitor to other “discovery tools” and “information sources” than it is to Facebook. Facebook is unquestionably the number one resource for “sharing with the people in your life.” From this perspective, Facebook competes (extremely well) with email, instant messengers, and certainly other symmetric social networks like MySpace. Twitter, on the other hand, competes most directly with other tools that help you find important links, news, and information. It is in this broad, non-friend based crowd-sourcing and speed of discovery where Twitter truly shines. A recent Tweet by famed sci-fi author William Gibson highlights this point. Having become accustomed to the non-linear speed of information flow on Twitter, Gibson grew frustrated watching news of the Osama bin Laden killing on TV: “Network news feels like trying to suck cold tar through a milkshake straw.

Some who understand this point have suggested that Twitter is merely a “Better RSS reader.” While this analogy is directionally more accurate than the Facebook comparison, it greatly underestimates the power and value of Twitter. RSS feeds are simply computerized information “routers” that require complex setup, initialization, and maintenance. Twitter has three breakthroughs that make it dramatically more powerful than simple RSS. First and foremost, your personalized Twitter feed is human-curated by a potential universe of millions of curators. When you “check Twitter” you are looking at the specific articles and links purposefully chosen by people you have chosen to follow. That is powerful leverage. Second, it is easily extensible. Due primarily to the concept of “retweeting,” the simple act of using Twitter exposes you to new and interesting sources to follow. It evolves into a richer and more customized offering over time. You discover new people as well as new information. Lastly, Twitter’s unique handles and follower networks create a strong-form network effect that has high lock-in and high switching costs. Twitter and its top tweeters have a deeply symbiotic relationship.

So what can Twitter do to solve this misperception problem? The first thing they can fix is the new user registration flow, a process that has already begun. Earlier this year, a new user would be encouraged to “tweet” very early in the registration process, basically reinforcing the perception problem. Today’s “first 60-second” Twitter experience is quite different and revolves around choosing the influencers you will follow. You should expect even more evolution in this direction in the future. Next, Twitter must make it crystal clear to the press and prospective user that there is an amazingly powerful value proposition for non-broadcasting users. This will not be easy, as it requires a reprogramming of perception across a broad audience. Not only will this aid in incremental adoption, but it will also help subdue the confusion with respect to Facebook.

Twitter is on an amazing trajectory and will continue to increase in usage and influence.  However, the power of this discovery platform is much more about the tweets themselves, and not simply about every single user having the ability to tweet.

[Follow Me on Twitter]

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All Revenue is Not Created Equal: The Keys to the 10X Revenue Club

Posted on May 24, 2011. Filed under: casual games, Internet, Uncategorized, Venture Capital, Web/Tech |

[Follow Me on Twitter]

“ Don’t you know that you are a shooting star,
And all the world will love you just as long,
As long as you are.”  — Paul Rodgers, Shooting Star

With the IPO market now blown wide-open, and the media completely infatuated with frothy trades in the bubbly late stage private market, it is common to see articles that reference both “valuation” and “revenue” and suggest that there is a correlation between the two. Calculating or qualifying potential valuation using the simplistic and crude tool of a revenue multiple (also known as the price/revenue or price/sales ratio) was quite trendy back during the Internet bubble of the late 1990s. Perhaps it is not peculiar that our good friend the price/revenue ratio is back in vogue. But investors and analysts beware; this is a remarkably dangerous technique, because all revenues are not created equal.

What drives true equity value? Those of us with a fondness for finance will argue until we are blue in the face that discounted cash flows (DCF) are the true drivers of value for any financial asset, companies included. The problem is that it is nearly impossible to predict with any accuracy what the long-term cash flows are for a given company; especially a company that is young or that might be using an innovative and new business model. Additionally, knowing what long-term cash flows look like requires knowledge of a vast number of disparate future variables. What is the long-term growth rate? What is the long-term operating margin? How long will this company hold off competition? How much will they be required to reinvest? Therefore, from a purely practical view, the DCF is an unruly valuation tool for young companies. This is not because it is a bad theoretical framework; it is because we don’t have accurate inputs. Garbage in, garbage out.

Because of the difficulty of getting DCF right, investors commonly use a handful of other shortcuts to determine valuations. “Price earnings ratio” and “enterprise value to EBITDA” are common shortcuts, with their own benefits and limitations. I want to argue that for a variety of reasons, the price/revenue multiple is the crudest valuation tool of them all.

The following chart highlights 2012 forward price/revenue ratios for 122 global Internet stocks. The broad range of results is nothing short of staggering. On one end is Overstock, trading at 0.2X analyst’s 2012 revenue estimates. On the other end is, the leading Chinese video website (recent IPO LinkedIn is not included in this list).  Youku trades at 21.7X analysts average 2012 revenue estimate. The other companies live at many different places along this wide continuum. Now consider that the press and some investors frequently use price/revenue as their primary valuation tool when our data suggests there is a 100X difference in value per sales dollar from Overstock to Talk about room for error! What is that hot new company worth? This graph would suggest that the company’s revenue alone is a very poor guide.

Before we talk about why there is such disparity, it is important to highlight a few more points. As you can see in the above graph, there is a very long tail to the left. Basically, there are many more low-price/revenue multiple companies than high. The following table shows this statistically. Over 72% of the companies have a 2012 price/revenue multiple below 4x. Also, you can see that only 12 of these 122 companies (<10%) have multiples over 7X. There are only 5 above 10X. Also recognize that the majority of these high multiple companies are domiciled outside the U.S. This is important because the press tends to favor the higher multiples, such as 10X revenues, as their “defaults.” The problem is, only a handful of companies deserve to be in the “10X club.”

What causes such a wide dispersion of price/revenue multiples? While one might not have the specific numbers required to complete an accurate DCF, we do know which business qualities would have a positive impact on a DCF exercise, all things being equal. When investors see a large number of these traits, they then have an increased confidence that the elements are in place that will lead to a strong DCF value over time. You often hear people refer to companies with strong DCF characteristics as having high “revenue quality.” Companies with characteristics that are inconsistent with a strong DCF model are said to have low “revenue quality.”

Here are some of the key business characteristics that would be used to separate high quality revenue companies from low quality revenue companies, and therefore are the distinguishing traits that warrant high price/revenue multiples.

1. Sustainable Competitive Advantage (Warren Buffet’s Moat)

By far, the most critical characteristic that separates high multiple companies from low multiple companies is competitive advantage. This concept, well explained in Porter’s book by the same name, basically asks the question, “How easy is it for someone else to provide the same product or service that you provide?”  If your company has “high barriers to entry,” Wall Street will be super excited, as investors will have confidence discounting cash flows many, many years into the future. Coca-Cola has a 5% estimated 2012 growth rate, and a 3.6x price/revenue multiple. RIM has a 12% estimated 2012 growth rate and a 0.77x price/revenue multiple. What gives? Investors expect Coke to be around in pretty much its same form 50 years from now. It is much harder to say that with confidence about RIM. Warren Buffet famously refers to these barriers to entry as an “economic moat,” inferring an image of the body of water that protects access to a castle.

[For more on this topic, I highly reccomendan amazing paper on this subject, Competitive Advantage Period “CAP,” The Neglected Value Driver by Mike Mauboussin, the Chief Investment Strategist at Legg Mason, and an adjunct finance professor at Columbia Business School.]

If high price/revenue multiple companies have wide moats or strong barriers to entry, then the opposite is also true. Companies with little to no competitive advantage, or companies with relatively low barriers to entry, will struggle to maintain above-average price/revenue multiples. If an investor fears that a company’s competitive position (which allows them to create excess cash flow) is tenuous and will deteriorate, then the value of the enterprise may be worth the cash flows only from the next several years.

2. The Presence of Network Effects

No discussion of competitive advantages and barriers to entry is complete without a nod to perhaps the strongest economic moat of all, network effects. In a system where the value to the incremental customer is a direct function of the customers already in the system, you have a powerful dynamic that tips towards winner take all. Perhaps the definitive piece on this type of advantage is Brian Arthur’s Increasing Returns and Two Worlds of Business published in HBR back in 1996.  This “second world” that Brian refers to is one where the market leader has an unfair advantage that is reinforced by network effects.

There are a few important things to remember about network effects. Some network effect systems are stronger than others. What is key is the decay rate of value of the incremental user to the customer value function. Second, networks effects are discussed way more than they exist. Many things people indentify as network effects are merely economies of scale, which are not nearly as powerful. Unfortunately, strong form network effect companies are far and few between. Fortunately, when they do exist, they are typically leading candidates for the 10X+ price/revenue multiple club.  Microsoft, Ebay, Skype, Google Adwords, and Facebook (in their prime) all benefited from network effects.

3. Visibility/Predictability Are Highly Valued

For the same reason that investors favor companies with sustainable competitive advantages, investors favor pricing models that provide a high level of predictability and consistency in the future. It is easy to see why revenue visibility would have a positive impact on a DCF analysis. The more certain you can be of future cash flows, the higher premium you will put on a business, and as a result, you will see a higher price/revenue multiple. One obvious example of this is the predictable nature of SAAS subscription revenue. trades at a staggering 7.5x 2012 estimated revenues. SuccessFactors trades at 7.9x 2012 estimated revenues.  Subscription revenue businesses take longer to grow than traditional software businesses, but once you reach scale investors put premium multiples on the predictable future revenue streams.

The opposite of subscription revenue is revenue that is one-time or episodic. Traditional software models are one-time in nature. Consulting revenue is also typically one-time. Revenue that will only happen once, or that is highly likely to go away in future years, will command much lower price/revenue multiples. As a general rule, game companies, where the “hit” nature of the product offering will eventually ensure a finite life of most of its products, typically trade at discounted price/revenue multiples. Activision trades at just over 2X 2012 estimated revenues. Electronic Arts trades at 1.7x times the same estimate. Non-publisher game companies, where revenues may often come from a single title, will have even lower price/revenue multiples. Conversely, the game companies that get higher multiples are ones that own more of a publishing/distribution platform, such as TenCent in China. These companies are able to extract rent from whatever the hot game happens to be, and are therefore less vulnerable to “hit” risk.

4. Customer Lock-in / High Switching Costs

If investors value predictability, than retaining customers for long periods of time is obviously a positive. Conversely, if customers are churning away from your company, this is a huge negative. Investors are highly fixated on churn rates, as they should be. Churn has a direct and significant impact on a DCF model. With subscription models, a low-churn customer is quite valuable. In fact, companies with excessively low churn rates (5% annually or less) are very likely to have price/revenue multiples in the top decile. Obviously, high churn rates are really bad for all valuation multiples.

For non-subscription businesses, customer-switching costs also play an important role. If it is relatively easy for your customer to switch back and forth from your products to you competitors, you will likely have a lower price/revenue multiple as your pricing power will be quite limited. On the other hand, if it is quite difficult for a customer to switch away from your product/service, you are likely to have stronger pricing power, and longer customer life, which will inevitably result in better DCF dynamics. Switching costs can take many forms – technical lock-in, data lock-in, high startup costs with a new vendor, and downstream revenue dependencies are just a few.  All things being equal, high switching costs are a positive for price/revenue multiples, and low switching costs are a negative.

5. Gross Margin Levels

This may seem super-basic or even tautological but there is a huge difference between companies with high gross margins and those with lower gross margins. Using the DCF framework, you cannot generate much cash from a revenue stream that is saddled with large, variable costs. As a result, lower gross margin companies will trade a highly discounted price/revenue multiples. Amazon (20% gross margin), which is certainly among the very best retailers when it comes to execution, trades at a low 1.5x 2012 revenue estimates. Wal-Mart (25% gross margin) trades at 0.41x 2012 revenues. Best Buy (24% gross margin) trades at only 0.22x forward revenues. All things being equal, gross margin percentage should have a direct impact on price/revenue multiple, as there will obviously be more gross margin dollars to contribute to free cash flow. Journalists who quickly apply 10x multiples to all private companies should at the very least consider gross margin levels in their analysis.

6. Marginal Profitability Calculation

Investors love companies with scale. What this means is that investors love companies where, all things being equal, higher revenues create higher profit margins. Microsoft had wonderful scale in this manner for many, many years. Selling more copies of the same piece of software (with zero incremental costs) is a business that scales nicely. Companies that are increasing their profit percentage while they grow are capable of carrying very high valuation multiples, as future periods will have much higher earnings and free cash flow due to the cumulative effect of growth and increased profitability.

In order to measure how a business is scaling, many investors look at marginal incremental profitability. This can be done on a quarter-over-quarter basis, or a year-over-year basis. Simply look at the change in revenue versus the change in costs, and then calculate the incremental operating margin of the two results. If this marginal profitability number is much higher than historical profitability, a company is scaling nicely, and the investor has picture proof of that occurrence. If this number is lower than historic profitability, it raises a red flag for investors, who may be concerned that investments in new growth initiatives are yielding lower cash flow per dollar than previous investments.

Google’s recent first quarter results provide a nice example here. As you can see in the graph, Google’s incremental marginal profitability for Q1 was actually negative on both a year-over-year and a quarter-over-quarter basis. If a company is scaling nicely, you will see a marginal incremental profitability that is actually higher than the current profit margin. Google stated on its earnings call, that the company was simply investing for the long-term over the short-term, and was not concerned about this trend. Investors viewed things differently, and sent the stock down $48 the next day, representing a 7% fall from $578 to $530/share.

This is also the reason that “human capital” businesses like consulting businesses often have trouble with low valuations on Wall Street.  If the majority of costs are people, and people are also the key input for any work product, you will find the ability to generate increased marginal profitability quite difficult.

7. Customer Concentration

In their S-1, companies are required to highlight all customers that represent over 10% of their overall revenue?  Why do investors care about this?  Once again, all things being equal, you would rather have a highly fragmented customer base versus a highly concentrated one. Customers that represent a large percentage of your revenue have “market power” that is likely to result in pricing, feature, or service demands over time. And because of your dependence on said customer, you are likely to be responsive to those requests, which in the long run will negatively impact discounted cash flows. You also have an obvious issue if your top 2-5 customers can organize against you. This will severely limit pricing power. The ideal situation is tons of very small customers who are essentially “price takers” in the market.  Google’s AdWords program is a great example.

8. Major Partner Dependencies

Investors will discount the price/revenue valuation of any company that is heavily dependent on another partner is some way or form. A high profile example of this is Demand Media’s reliance on Google’s SEO traffic. Google isn’t the customer per se, but they can heavily impact the outcomes for Demand. And even if they don’t impact them (the recent quarter was in line with expectations), the mere awareness that they could, can have drastic impact on long-term valuation, and therefore price/revenue multiple.  These dependencies are also disclosed in the S-1 under “Risk Factors.” Here is the example of the risk disclosure of Demand’s dependence on Google from an SEO perspective:

“We depend in part on various Internet search engines, such as Google, Bing, Yahoo!, and other search engines to direct a significant amount of traffic to our owned and operated websites. For the quarter ended September 30, 2010, approximately 41% of the page view traffic directed to our owned and operated websites came directly from these Internet search engines (and a majority of the traffic from search engines came from Google), according to our internal data.”

These strong dependencies eat away at investors simply because the company is exposed to issues that are out of the control of management. As an example, Kayak’s potential IPO buyers will need to get comfortable with Google’s acquisition of ITA, Kayak’s use of ITA, and whether or not Google goes from being a source of traffic to a competitor. Likewise, if and when Zynga files for an IPO, new investors will be inherently betting on whether or not Zynga’s Facebook dependency is a positive or a negative. No one wants a partner policy or algorithm change to have unpredicted negative impacts on a public company. These risks are accounted for with lower valuation multiples.

9. Organic Demand vs. Heavy Marketing Spend

All things being equal, a heavy reliance on marketing spend will hurt your valuation multiple. Think about this simplistic example. There are two stores in the middle of town. One has a product/service that customers love, and as a result, customers flock to the store day in and day out all on their own. These customers then tell other potential customers, and through this “word of mouth” process, the customer base grows even larger. The second storeowner advertises frequently, and all new customers are a result of this advertisement and promotion (which obviously costs $$). Which business would you prefer to own?  Which one would likely have higher cash flows?  If you have to “buy” or “rent” your customers, you have a non-optimal business model – plain and simple.

The empirical data backs this up. You will be hard pressed to find a company with a heavy marketing spend with a high price/revenue multiple. Perhaps the very best Internet company that invests heavily in marketing is Netflix (marketing is about 15% of sales in recent quarter). When it comes to execution, Netflix is considered by many to be the best of the best. So you have a company that is highly regarded for their management prowess, and that is growing over 50% year over year. Yet, they trade at 4X 2011 revenue estimates and 3X 2012 estimates. And this is the best of the best.  The majority of companies that are heavy marketers trade at price/revenue multiples well below Netflix.

Consider another point. Most of the companies that have really high multiples, and that have been highly respected by investors all have or have had organic growth: Yahoo, Ebay, Google, Facebook, Skype, OpenTable, Baidu. These business models did not require marketing. The picture included below is borrowed from a Skype slide deck from a few years back, and does an amazing job of highlighting the difference between “bought traffic” and organic growth. As Niklas highlighted, the cost of acquiring a new Skype user was $0.001, versus $400 for Vonage, a very heavy marketer. Which company deserved a higher price/revenue multiple?

For a period of time, Jeff Bezos was a heavy investor in marketing, but after a while he retrenched. “About three years ago we stopped doing television advertising. We did a 15-month-long test of TV advertising. And it worked, but not as much as the kind of price elasticity we knew we could get from taking those ad dollars and giving them back to consumers,” said Bezos. “More and more money will go into making a great customer experience, and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people find out.”

This should not be read as a blanket condemnation of all marketing programs, but rather a simple point that if there are two businesses that are otherwise identical, if one requires substantial marketing and one does not, Wall Street will pay a higher valuation of the one with organic customers.

10. Growth

We saved the best for last. Nothing contributes to a higher valuation multiple like good ole’ growth. Obviously, the faster you are growing, the larger, and larger future revenues and cash flows will be, which has direct implications for a DCF. High growth also implies that a company has tapped into a powerful new market opportunity, where customer demand is seemingly insatiable. As a result, there is typically a very strong correlation between growth and valuation multiples, including the price/revenue multiple.

There is another reason why the premium paid for growth in 2011 may be even higher than it has been in the past.  As you can see from the table below, some of the largest names in technology are really struggling to grow. When you combine this fact with the paucity of IPOs from the past five years, the public technology investor has been starved from investing in companies with interesting growth characteristics. As such, they are likely to be super-excited by any company with a growth rate over 25%. If its over 50 or 100%, they will be ecstatic. Trading in and out of companies with low growth rates is simply not that interesting to an investor.

So growth is good, correct? There is a reason to save growth for last. While growth is quite important, and even thought we are in a market where growth is in particularly high demand, growth all by itself can be misleading. Here is the problem. Growth that can never translate into long-term positive cash flow will have a negative impact on a DCF model, not a positive one. This is known as “profitless prosperity.”

In the late 1990s, when Wall Street began to pay for “revenue” and not “profits” many entrepreneurs figured out a way to give them the revenues they wanted. It turns out that if all you want to do is grow revenues, with disregard for the other variables, it is quite simple to “manufacture” awe-inspiring revenue growth. To prove the point, consider this oft-used example from the Internet bubble. What if I had a business where I sold dollars for $0.85? What would my revenue growth look like? Obviously, you could grow this business to $ billions in revenue tomorrow. While this may be tongue and cheek, the real world example of the “dollar for $0.85” metaphor is any business where the value transfer to customers and suppliers and employees cannot be sustained at a positive profit. The customer will be thrilled with any “below market” offering, and will rush in to get all they can. In this case, the growth was actually created by the demand for the unsustainable offering.

There is another situation where growth can be misleading. If a company stumbles on to a hot new market, but lacks “barriers to entry” or does not have a sustainable competitive advantage, there will eventually be trouble. In fact, the very success of the first company in the field will act as a siren inviting others into the market, which, in the absence of a competitive advantage, will lead to margin erosion. Many electronics products follow this trend as some hot new product is quickly commoditized.

The 10X Club

So there are ten business characteristics that can impact a company’s chances of making it into the 10X+ price/revenue multiple club. Clearly, some of these variables are interdependent, and clearly you may find a company or two without every single characteristic, that still make the club. That said, most of the companies that trade at 10X or higher in terms of price/revenue will do extremely well against this scorecard.

All of which brings us to last week’s real world example, LinkedIn.  There has been much written about the LinkedIn IPO, and its tremendous after-market performance. As of Monday, LinkedIn’s market capitalization was $8.3 billion. Analysts have not published forward revenue estimates, but we have heard of investor models that put 2012 revenue anywhere between $550 and $700mm. Assuming these are accurate, LinkedIn trades between 11.8-15x 2012 revenues. This lofty valuation has attracted scrutiny from around the globe, including skeptical analysis from both the New York Times and Barron’s.

In the table below, you will see that LinkedIn does extremely well against our 10X club criteria list. It has growth, it has very high barriers to entry, it has network effects, and it has little to no dependencies. The only criticism one might have is that they are not showing enough profitability or marginal profitability. Profitability increased from Q3 to Q4 last year, but the company ramped sales spending in Q1, and profitability waned. So, assuming that the company is willing to show profit expansion over the next few years, it’s not that unreasonable for the company to trade at a 10X price/revenue multiple.

However, all companies with which the press and public are enamored are not LinkedIn. There are many hot brand-names with lofty private valuations and strong revenues, that would not do so well on the “10X scorecard.” Over the next 12-18 months we should see these companies test the public markets, and with the benefit of data and a truly liquid marketplace, we should gain a better appreciation for real valuation. If we’ve learned anything from the past market cycles, it’s that the fundamentals eventually matter, and all revenues are decidedly not created equal.

Update (5/26/2011): After some feedback from readers, and some further thoughts, there are a few more additions to the list worth mentioning, although in less detail.

1. Capital Expenditure Intensity – All things being equal, a company with heavy CapEx will trade at a lower price/revenue multiple (for sure). Capital intensity requires constant funding which will dilute either shares (through increaased offferings) or directly use up earned cash.

2. Cash flow / Earnings – Some companies generate way more cash flow than earnings, and some do the opposite (generate way more earnings than cash flow). The higher your ratio is of cash/earnings the better off you are. This can be accomplished in numerous ways, but one of the more common is to collect cash from your customer ahead of your accounting driven revenue-recognition. Cash is king, and if your cash margin is better than your accounting net income margin, you are golden. The opposite is also true. Companies that genreate far less free cash flow than earnings are going to have lower valuation multiples.

3. Optionality – This topic is a bit more abstract, but sometimes a company, due to its market position, is in a strong position to have optionality on a whole new business. A few years back, Amazon was trading at 1x revenue and had just launched AWS. AWS was an “option” on a whole new business, and eventually began to be valued as such.

4. TAM – One of the readers asked about TAM, which stand for Total Available Market. The assertion is that TAM can affect valuation multiple. I understand the concept, but I have not seen this play out in reality. Most of the companies that suffer from TAM never make it to the public markets. Also, companies that have high price/revenue multiples typically have optionality into other markets. So basically, I think TAM can radically affect private company valuations, but less so for public.

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Silicon Valley’s IPO Anxiety

Posted on November 15, 2010. Filed under: Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , |

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“Living in the limelight
The universal dream
For those who wish to seem.
Those who wish to be
Must put aside the alienation,
Get on with the fascination…”
— Limelight from Moving Pictures, Rush

If you could travel back in time to the early 1990’s and ask Silicon Valley’s top entrepreneurs and private company executives about their long-term career ambitions, you would hear a constant theme – they all wanted to be part of an Initial Public Offering (IPO). Back then, taking a company public, either as a CEO, CFO, or founder, held an allure similar to that of a young athlete dreaming of making it in the major leagues. Clearly, not everyone was able to go public, but that of course added to appeal. Everyone still wanted to go public. They all dreamed of playing on the business world’s biggest business stage.

A great deal has changed since then. First, we lived through the peculiar time now known as the Dot-com bubble, where the elite requirements for going public were greatly reduced. This was followed by a period of heavy regulation where many aspiring startups felt as if they were absorbing the burden of sins committed by the likes of Enron and WorldCom, two companies that are far away from Silicon Valley. If you believe what you read, we now live in a world where young entrepreneurs have a more cynical view of the IPO and being public in general. It is common today to read a phrase like “You don’t have to go public early to provide liquidity to early investors or employees.” It is critical to consider just how far away “don’t have to” is from “want to” or “dream of”.

How Did It Get This Bad?

There are many potential causes of this widespread pessimism. First and foremost, going public and being public are not nearly as much fun as they once were. The combination of a rise of ambulance-chaser shareholder lawsuits, Sarbanes-Oxley, the requirement for CEO and CFO signatures on financial filings, and limited personal trading flexibility has unquestionably made being public less enjoyable for executives. Increased bureaucracy and red-tape almost never lead to increased enthusiasm.

We may also have a perturbed notion of what a “healthy” IPO market looks like. For many, the go-go days of the late 1990’s stick in their mind as the definition of a strong IPO market. Unfortunately, the IPO market of 1999 was a myth, a façade, a once-in-a-lifetime mirage that you will never see again. While that period was economically fruitful, it was clearly manic and a long, long way from being healthy. Moreover, it was completely and utterly unsustainable. It also may have “cheapened” our view of the IPO. If anyone and everyone can go, it is no longer a heroic accomplishment.

One recent argument knocking the IPO is as follows: Wall Street is too short-term focused, and that if you want to run your company for the long-term you should remain private. There are three great reasons that this “can’t focus on the long term” argument falls short — Jeff Bezos, Marc Benioff, and Reed Hastings. All three of these amazing entrepreneurs turned CEOs took their company public on a standard IPO time frame. They also all three conveyed to Wall Street that they would postpone short-term earnings results in order to chase a greater long-term objectives and ambitions. The intelligent mutual fund investors that were swayed by their convincing arguments (there were many) were handsomely rewarded. Furthermore, Bezos, Benioff, and Hastings all three used “being public” as a bully-pulpit to tell their version of their industry’s story, thereby aiding their advantage. If you are unconvinced go ask Steve Riggio, Tom Siebel, or Blockbuster CEO Jim Keyes.

Certainly one contributor to the negativity surrounding the Silicon Valley view of the IPO market is the negative perception of the local press echoing off the hillsides of the Santa Cruz mountain peaks. Over the past several years, it has become quite common to read Silicon Valley articles and blog-post offering near-eulogies of the high-tech IPO. TechCrunch refers not to simply the “IPO” but to the “dreaded IPO,” or the “Poor, Pilloried, Tech IPO.” Famed early stage investor and typically glass-half-full blogger Fred Wilson recently penned “IPOs Just Aren’t What They Used To Be.” The San Francisco Chronicle stated that the “market for initial public offerings remains badly broken,” and the ecosystem “..has been destroyed.” And despite the numerous successful IPOs in the last two years that have supposedly put an “end to the IPO drought,” the only thing that doesn’t seem to go away is the use of the phrase “IPO drought.” If that were not enough, the NVCA (National Venture Capital Association) argues the situation is so dire that we need a Four Pillar Plan To Restore Liquidity. The pessimism is consistent and deafening. The glass isn’t simply half-empty; everyone seems to think there is a hole in the bottom of it.

How Bad Is It Really?

A more optimistic eye can see that the IPO data is actually improving. This quote from the NVCA’s second quarter update is rather straightforward:

Venture-backed company exit activity showed continued momentum during the second quarter of 2010, with the best quarterly total for venture-backed Initial Public Offerings (IPOs) since the fourth quarter of 2007, according to the Exit Poll report by Thomson Reuters and the National Venture Capital Association (NVCA). The quarter ended with 17 venture-backed IPOs, marking the third consecutive quarter for increased offerings, by number and by dollar amount.

Looking at the Q3-2010 NVCA data included above, you can see that 2010 is markedly improved over 2009. We have already tripled all of last year in the first three quarters of this year. Moreover, with a healthy Q4, we could meet or beat the annual numbers from 2005 and 2006. If you limit the data to VC backed companies in the U.S. in high technology (leaving out Pharma and bio med; which is different from the above), there were five in 2008, twelve in 2009, and 25 year-to-date in 2010. These data points are clearly up and to the right. And while they may not hit the bar we are looking from for a cyclical market high point, it surely makes it hard to say the IPO market is fatally flawed. And it unquestionably not “closed.”

The Majority of Recent IPOs Are Outside of Silicon Valley

U.S. High Technology / VC Backed IPOs Since the Beginning of 2008 (XLS)

The Excel spreadsheet embedded above contains a detailed look at all of the high-tech VC backed U.S. IPOs since the beginning of 2008. There is some very surprising data in this table. First, these IPOs have performed relatively well since their initial offering. On average, these IPOs have averaged 55.9% in price appreciation since their IPO date. This represents almost $14B of post IPO value creation as a group. Moreover, 19 of the 42 companies are worth over $1B. A full nineteen VC-backed companies with recent IPOs are now worth over $1b!  The press that keeps yearning for the next “big” IPO in Silicon Valley and complaining about the health of the IPO market, doesn’t spend much time talking about RackSpace ($3.3B market cap), RealPage ($1.8B market cap), GreenDot ($2.2B), or Ancestry ($1.1B) – all recent IPOs that have traded up quite nicely since they went public. Maybe there is a reason for this.

Is there any chance that the negative IPO sentiment that is reverberating through Silicon Valley is actually having an impact on the local IPO volume? One might expect, that as the epicenter of innovation, Silicon Valley would warrant more than its fair share of IPOs. But the data shows the exact opposite (see table below). In this same spreadsheet of recent IPOs, we have highlighted whether each company has its headquarters here in Silicon Valley or elsewhere in the United States. The shocking reality is that only 11 of the 42 high-tech, venture backed IPOs since 2008 reside in Silicon Valley. In other words, 74% of these IPOs hail from outside of the SV echo chamber.  If you look at the data in terms of initial IPO value, 78% of the overall value is from outside SV. In terms of value today its 73.5% (SV IPOS have outperformed those outside SV).  Perhaps these out-of-market IPOs aren’t well covered within Silicon Valley, and perhaps the negative IPO sentiment isn’t well heard outside of it. Our pessimism may have led to a self-fulfilling prophecy.

Demand or Supply Problem?

There is an interesting commentary at the end of the San Francisco Chronicle article that we previously discussed. “Brent Gledhill, with William Blair & Co., a small investment bank in Chicago, said he has buyers for small IPOs, but can’t get sellers.”  This argument, which was also supported by Paul Deninger of Jefferies, suggests that we have a “supply” problem, not a demand problem. He has BUYERS but not SELLERS. The problem is not that Wall Street doesn’t want product, it is the opposite; that we are not offering them enough of it. While it is clearly a chicken-egg argument, you simply cannot have a healthy IPO market if the leading high-quality companies are unwilling to file. The problem may be attitudinal, not structural.

To this point, and perhaps ironically to some, most of the people I know that work in high tech mutual funds and hedge funds would like to see more IPOs not less. They are tired of trading the same large technology names that are showing limited equity returns over the past 10 years, and have very low growth opportunities/ambitions. If you look at the the forward revenue growth estimates for technology bellwether stocks you may be surprised: Intel (3.5%), HP (5.6%), Microsoft (6.8%), Cisco (11.1%),Ebay (11.4%), and Yahoo (3.3%). And many of these stocks are flat to down for the past decade! Even Google, the youngest of the large cap tech plays has a go forward growth estimate of below 20%. As you can imagine, these traditional “must have” technology names are not contributing to mutual fund outperformance the way they once did. Fund managers desperately need more exposure to growth. They also crave exposure to new trends like social networking and mobile computing, but with limited IPOs they have limited ways to invest in these new innovative trends. They simply need more “quality” product.

Valuations Are “Higher” in the Public Market

As a result of this scarcity of growth across the broader set of public companies, strong category leaders like OpenTable, GreenDot, Realpage and are seeing healthy valuations in the public market. These high growth Internet leaders trade at PE multiples (30-50x) that are roughly twice that of Internet leaders Microsoft, Yahoo, Ebay, and even Google. The IPO market is currently paying a substantial premium over the M&A market (the exact opposite of what you read). The same large companies that are struggling to find growth have reduced valuation multiples (P/E, P/S). This in turn makes it hard for them to pay strategically high prices in an acquisition. Therefore, entrepreneurs that follow the advice from the San Francisco Chronicle, and are “looking to be acquired” may be leaving ample money on the table.

As an example, drill down on RealPage, a Dallas based leader in SAAS solutions for property management companies. It is currently trading at $1.86B after a successful August IPO. They currently trade at about 8.7X annualized Q2 revenue. Which potential acquirer would pay this valuation for a private vertical industry specific SAAS play? Do you think Salesforce, who has never done a large acquisition, would? Do you think Oracle (who trades at 3.5x sales would)? What about SAP (3.8X sales)? IBM (1.7x sales)? Or consider GreenDot which went public in July and currently trades at a $2.2B market capitalization. This valuation equates to roughly 6 times 2010 revenues. Do you think American Express (currently trades at 2X revenues) would have offered that in a private transaction?  What about  This recent Internet IPO is currently trading at a market capitalization of $1.17B. Which large Internet company would have paid close to $1B for Ancestry? None is my answer.

We should also consider DataDomain, 3Par, and Arcsight, all companies with remarkable sell-side M&A transactions who went public BEFORE engaging in an M&A transaction. Being public is a wonderful way to establish a baseline valuation in an eventual corporate sale. There is no chance someone would make an offer at or below the current market price, as the expectation is to pay a market premium. And because the BOD has a very high duty in terms of maximizing shareholder value, these deals are often seen by multiple bidders and therefore more likely to be competitive than a private transaction. Lastly, and not to be ignored, public company sales have zero escrow provisions. These escrows typically put at risk 10-15% of the transaction value when a private company is acquired. Being public before you get acquired can be extremely valuable.

Your Company Is Not Facebook

A large contributor to the negative IPO press is Facebook’s definitive view that it prefers to postpone its IPO well into the future. Recent comments suggest an IPO may be put off until 2012. As a top three worldwide Internet site, the press is obviously interested in what Facebook wants to do. Also, because of its huge impact, and the emerging trend of social networking, the buy-side is quite interested in owning Facebook. The demand for an IPO, were one to happen, would be enormous. And that is probably an understatement. However, it is critical to put this in perspective relative to everyone else.

Facebook is the exception not the rule. They can do what they want when they want. They can raise money privately at any time if they feel the need to do a cash acquisition. There are literally firms willing to wait in line to give them money. They can hold a press events and everyone comes, so they certainly do not need to be public to broadcast their message. However, they are also a miserable proxy for the average private company CEO and BOD to consider. Your company is not like Facebook, and it should not build its IPO plans based on what Facebook does or does not do.

Things Are Looking Up

This entire problem may be self-correcting. The BOD and executives from the companies that have not gone public have certainly noticed the successful offerings, post-market performance, and valuations of the IPOs mentioned herein. As such many of these executives are now marshalling the forces for their own IPO. As an example, Betfair, a long awaited IPO in the UK (congrats @jdh) just went public and had strong results. Skype and ZipCar have filed, and all indications are that LinkedIn is working on its own filing. There is also a good chance that companies like AutoTrader and eHarmony will come public soon, and there have been multiple rumors of IPOs at companies such as Hulu and Pandora.

In addition, the very recent press seems to also be singing a different tune than the dire press from this summer.  Check out the following headlines from the last few weeks:

I recently had the opportunity to hear the story of how Tim Sullivan, the former leader of, went into five years ago as CEO.  At the time, the company’s growth had slowed and many had assumed it had seen its better days. Tim and his team and began a multi-year turn-around that would eventually lead to last year’s respectable IPO. Last week, the company completed a successful secondary offering. Tim shared with me all of the amazing work that went into reigniting this market leader (a very impressive story), but I was most surprised when he talked about the IPO process. His face broke out into this huge grin as he described watching the stock trade that first day. You could clearly see the type of IPO enthusiasm that once reigned supreme in Silicon Valley. For Tim, the dream was still alive, and more importantly he was able to turn his dream into reality.

Waves of pessimistic analysis can become self-reinforcing and began to influence rather than just inform. That appears to be the case with respect to local attitudes towards high-tech IPOs. Next time you hear someone talking about how broken the IPO market is, please let him or her know that despite what you read, many great companies are going public and are having remarkable success. And if they still doubt you, tell them reach out to Steven Streit at GreenDot, Zorik Gordon at ReachLocal, Doug Valenti at QuinStreet, or any of the 38 other CEOs who recently stood up and walked through the door that everyone else says isn’t open. Their story should be at least as compelling as focusing on the few companies that don’t seem all that interested.

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Android or iPhone? Wrong Question

Posted on January 5, 2010. Filed under: iphone, Mobile, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , , |

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In a recent New York Times article, Kathryn Huberty, a Morgan Stanley analyst was quoted suggesting that Apple’s iPhone is the key catalyst for an important new technology trend. “Applications make the smartphone trend a revolutionary trend – one we haven’t seen in consumer technology for many years.” This argument rings true in that the “after iPhone” smartphone market is dramatically more interesting than the “pre-iPhone” smartphone market. Later, Ms. Huberty made an even bolder statement, “The iPhone is something different. It’s changing our behavior…The game that Apple is playing is to become the Microsoft of the smartphone market.”  Or perhaps not.

Many analysts and bloggers have worked hard to position “iPhone vs. Android” as the title fight of the decade in the technology industry. It is an easy comparison to want to make. Both phones use rich microprocessors, are graphical, both have GPS and Wifi. They both run a sophisticated operating system, and they both give you access to thousands and thousands of third party applications. In most practical ways, they seem similar. However, there is one fundamental difference – business model choice.

When Apple launched the iPhone, it was able to secure an unprecedentedly strong business relationship with AT&T. Not only did Apple want control over the user interface, something carriers had been extremely reluctant to cede, it also wanted previously unrealized economics for a handset or OS designer. Apple insisted on upfront revenue dollars as well as a cut of the cellular service stream. AT&T, desperate for a win vs. Verizon, acquiesced.  The product was launched to rave reviews from analysts and consumers alike. It really was a brand new market and a brand new product. As noted earlier, we only “thought” we had seen smartphones before the iPhone. This market, as Ms. Huberty notes, looks like one that is Apple’s to lose.

With the iPhone’s massive success, it would be hard in retrospect to challenge the thinking behind Apple’s business model choice. After all, it will always be true that Apple was the company that “cracked open” the famed Walled Garden of carrier-land. They also did it with style, demanding golden economics as it disrupted a previously obstinate industry. And although AT&T may have become “comfortable” with its choices as a result of the iPhone’s success, other carriers suddenly had an “iPhone problem.” Enter Google.

If Apple’s business model is aggressive relative to the carriers, in contrast Google’s seems unrealistically accommodating. You want to control the user interface? No problem. Want access to the code? We’ll make it open source. What kind of economics do we want? Nothing at all.  What the hell, we will pay you!  That’s right.  Google will give the carrier ad splits that result from implementing the Google search box on any Android phone. FBR Capital Markets suggests that Google is taking this idea one step further in its November 24, 2009 report titled Implications of a Potential Share Shift to Android-Based Wireless Devices. “Recent support for Android-based devices appears to be correlated with significant up-front financial incventives paid by Google to both carriuer and handset vendors.” FBR goes on to suggest that these incentives may be as high as $25-50 per device. This is simply an offer that no carrier can refuse, particularly when U.S. carriers are currently in the habit of paying $50-150 per handset sold in subsidies.

While Apple may have opened the proverbial Walled Garden, it is Google, with its aggressive Android offering, that aims to obliterate it. Make no mistake about it; Apple was the pioneer with the amazing revolutionary product. Also, with no iPhone, there is no Android. This is not to say that Android copied iPhone, but rather the impetus to adopt and trust Google’s Android offering was driven by a market dynamic that resulted directly from the iPhone’s success.  Without the iPhone, it is possible that most carriers might have opted not to use Google’s OS solely for the reason that letting a powerful company like Google in the front door can be a risky strategic bet.

All of this is now history. The iPhone does exist, and it is wildly popular. There are an estimated 55 million iPhones in use around the world. Despite this remarkable success, history will also show that Apple intentionally chose a business model with plenty of room for disruption underneath its pricing structure. It also chose a single carrier as a partner, which resultantly threatened others. Then Google built a product and a strategy that allayed the carrier’s relative fears. Google gave them what they wanted, and then even gave them money. It could afford to do this because Google aims solely to protect the great business they already have in advertising, not to make money directly from the product (HW or SW in this case). Microsoft Windows, Internet Explorer, and Mozilla’s Firefox represent choke points on the personal computer whereby Google could lose search share, or at least be forced to pay a toll. In mobile, they see a chance to potentially eliminate the toll-takers.

With a business model that allows for much broader distribution and price points that are well beneath the iPhone, Google’s Android won’t compete directly with the iPhone.  For the iPhone loyalist, like Stewart Alsop who railed against Android, Android is simply not an option.  This price insensitive user demands the very best experience they can possibly have and this is still the iPhone. Users won’t switch in mass from the iPhone to the Android. It’s the other 3.95 billion cell phone users that are highly likely to consider Android a step up from their current feature phone. The Android strategy results in phones at much lower prices with much more diversity which will hit a braoder set of demographics. Apple can and will quintuple its current market share and still have a small portion of the overall cell phone market.

This is why the two products do not compete head to head. With its super aggressive model, Android will be the choice of the masses, and with its sleek design and non-compromising price point, Apple will rule the high end. Many have suggested that Apple is perfectly happy with its high-margin spot at the top of the food chain. They are doing exceptionally well with that position in the personal computer market – in fact, they are currently gaining share at an accelerating pace. So no need to worry about Apple, they are doing just fine (as their stock price suggests). They are just not currently executing a model to become the “Microsoft” of the smartphone market.

Some will argue that the best product will win the market and that Apple will still dominate the smartphone market. The history of the personal computer market is no omen for this thesis. If you think about it, the people that know this better than anyone are the exact Apple loyalists who have been frustrated for years at Apple’s lack of dominance in the PC market. Disruptive business strategies can and have trumped better products. And with no change to the current market, the Android leveraged position in the market could result in staggering unit share gains. This is not to say that the Google Android is better than or as good as the Apple iPhone. The key point is that it does not have to be. It only needs to be dramatically better than the current feature phone. Which it is.

While Apple will be fine as Android gains steam, the amount of shrapnel flying around this new marketplace is immense, so expect innocent bystanders to be compromised.  Recognize that as Google’s play here is as much defense as offense, they have less of a need to “make a profit,” at least right out of the gate.  This type of attitude always makes for a messy competitor.  Also, because of the sheer breadth of the effort in terms of number of handset makers and number of carriers, Android will be marketed extremely aggressively.  Lastly, the early application leaders are beginning to believe it’s a two horse race.  Currently the iPhone is priority number one.  That said, increasingly these application vendors are seeing Android as the primary second platform to support.  Others are falling further and further behind.

Also, Android doesn’t appear to be an OS that stops at the smartphone market.  Expect much experimentation with a variety of hardware manufactures and almost any and every embedded device market from navigation devices to e-readers to tablets and beyond.  Android gives every Korean, Taiwanese, and Chinese manufacture whoever wanted to approach these markets a huge head-start.  Additionally, the more of these vendors that build on Android, the more Android will evolve for the better.  The number of applications will increase, and the problems will get worked out.  Just like Microsoft worked its way from Windows to Windows 3 and eventually to Windows 7, Android will improve with time as well.

With its disruptive and leveraged strategy, it is Google that is attempting to be the Microsoft of the smartphone market.  Perhaps ironically, Apple is well positioned to be the “Apple” of the smartphone market.

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    …focusing on the evolution and economics of high technology business and strategy. By day, I am a venture capitalist at Benchmark Capital.


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