It’s easy to create a Unicorn (over $1 billion in market value in under 10 years):
Get to $100m in annual revenues and be valued at 10x revenue.
That was a joke. It is of course, really hard to create a Unicorn. I happen to think that it is easier to create a Unicorn in Fintech than in any other market, but it is still very hard. There is a reason that they are called Unicorns – they are rare.
Of course, you could also get to $200m in annual revenues and be valued at 5x revenue (readers of this blog are good at math, so they know this).
In this post I focus on how you get valued by investors at 10x revenue. Assume that investors are smart. This is not about the short valuation spikes that happen occasionally when a company is massively overvalued. This is about how to be valued at 10x because a year from now you can be worth twice as much and be valued at a lower multiple because you have “grown into your valuation”.
I am indebted to this post by Bill Gurley (Partner at Benchmark Capital) from May 2011. It is a classic. If you don’t already know it, please read it before reading this post. It will explain the 10 attributes in more detail and crucially explains why revenue is the right metric. I will quote from his blog to explain why revenue is the right metric as long as it is “high quality revenue”:
“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.”
A simpler way to look at these 10 attributes is how to get high quality revenue.
1. Competitive Advantage Period
This is why Warren Buffet talks about Coca Cola as a “forever” stock. As Bill Gurley puts it:
“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.”
Coca Cola has the kind of lightweight business model that we associate with digital startups. I explore how Coca Cola and other great companies like Apple and American Express do this using the art of the chef in a chapter of my book Mindshare to MarketShare (shameless plug, buy it here on Amazon for the bargain price of $28).
Competitive Advantage Period in tech is shorter. That is the bad news. The good news is that you can get to $100m or a $1 billion in annual revenue far, far faster in tech than in any other business. I did some research to discover a halving of Competitive Advantage Period in each wave of technology. This was the reason that I was bearish on Facebook at their IPO. I thought that Facebook was the winner of the desktop era and that somebody else would supplant Facebook in the mobile era. I underestimated Mark Zuckerberg’s determination not to let that happen even if that meant paying “ridiculous” valuations for Instagram and WhatsApp.
2. Network Effects
This is the biggie. It will drive all the other criteria. Network effects have to be intrinsic or “organic”. You can amplify Network Effects with conventional techniques such as affiliate marketing; but you cannot create Network Effects using marketing techniques. Intrinsic Network Effects comes when users/customers invite other users to join because they need those other users to join in order to benefit from the service.
3. Revenue Visibility
This is why perpetual licensing software companies are valued about as highly today as a pig iron smelter in Kazakstahn (although savvy PE have learned the game that was pioneered by the Misys founder, Kevin Lomax, of looking at the Annual Maintenance fees). SAAS monthly recurring revenues are valued higher. Ventures that use Freemium where you can easily model revenue forecasts through tweaks in the financial model are value even higher.
4. Customer Lock-In aka High Switching Costs
Churn is the kryptonite of digital Unicorns. High churn leads to spending more to acquire new customers. Customer Lock-In is the way to avoid Churn. Like Network Effects, Customer Lock-In has to be organic. The kind of Customer Lock-In where you have to work really hard to delete your account does not count. Customers have to love being locked in or at least know that it would be a real pain to switch so they “grin and bear it”.
5. Gross Margin Levels
This is the most obvious criteria for revenue quality. It was why the software licensing business was so good for so long (sell a License for $1 million and send a tape that costs $5; it was as close to 100% gross margin as you will find in this world). SAAS gross margin is usually over 85% (allowing 15% for hardware cost). Don’t even think of trying to join the 10x revenue club if you have gross margins lower than 50%.
During the Dot Com Bubble you could get to $100m by selling $1 for 99 cents and still be valued at $1 billion. That game is long over.
6. Marginal Profitability Calculation
This is what enables investors to pay a lot of money for unprofitable companies, which looks crazy by all the old PE calculations of public market investors. If all the other attributes are true, you can easily see how profits will grow fast once you cross a certain revenue threshold. At that point your fixed overheads become far less relevant than your gross margins.
7. Customer Concentration
This is only an issue if you sell to Enterprise. If your customers are consumers or SMB, this is never an issue. Its one reason that investors like consumers or SMB focused companies.
8. Major Partner Dependencies
This is the one to watch for consumers or SMB focused companies. If you get too great a % of revenue from a few partners, you are vulnerable to those partners switching their attention to the latest “belle at the ball”.
9. Organic Demand vs Heavy Marketing Spend
This is the issue I was concerned with when I looked at OnDeck. It also worries me whenever I see too many billboard ads. I think billboards are a smart form of advertising because of attention span fatigue online. However whenever I see a lot of billboard ads, I think of investor money being misspent in a rush for growth in order to raise more money. There were too many billboard ads in Silicon Valley in 1999 and in India in 2000 (during India’s brief 3 month bubble). One concern I have with the story that London is becoming the Fintech Capital of the World story is too many billboard ads. You can defend and maintain a brand using advertising, but very few brands have been built using advertising.
This is where it all comes together. Investors pay more for fast growth than slow growth. One of the simplest ways to value companies is PEG (Price Earnings Growth). More than 1xPEG is usually considered expensive. This normalizes a company growing at 10% pa that is valued at PE=10, versus a a company growing at 50% pa that is valued at PE=50. At around $100m in revenues, you need at least 50% annual growth to be considered for invitation to the 10x Revenue Club.