User and Subscriber Businesses: The Good, the Bad and the Ugly!

In a series of posts over the course of the last year, I argued that you can value users and subscribers at businesses, using first principles in valuation, and have used the approach to value Uber riders, Amazon Prime members and Spotify & Netflix subscribers. With each iteration, I have learned a few things about user value and ways of distinguishing between user bases that can create substantial value from user bases that not only are incapable of creating value but can actively destroy it. I was reminded of these principles this week, first as I wrote about Walmart's $16 billion bid for 77% of Flipkart, a deal at least partially motivated by shopper numbers, then again as I read a news story about MoviePass and the potential demise of its "too good to be true" model, and finally as I tripped over a LimeBike on my walk home. 

User Based Value

My attempt to build a user-based valuation model was triggered by a comment that I got on a valuation that I had done of Uber about a year ago on my blog. In that post, I approached Uber, as I would any other business, and valued it, based upon aggregated revenues, earnings and cash flows, discounted back at a company-wide cost of capital. I was taken to task for applying an old-economy valuation approach to a new-economy company and was told that that the companies of today derive their value from customers, users and subscribers. While my initial response was that you cannot pay dividends with users, I realized that there was a core truth to the critique and that companies are increasingly building their businesses around their members. 

Consequently, I went back to valuation first principles, where the value of any asset is a function of its cashflows, growth and risks, and adapted that approach to valuing a user or subscriber:

To get from the value of existing users to the value of an entire company, I incorporated the value effect of new users, bringing in the cost of acquiring a new user into the value:

I applied closure by consider all corporate costs that are not directly related to users or subscribers in a corporate cost drag, a drag because it reduces the value of the business:

Cumulating the value of existing and new users, and netting out the corporate cost drag yields the value of operating assets, i.e., the same value that you would derive by discounting the free cash flows to the entire business by its overall cost of capital. You would still need to clean up, by adding in cash, netting out debt and dealing with outstanding options, but that process is the same in both models.

I would hasten to add that a user-based value model is not a panacea to any of the valuation challenges that we face with young, user-based companies. In fact, the difficulties with obtaining the raw data needed on user renewal rates and acquisition costs can be so daunting that any potential advantages that you obtain by looking at user-level value can be drowned out by noise. It is also worth emphasizing that its user-focus notwithstanding, this model is grounded in fundamentals, with value coming, as it always does, from cash flows, growth and risk. I am still learning about this model, but I have put down what I have learned over the last year, when valuing Uber, Amazon Prime and Netflix, into a paper that you can download, read and critique.

Good, Bad and Indifferent User-based Models

One of the motivations for my user-focused valuation was based upon casual empiricism. In my view, many venture capitalists and public investors are pricing user-based companies on user count, with only a few seriously trying to distinguish between good, indifferent and bad user-based models. One of the bonuses of using a user-based model is that it provides a framework for differentiating between great and mediocre user-based companies.

Drivers of Value

A standard critique that old-time value investors have of user-based companies is that they all lose money, but that is not true. There are user-based companies that make money, but it is also true that the user-based model is still in its infancy and that many user-based companies are young, and therefore lose money. That said, there are elements of the cost structure that you can look at, to make judgments on which user-based companies are most likely to grow out of their problems and which ones are just going to grow their problems.

a. Cost Structure: Most young, user-based companies lose money but at the risk of sounding unbalanced, there are good ways to lose money and bad ones, from a value perspective. 

1. Servicing Existing Users versus New User Acquisition: From a value perspective, it is far better for a company to be losing money, because it is spending money trying to acquire new users, than it is to be losing money, because it costs so much to service existing users. The latter signals a bad business model, at least for the moment, whereas the former offers a semblance of hope.
2. Fixed versus Variable Costs: For mature companies with established business models, it is better to have a more flexible cost structure (with more variable costs and less fixed costs). With money-losing, high-growth companies, the reverse is true, since it is the fixed cost portion that yields economies of scale, as the company grows.

b. Growth: Repeating a value nostrum, growth is not always value-creating and not all growth is created equal.

1. Existing versus New Users: A user-based model, where you can grow cash flows from existing users is more valuable, other things remaining equal, than a user-based model that is dependent on adding new users for growth. The reason is simple. Since a company already has expended resources to get existing users, any added revenue it derives from them is more likely to flow directly to the bottom line. Adding new users is more expensive, partly because it costs money to acquire them, but also because new users may not be as active or lucrative as existing ones.
2. Cost of New User Acquisition: This is a corollary of the first proposition, since the value of a new user is net of user acquisition costs. Consequently, user-based companies that are more cost-efficient in adding new users will be worth more than user-based companies that spend considerable amounts on promotion on marketing, to the same end.  

This contrast is best illustrated by looking at Netflix and Spotify, both subscriber-based companies, but with very different models for paying for content. Netflix pays for content as a fixed cost, and derives economies of scale, when it adds fresh subscribers, whereas Spotify pays for content, based upon how much subscribers listen to songs, making it a variable and existing user based cost. As a result, Netflix derives much higher value from both existing and new subscribers:

	Netflix	Spotify
Number of Subscribers	117.6	71
Annual Revenue/Subscriber	$         113.16	$         77.63
Subscriber Service Expenses (as %)	18.90%	79.24%
CAGR in subscriber count	223.93%	369.86%
Value per Existing Subscriber	$         508.89	$       108.65
Cost of acquiring New Subscriber	$         111.01	$         27.30
Value per New Subscriber	$         397.88	$         81.35
Value of all Existing Subscribers	$    59,845.86	$    7,714.28
+ Value of all New Subscribers	$  137,276.49	$  20,764.56
- Corporate Cost Drag	$  111,251.70	$  13,139.75
=Value of Operating Assets	$    85,870.65	$  15,339.10

c. Revenue Models: There are three user-based models, the first is the subscription-based model (that Netflix uses), the second is the advertising-based model (that Yelp uses) and the third is a transaction-based model (that Uber uses). There are companies that use hybrid versions, with Amazon Prime (membership fees and incremental sales) and Spotify (Subscription plus Advertising) being good examples. Each model comes with its pluses and minuses. 

1. Subscription models tend to be stickier (making revenues more predictable) but they offer less upside potential (it is difficult to grow subscription fees at high rates).
2. Advertising models scale up faster, since they require little in capital investment and adding new users is easier (since they free), but revenues are heavily driven by user intensity (how much time you can get users to stay in your ecosystem) and exclusive data (collected in the course of usage).
3. Transaction models are the riskiest, since they require users to use your product or service, but they also offer the most upside, since your upside is less constrained. Amazon Prime's value, in my view, does not stem primarily from the subscription revenues of $99/year but from Amazon's capacity to sell Prime members more products and services.

While no model dominates, picking the wrong revenue model can quickly handicap a business. For instance, using a subscription-based model for a transaction business, where usage varies widely across users, can result in self-selection, where the most intense users choose the subscription-based model to save money, and less intense users stay with a transaction-based model.

Differentiating across User-based Models

With the user-based framework in place, we can start distinguishing between user-based companies. Using existing user value and new customer acquisition costs as the dimensions, we can derive a matrix of companies that go from user-value stars to user-value dogs.

While the combination of high user value with low user acquisition costs may sound like a pipe dream, it is what network benefits and big data, if they exist, promise to deliver. 

• Network benefits refer to the possibility that as you grow bigger, it becomes easier for you to get even bigger, making it less costly to acquire new users. That is the promise of ride sharing, for instance, where as a company gets a larger share of a ride sharing market, both drivers and customers are more likely to switch to it, the former, because they get more customers and the latter, because they find rides more quickly.
• Big data, in a value framework, offers user-based companies an advantage, since what you learn about your users can be used to either sell them more products or services (if you are a transaction-based company), charge them higher premiums (if you are subscription-based) or direct advertising more effectively (if advertising-based). 

Many user-based companies aspire to have network benefits and to use data well, but only a few succeed.

The Pricing Game

As I look at user-based companies, some of which are being priced at billions of dollars, I am struck by how few of them are built to be long term businesses and how many of them are being priced on user numbers and buzz words. Using the framework from the last section, I would like to develop some common features that bad user-businesses seems to share in common and use one high profile examples, MoviePass , to make my case.

Mediocre User-based Companies
Given that so many young companies market themselves, based upon user and subscriber numbers, and that some of them can become valuable companies, are there signs that you can look for that separate the good from the mediocre companies? I think so, and here are a few red flags:

1. All about users, all the time: If the entire sales pitch that a company makes to investors is about its user or subscriber numbers, rather than its operating results (revenues and operating profits/losses), it is a dangerous sign. While large user numbers are a positive, it requires a business model to convert these users into revenues and profits, and that business model will not develop spontaneously. Companies that do not work on developing viable business models go bankrupt with lots of users.
2. Opacity about user data: It is ironic that companies that market themselves to investors, based upon user numbers, are often opaque about key dimensions on users, including renewal (churn) rates, user behavior and side costs related to users. The companies that are most opaque are often the ones that have user models that are not sustainable.
3. Bad business models: If having no business model to convert users to operating results is a bad sign, it is an even worse sign when you have a business model that is designed to deliver losses, not only in its current form, but with no light at the end of the tunnel. That is usually the consequence of having losses that scale up as the company gets bigger, because there are economies of scale. 
4. Loose talk about data: The fall back for many user based companies that cannot defend their business models is that they will find a way to use the data that they will collect from their users to make money in the future (from targeted advertising or additional products and services), without any serious attempt to explain why the data will give them an edge.
5. And externalities: Many user based companies argue that their "innovative" twists on an existing business will both expand and alter the business, leading to benefits for other players in that business, who, in turn, will share their benefits with the user based companies.

The bottom line is simple. It is easy to build user numbers, if you sell a product or service at way below cost, but if your objective is build a long-standing user-based companies, you need a pathway to profitability that is defined early and worked on continuously.

MoviePass: Too Good to be True? 

If you subscribe to MoviePass, for a monthly subscription of $10, you get to watch one theatrical movie, every day, for the entire month. Given that the average price of a theater ticket in the US is $9, this sounds like an insanely good deal, and for an avid movie goer, it is, and the service had two million subscribers in May 2018. MoviePass, though, pays the theaters for the tickets, creating a model that is more designed to drive it into bankruptcy than to deliver profits.

MoviePass Economics

When confronted by the insanity of the business model, Mitch Lowe, the CEO of MoviePass, argued that after an initial burst, where subscribers would see four or five movies a month, they would settle into watching a movie a month, allowing the service to break even. Since Mr. Lowe is a co-founder of Netflix and a former CEO of Redbox, I will concede that he knows a lot more about the movie business than I do, but this is an absurd rationale. If the only way that your service can become viable is if people don't use it very much, it  is not much of a service to begin with.  

In its early days, MoviePass seemed to be trying to build a viable business model, and acquired some high profile venture capital investors, but it was eventually acquired by Helios and Matheson, a data analytics firm, in a  transaction in August 2017. It is Helios and Matheson, intent on giving both data and analysis a bad name, that instituted the $10 a month for a movie-a-day subscription. The subscription worked in delivering users but it, not surprisingly, came with large losses. As MoviePass has continued to burn cash (more than $20 million a month by April 2018), the share price of Helios and Matheson has collapsed, in a belated recognition of its non-viable business model.

Adding to the sense that no one in this company has a grip on reality, Ted Farnsworth, the CEO of Helios and Matheson, argued that the service would continue and had acquired a $300 million line of credit. Since his backing for this line of credit was that he could issue the remaining authorized shares at the current market price, this indicates either extreme ignorance (potential equity issues don't comprise a line of credit) or unalloyed deception, neither of which is a quality that builds trust. Along the way, there have been other attempts to rationalize the model, including the possibility of using the data collected from subscribers to target advertising and the sharing of additional revenues generated by theaters and studios from more movie going. There is nothing exclusive about the data that will be collected from MoviePass subscribers and it is unlikely that theaters and small studios, already on the brink financially, will be willing to share their revenues. In short, this is a bad business model hurtling to a bad end, and the only question is why it took so long.

The Bottom Line

To build a good user-based business, you have to start with the common sense recognition that users are not the end game, but a means to an end. Unfortunately, as long as venture capitalists and investors reward companies with high pricing, based just upon user count, we will encourage the building of bad businesses with lots of users and no pathways to becoming successful businesses.

YouTube Video


Paper on User Based Value

1. Going to Pieces: Valuing Users, Subscribers and Customers

Blog Posts on User-based Value

1. Valuing Uber Riders
2. Valuing Amazon Prime Members
3. Valuing Spotify Subscribers
4. Valuing Netflix Subscribers

Read More

Venture Capital: It is a pricing, not a value, game!

Venture capitalists (VCs) don’t value companies, they price them! Before you explode, implode or respond with righteous indignation, this is not a critique of what venture capitalists do, but a recognition of reality. In fact, not only is pricing exactly what you should expect from VCs but it lies at the heart of what separates the elite from the average venture capitalist. I was reminded of this when I read a response from Scott Kupor of Andreessen Horowitz, to a Wall Street Journal article about Andreessen, that suggested that the returns earned by the firm on its funds were not as good as those earned at other elite funds. While Scott’s intent was to show that the Wall Street Journal reporter erred in trusting total returns as a measure of VC performance, I think that he, perhaps unintentionally, opened a Pandora’s box when he talked about how VCs attach numbers to companies and how these numbers get updated, and how we (investors, founders and VCs) should read them, as a consequence.

The WSJ versus the VC: A Recap

Let’s start with the Wall Street Journal article that triggered the Kupor response. With the provocative title of “Andreessen Horowitz’s returns trail venture capital elite”, it had all the ingredients for click bait, since a big name (Andreessen Horowitz) failing (“trail venture capital elite”) is always going to attract attention. I must confess that I fell for the bait and read the article and walked away unimpressed. In effect, Rolfe Winkler, the Journal reporter, took the three VC funds run by Andreessen and computed an IRR based upon the realized and unrealized gains at these funds. I have reproduced his graph below:

While the title of the story is technically correct, I am not sure that there is much of a story here. Even if you take the Journal’s estimates of returns at face value, if I were an investor in any of the three Andreessen funds, I would not be complaining about annual returns of 25%-42%, depending on the fund that I invested in. Arguing that I could have done better by investing in a fund in the top 5% of the VC universe would be the equivalent of claiming that Kevin Durant did not having a good NBA season last year, because Lebron James and Stephen Curry had better seasons.

In the hyper-competitive business of venture capital, though, the article must have drawn blood, since it drew Scott Kupor's attention and a response. Scott focused attention specifically on what he believed was the weakest link in the Journal article, the combining of realized and unrealized gains to estimate an internal rate of return. Unlike investments in public equities, where the unrealized returns are based upon observed market prices for traded stocks and can be converted to realized returns relatively painlessly, Scott noted that unrealized returns at venture capital funds are based upon estimates and that these estimates are themselves based upon opaque VC investments in other companies in the space and not easily monetized. Implicitly, he seemed to be saying that not only are unrealized returns at VC funds subject to estimation error, but also to bias, and should thus be viewed as softer than realized returns. I agree, though I think it is disingenuous to go on to argue that unrealized returns should not be considered when evaluating venture capital performance, since VCs seem to have qualms about using them in sales pitches when they serve their purpose.

The VC Game

The Kupor response has been picked in the VC space, with some commenters augmenting legitimate points about return measurement but many more using the WSJ article to restate their view that non-VC people should stop opining about the VC business, because they don’t understand how it works. Having been on the receiving end of this critique at times in the past, you would think I would know better than to butt in, but I just can’t help myself. I may not be qualified to talk about the inner workings of the venture capital business, but I do believe that I am on firmer ground on the specific topic of how VCs attach numbers to the companies that they invest in.

VCs price businesses, not value them!

I have made the distinction between value and price so many times before that I sound like a broken record, but I will make it again. You can value an asset, based upon its fundamentals (cash flows, growth and risk) or price it, based upon what others are paying for similar assets, and the two can yield different numbers.

In public investing, I have argued that this plays out in whether you choose to play the value game (invest in assets where the price < value and hope that the market corrects) or the pricing game (where you trade assets, buying at a lower price and hoping to sell at a higher).  I would be glad to be offered evidence to the contrary but based upon the many VC "valuations" that I have seen, VCs almost always play the pricing game, when attaching numbers to companies, and there are four ways in which they seem to do it:

1. Recent pricing of the same company: In the most limited version of this game, a prospective or existing investor in a private business looks at what investors in the most recent prior round have priced the company to gauge whether they are getting a reasonable price. Thus, for an Uber, this would imply that a pricing close to the $62.5 billion that the Saudi Sovereign fund priced the company at, when it invested $3.5 billion in June 2016, will become your benchmark for a reasonable price, if you are investing close to that date. The dangers in doing this are numerous and include not only the possibility of a pricing mistake (a new investor who over or under prices the company) spiraling up and down the chain, but also the problems with extrapolating to the value of a company from a VC investment in it.
2. Pricing of “similar” private companies: In a slightly more expanded version of this process, you would look at what investors are paying for similar companies in the “same space” (with all of the subjective judgments of what comprises “similar” and “same space”), scale this price to revenues, or lacking that, a common metric for that space, and price your company. Staying in the ride sharing space, you could price Lyft, based upon the most recent Uber transaction, by scaling the pricing of the company to its revenues (relative to Uber) or to rides or number of cities served.
3. Pricing of public companies, with post-value adjustments: In the rare cases where a private business has enough operating substance today, in the form of revenues or even earnings, in a space where there are public companies, you could use the pricing of public companies as your basis for pricing private businesses. Thus, if your private business is in the gaming business and has $100 million in revenues and publicly traded companies in that business trade at 2.5 times revenues, your estimated value would be $250 million. That value, though, assumes that you are liquid (as publicly companies tend to be) and held by investors who can spread their risks (across portfolios). Consequently, a discount for lack of liquidity and perhaps diversification is applied, though the magnitude (20%, 30% or more) is one of the tougher numbers to estimate and justify in practice.
4. Forward pricing: The problem with young start-ups is that operating metrics (even raw ones like riders, users or downloads) are often either non-existent or too small to be base a pricing. To get numbers of any substance, you often have to forecast out the metrics two, three or five years out and then apply a pricing multiple to these numbers. The forecasted metric can be earnings, or if that still is ephermal, it can be revenues, and the pricing multiple can be obtained not just from private transactions but from the public market (by looking at companies that have gone public). That forward value has to be brought back to today and to do so, venture capitalists use a target rate of return. While this target rate of return plays the same mechanical role that a discount rate in a DCF does, that is where the resemblance ends. Unlike a discount rate, a number designed to incorporate the risk in the expected cash flows for a going concern, a target rate of return incorporates not just conventional going-concern risk but also survival risk (since many young companies don’t make it) and the fear of dilution (a logical consequence of the cash burn at young companies), while also playing role as a negotiating tool. Even the occasional VC intrinsic value (taking the form of a DCF) is a forward pricing in disguise, with the terminal value being estimated using a multiple on that year's earnings or revenues.
   
   
   

At the time of a VC investment, the VC wants to push today’s pricing for the company lower, so that he or she can get a greater share of the equity for a given investment in the company. Subsequent to the investment, the VC will want the pricing to go higher for two reasons. First, it makes the unrealized returns on the VC portfolio a much more attractive number. Second, it also means that any subsequent equity capital raised will dilute the VC’s ownership stake less. If you reading this as a criticism of how venture capitalists attach numbers to companies, you are misreading it because I think that this is exactly what venture capitalists should be doing, given how success is measured in the business. This is a business where success is measured less on the quality of the companies that you build (in terms of the cash flows and profits they generate) and more on the price you paid to get into the business and the price at which you exit this business, with that exit coming from either an IPO or a sale. Consequently, how much you are willing to pay for something becomes a process of judging what you will get when you exit and working backwards.

But Venture Capitalists have a data problem

It is not just venture capitalists who play the pricing game. As I have argued before, most investors in public markets (including many who call themselves value investors) are also in the pricing game, though they use pricing metrics of longer standing (from PE to EV/EBITDA) and have larger samples of public traded firms as comparable firms. The challenges with adapting this pricing game to venture capital investments are primarily statistical:

1. Small Samples: If your pricing is based upon other private company investments, your sample sizes will tend to be much smaller, if you are a VC than if you a public company investor. Thus, as an investor in a publicly traded oil company, I can draw on 351 publicly traded firms in the US or even the 1029 publicly traded companies globally, when making relative value or pricing judgments. A VC investor pricing a ride sharing company is drawing on a sample of less than ten ride sharing firms globally.
2. With Infrequent Updating: The small sample problem is exacerbated by the fact that unlike public companies, where trading is frequent and prices get updated for most of the companies in my sample almost continuously, private company transactions are few and far between. In many ways, the VC pricing problem is closer to the real estate pricing than conventional stock pricing, where you have to price a property based upon similar properties that have sold in the recent past.
3. And Opaque transactions: There is a third problem that makes VC pricing complicated. Unlike public equities, where a share of stock is (for the most part) like any other share of stock and the total market value is the share price times number of shares outstanding, extrapolating from a VC investment for a share in a company to the overall value of equity can be and often is complicated. Why? As I noted in an earlier post on unicorn valuations, the VC investment at each stage of capital-raising is structured differently, with a myriad of options embedded in it, some designed for protection (against dilution and future equity rounds) and some for opportunity (allowing future investments at favorable prices). As I noted in that post, a start-up with a "true" value of $750 million can structure an investment, where the VC pays $50 million (instead of $37.5 million) for 5% of the company, by adding enough optionality to the investment. I may be misreading Scott's section on using option pricing to price VC investments, but if I am reading it right, I think Scott is saying that Andreessen uses option pricing models to clean up for the add-on options in VC investments to get to the fair value. Put differently, Andreessen would put a value of $750 million on this company rather than the $1 billion that you would get from extrapolating from the $50 million for 5%.

I am sure that nothing that I have said here is new to venture capitalists, founders and those close to the VC process, but it is the subtle differences that throw off those whose primary experience is in the public markets. That is one reason that public investors should take the numbers that are often bandied about as valuations of private companies (like Palantir, Uber and Airbnb) with a grain of salt.  It is also why I think that public investors like mutual funds and university endowment funds should either tread lightly or not all in the space. Even within the VC business, it is sometimes easy, especially in buoyant times to forget how much the entire pricing edifice rests as much on momentum and mood, as it does on the underlying fundamentals.

With Predictable Consequences

So, let’s see. VCs price companies and that pricing is often based upon really small samples with infrequently updated and tough-to-read data. The consequences are predictable.

1. The pricing estimates will have more noise (error) attached to them. The pricing that I obtain for Lyft, based upon the pricing of Uber, Didi Chuxing and GrabTaxi, will have a larger band around the estimate and there is a greater chance that I will be wrong. 
2. The pricing will be more subjective, since you have the freedom to choose your comparable firms and often can use discretion to adjust for the infrequent data updating and the complexity of equity investments. While that may seem to just be a restatement of the first critique, there is also a much greater potential for bias to enter into the process. Not surprisingly, therefore, not all VC returns are created equal, especially when it comes to the unrealized portion, with more aggressive VCs reporting “higher” returns than less aggressive VCs. That is perhaps the point being made by Scott about realized versus unrealized returns.
3. The pricing will lag the market: It is a well-established fact that the capital coming into the VC business ebbs and flows across time, with the number of transactions increasing in up markets and dropping in down markets. When there is a severe correction (say, just after the dot-com bust), transactions can come to a standstill, making repricing difficult, if not impossible. If VCs hold off on full repricing until transactions pick up again, there can be a significant lag between when prices drop at young companies and those price drops getting reflected in returns at VC firms.
4. There is a price feedback loop: Since VC pricing is based upon small samples with infrequent transactions, it is susceptible to feedback loops, where one badly priced transaction (in either direction) can trigger many more badly priced transactions. 
5. And a time horizon issue: The lack of liquidity and small samples that get in the way of pricing holdings also introduce a constraint into the pricing game. Unlike public market investors, where the pricing game can be played in minutes or even fractions of a minute on liquid stocks, private market pricing requires patience and more of it, the younger a company is. Put differently, winning at the VC pricing game may require that you take a position in a young start up and bide your time until you build it up and find someone who will find it attractive enough to offer you a much higher price for it. This is perhaps what Scott was talking about, in his response, when he talked about this being VC investing being a "long" game.

There is one final point that also needs to be made. Much as we like to talk about the VC market and the public market as separate, populated by different species, they are linked at the hip. To the extent that a venture capitalist has to plot an exit, either in an initial public offering or by selling to a publicity traded company, if the public market catches a cold, the venture capital market will get pneumonia, though the diagnosis may come much later.

The VC Edge

If I were to summarize the entire post in a couple of sentences, here is what it would say. Venture capitalists price the companies they invest in, base that pricing on small samples of opaque transactions and the pricing is therefore more likely to be wrong and lag reality. That sounds pretty damning, but I think that these features work to the advantage of venture capitalists, or at least the very best among them. That may sound contradictory, but here is my basis for making that statement.

1. The average VC does better than the average public market active investor: Both VC and public market investors play the pricing game, with the latter having the advantage of more and better data, but over time, venture capitalists seem to deliver better results than public market investors, as seen in the graph below. These are raw returns and I do realize that you have to adjust for risk, but some of the biggest risks in venture capital (failure risk) have already been incorporated into long term returns. 

   

   Source: Cambridge Associates

2. The Elite: The most successful VCs not only earn higher returns than the top public market investors but that there seems to be more consistency in the VC business, insofar as the best of the VCs are able to generate higher returns across longer time periods. That would suggest that venture capitalists bring more durable competitive advantages to the investing game than public market investors.

How do I reconcile my argument that the VC pricing game is inherently more error-prone and noisy with the fact that VCs seem to make money at it? I think that the very factors that make it so difficult to price and profit of a VC investment are what allow VCs collectively to earn excess returns and the very best VCs to set themselves apart from the rest. In particular, the best in the business set themselves apart from the rest on three dimensions:

1. They are better pricers (relatively): As Scott notes in his piece, the price that you can attach to a VC investment can vary widely across investors and he uses the example of how Andreessen's option pricing approach can yield a lower pricing for the same company than an alternative approach. While all of these prices are undoubtedly wrong (because they are estimates), some of them are less wrong than others. Repeating a statement that I have made before, you don't have to be right to make money, you just have to be less wrong than everyone else and the chances of you doing that are greater in the VC pricing game.  
2. They can influence the pricing game: Unlike public market investors, who for the most part can observe company metrics but not change them, venture capitalists can take a more active role in the companies that they invest in, from informally advising managers to more formal roles as board members, helping these companies decide what metrics to focus on, how to improve these metrics and how (and when) to cash in on them (from an IPO or a sale).
3. They have better timing: The pricing game is all about timing, and the VC pricing game is more emphatically so. To be successful, you not only have to time your entry into a business right but even more critically, time your exit from it. 

If you are an investor in a VC fund, therefore, you should of course look at both realized returns and unrealized returns, but you should also look at how the fund measures its unrealized returns and how it has generated its returns. A realized return that comes primarily from one big hit is clearly less indicative of skill than a return that reflects multiple hits over longer time periods. After all, if separating luck from skill is difficult in the public marketplace, it can become even more so in the venture capital business.

YouTube Video

Read More

The Bonfire of Venture Capital: The Good, Bad and Ugly Side of Cash Burn!

In my last post on Uber, I noted that it was burning through cash and that this cash burn, by itself, is neither unexpected nor a bad sign. Since I got quite a few comments on what I said, I decided to make this post just about the causes and consequences of cash burn. In the process, I hope to dispel two myths held on opposite ends of the investing spectrum, the notion on the part of value investors, that a high cash burn signals a death spiral for a business and the equally strongly held belief, at the start-up investing end , that a cash burn is a sign of growth and vitality. 

Cash Burn: The what?
Since it is cash burn, not earnings burn, that concerns us, let’s start with the obvious. It is cash flow, not earnings, that is at the heart of a cash burn problem. While many money losing companies have cash burn problems, not all cash burn problems are money losing, and not all money losing companies have a cash burn problem. To understand cash burn, you have to start with a working definition of cash flows and my definition hews closely to what I use in the context of valuing businesses. The free cash flow to the firm is the cash left over after taxes have been paid and reinvestment needs (to maintain existing assets and generate future growth) have been met:

For mature, going concerns, the after-tax operating income and free cash flow to the firm will be positive (at least on average) and that cash flow is used to service debt payments as well as to provide cash flows to equity in the form of dividends and stock buybacks. Any remaining cash flow, after debt payments and dividends/buybacks, augments the cash balance of the company.

But what if the free cash flow to the firm is negative? That can happen either because a company has operating losses or because it has large reinvestment needs or both occur in tandem. If you have negative free cash flow to the firm, you can draw down an existing cash balance to cover that need and if that turns out to be insufficient, you will have to raise fresh capital, either in the form of new debt or new equity. If this negative cash flow is occasional and is interspersed with positive cash flows in other years, as is often the case with cyclical or commodity companies, you consider it to be a reflection of normal operations of the firm and it should cause few issues in valuation. If, on the other hand, a business has negative cash flows year in and year out, it is said to be burning through cash or having a “cash burn” problem.

To measure the magnitude of the cash spending problem, analysts use a variety of measures. One is to compute the dollar cash spent in a time period, usually a month, and that is termed the Cash Burn rate. Another is to compute the Cash Runway, the time period that it will take for a company to run through its existing cash balance. Thus, a firm with a $1 billion cash balance and a negative cash flow of -$500 million a year has a 2-year Cash Runway. In contrast, another company with a $1 billion cash balance and a negative cash flow of -$ 2 billion a year has only a 6-month Cash Runway. 

Cash Burn: The Why?

Looking at the definition of cash flows should give you a quick sense of why you get high cash burn values (and ratios) at some companies. If your company is and has been losing money or generating very small earnings for an extended period and it sees high growth potential in the future (and invests accordingly), your cash flows will reflect that reality. 

That combination of low operating income/operating losses and high reinvestment is what you should expect to see at many young companies and the resulting negative free cash flow to the firm will be the norm rather than the aberration. As the companies move through the life cycle, the benign perspective on cash burn is that this will cease to be a problem.

As the company scales up, its operating income and margins should increase and as growth starts to scale down (in future years), the reinvestment should start dropping. 

Cash Burn: The what next?
The combination of higher operating margins and lower reinvestment should generate a cross over point where cash flows turn positive and these positive cash flow will carry the value. Rather than talking in abstractions, let me use the numbers in my August 2016 Uber valuation to illustrate. The story that I am telling in these numbers is of a going concern and success, with high revenue growth accompanied by improving operating margins as the first leg, followed by declining growth (and reinvestment) converting negative cash flows to positive cash flows in the second leg and a steady state of high earnings and cash flows reflected in a going concern value in the final phase.

In my Uber forecasts, the cash flows are negative for the first six years, with losses in the first five years adding on to reinvestment in those years. The cash flows turn positive in year 7, just as growth starts to slow and accelerate in the final years of the forecasts.  Though these numbers are specific to Uber, the pattern of cash flows that you see in this figure is typical of the good cash burn story.

The life cycle story that I have laid out is the benign one, where after its start-up pains, a young company turns the corner, starts generating profits and ultimately turns cash flows around. Before you buy into the fairy talk that I have told you, you should consider a more malignant version of this story. In this one, the firm starts off as a growth firm with negative margins and high reinvestment (and cash burn). As the revenues increase over time and the company scales up, the cost structure continues to spiral out-of-control and the margins become more negative over time, rather than less. In fact, with reinvestment creating an additional drain on the cash flows, your free cash flow will be negative for extended and very long time periods and you are on the pathway to venture capital hell. To illustrate what the cash flows would look like in this malignant version of cash burn, I revisited the Uber valuation and changed two numbers. I reduced the operating margin (targeted for year 10) from 20% down to 5% (making ride sharing a commoditized business) and increased reinvestment to match a typical US company (by setting the sales to capital ratio to two, instead of three). The effects on the cash flows are dramatic.

The cash flows stay negative over the next ten years. In this scenario, it is very unlikely that Uber will make it to year 10 or even year 5, as capital providers will balk at feeding the cash burn machine?

So, when is cash burn likely to be value destructive or fatal? If the company operates in a market place, where competition keeps pushing product prices down and the costs of delivering these products continue to rise, it is already on a course to report bigger and bigger losses, even before considering reinvestment. If this company reinvests for growth and the product market conditions do not change (i.e., price cutting and rising costs are expected to continue), it is likely that the reinvestment will not deliver the earnings required to justify that investment. Here, there is no light at the end of the tunnel, as negative cash flows will generally become more negative over time and even when they do turn positive, will be insufficient to cover the burden of negative cash flows in earlier time periods.

Cash Burn: So what?

Though stories about young companies and their cash burn problems abound, there are few that try to make the connection between cash burn and value other than to point to it as a survival risk. To make the connection more explicit, it is worth thinking about why and how cash burn affects the value of an enterprise. 

1. Dilution Effect: A company has to raise cash to burn through it and if that cash is raised from fresh equity, as it inevitably has to be for young growth companies, the existing owners of the business will have to give up some of their ownership of the company. If you are an equity investor, the greater the cash burn in a company, the less of the company you will end up owning, even if it survives and prospers.
2. Growth Effect: The dilution effect presumes that there are capital providers who will be supply the cash needed to keep the firm going through its cash burn days, but what if that presumption is incorrect? The best case scenario for the firm, when capital dries up, is that it is able to rein in discretionary spending (which will include all reinvestment for growth) until capital becomes available again. In the meantime, though, the company will have to scale back its growth plans.
3. Distress Effect: The more dangerous consequence of capital drying up for a young firm with negative free cash flows Is that the firm’s survival is put at risk. This will be the case if the company is unable to meet its operating cash flow needs, even after cutting discretionary capital spending to zero. In this scenario, the firm will have to liquidate itself and given its standing, it will have to settle for a fraction of its value as a going concern.

In intrinsic valuation, both of these effects can and should be captured in your intrinsic value. 

1. The dilution effect manifests itself as negative cash flows in the early years and a drop in the present value of cash flows. For instance, in my Uber valuation, the present value of the expected cash flows for the first seven years, all negative, is $4.4 billion. While the positive cash flows thereafter more than compensate for this, I am in effect reducing the value of Uber by about 20% for these negative cash flows and this reduction can be viewed as a preemptive discounting of my equity stake in the company for future dilution.
   
2. When I discount the negative cash flows back to today and assume that Uber has no chance of game-ending failure, I am assuming that Uber has and will continue to have access to capital, partly because of its size and partly because existing investors have too much to lose if the company goes into death throes. If you believe these assumptions to be too optimistic, you can adjust the valuation in two ways. The first is by putting a cap on how much new capital the firm can raise each year, which will also operate as a constraint on future growth. The other is by allowing for a probability that the firm will fail, either because capital markets shut down or cash flows are more negative than expected. In my Lyft valuation in September 2015, for instance, I allowed for a 10% probability of this occurring and assumed that equity investors would get close to nothing if it did, effectively reducing my valuation today.

In pricing, how does it show up? In a young company, pricing usually involves forecasting revenues or earnings in a future time period, applying a multiple, at which you believe the company will be priced by a potential buyer or the market in an IPO, to these revenues and pricing and then discounting back that end price to today using a target rate of return.

As you can see, there is no explicit adjustment for cash burn in this equation. While you could bring in the effect of negative cash flows, just as you did in intrinsic valuation, by discounting them back to today and netting out against the pricing, doing that removes one of the biggest reasons why investors and analysts like pricing, which is that it is simple. The only adjustment mechanism left is the target rate of return and, in my view, it becomes the mechanism that venture capitalists and investors use to deal with cash burn concerns. Given that these target rates of return also carry the weight of reflecting failure risk, it should come as no surprise that VC target rates of return for investment look high (at 30%, 40% or even 50%) relative to rates used for established companies.

An Investor Checklist for Cash Burn

If you are an investor in a company, public or private, that is burning through cash, you may be wondering at this point what you would look at to determine whether a company’s cash burn is benign or malignant and whether it is on a glide path to glory or a Hari Kari mission. Here are some things to consider:

1. Understand why the company is burning through cash: Looking back at the constituents of free cash flows, there are multiple paths that can lead to negative free cash flows. The most benign scenario is one where a money making company reports negative cash flows because of large reinvestment. Not only is this negative cash flow a down payment for future growth but it is also discretionary, insofar as managers can scale back reinvestment if capital becomes scarce. The most dangerous combination is a money losing company that reinvests very little, since there is little potential for a growth payoff and management will be helpless if capital freezes up.
2. Diagnose the operating business: While there is often a lot of noise around the numbers, you still have to make your best judgments about the profitability of the underlying business. In particular, you want to focus on the pricing power that your company has and the economies of scale in its cost structure. The most benign scenario on this dimension is one where the company has significant pricing power and a cost structure that benefits from scale, allowing for margin improvement over time.
3. Gauge management skills: Managing a cash-burning company does require management to keep costs under control, while reinvesting to generate growth and to take care of short term cash flow problems, while mapping out a long term strategy. The best case scenario for investors is that the company is run by a management team that works within the cash flow constraints of today while mapping out pathways to profitability over time. The worst case scenario is that the company is managed by those who view negative cash flows as a badge of honor and a sign of growth rather than a temporary problem to overcome.
4. Growth/Reinvestment trade off: Since reinvesting for future growth can be a big reason for negative cash flows, to assess the payoff in value terms, you have to both estimate how much growth will be created and its value effect. In its most value-creating form, reinvestment will generate high growth coupled with high returns and its most value-destructive form, reinvestment will drain cash flows while generating low growth and poor profits.
5. Capital Market A firm with a cash burn problem is more depending upon capital markets for its survival, since a closing of these markets may be sufficient to put the firm into receivership. It is no surprise, therefore, that cash burning companies that have larger cash balances or more established capital providers are viewed more positively than cash burning companies that have less cash and have less access to capital.

This checklist requires subjective judgments along the way and you will be wrong sometimes, in spite of your best efforts. That should not stop you from trying.

The Bottom Line
If you are an investor in a company that is burning through cash, don't panic! If your investments are in young companies, it is exactly what you should expect to see though you should do your due diligence, examining the reasons for the cash burn in and the soundness of the underlying business model. If you are an old-time value investor, weaned on large dividends, positive cash flows and margin of safety, you may find yourself avoiding companies that have these cash burn problems but be glad that there are investors who are less risk averse than you are and willing to bet on these companies.

YouTube video


Posts on valuing young companies

1. Blood in the Shark Tank: Pre-money, Post-money and Play-money Valuations
2. Billion Dollar Tech Babies: A Blessing of Unicorns or a Parcel of Hogs
3. The Bonfire of Venture Capital: The Good, Bad and Ugly Side of Cash Burn

Read More