Saturday, September 1. 2012
Following on from Part (I), in my opinion this piece, " All Revenue is Not Created Equal: The Keys to the 10X Revenue Club" by Bill Gurley a few months ago sums up a lot of the main issues to think about around the business model, and some areas of customer attraction. I have abridged it below, but the full piece really is required reading.
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.
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 [Recommended reading, its an eye opener]. This “second world” that Brian refers to is one where the market leader has an unfair advantage that is reinforced by 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. Salesforce.com 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.
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.
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 (ie scaling)
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.
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 [Which is why we are sceptical of biusinesses based on Twitter or Facebook platforms]. 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 [usually] disclosed in the S-1 under “Risk Factors.”
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.
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.
A really good piece, I think its realy worth reading the whole piece and pasting it on the front of any startup's business plan design file.
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