Gear up your business (at the right time)

[Two posts in one day.  When it rains, it pours.  If you are bored, check out today's earlier post here]

One thing we as venture investors focus on, both at a theoretical level when we are making new investments and at at practical level when we as board members are helping our (particularly later stage) companies think through growth and investment strategies, is the concept of operating leverage.  Operating leverage, or as it is sometimes called, marginal profitability or gearing, is, at a simple level, the percent of incremental revenue dollars that flow to the bottom line.  This is important because most investors, especially public equity investors, and acquirers value companies based on earnings growth and a company with higher operating leverage will over time be more highly valued than a company with similar top line growth but lower operating leverage.

At a theoretical level, operating leverage is a sign of the health of your business model.  To the extent you make expensive widgets with limited ability to premium price, less will fall to the bottom line.  If you can sell the same high value, low cost product over and over again, more will flow.  If you have real network effects at work in terms of customer acquisition, sales and marketing costs as a percent of revenue will decrease.  If your R&D team can stay the same size, while revenues increase significantly, you will have high operating leverage.  Most venture investors are attracted to models with high leverage as it allows company to grow profitably very quickly, thus decreasing capital intensity (unless there are high capital expenses or financing costs, which i have ignored for purposes of simplicity).  As a result, as an entrepreneur thinking through your long term business model and the points of leverage becomes an important strategic planning exercise.

To bring this to life with some examples, I looked at Apple – the current gold standard among tech stocks -  and compared the P&L for Q1 2011 to Q1 2010.  In this time period, revenues grew 83%, or $11.2B, while operating earnings grew 98%, or $3.9B (taxes and below the line items have also been excluded for simplicity and comparison across companies).  This means that for every incremental dollar of revenue, 35% fell to the bottom line [$3.9/$11.2].  Pretty impressive.  I also looked at results for some recent IPOs and found that Zillow had operating leverage of 38%, Financial Engines 31%, Zynga 17% and Linkedin 9%.  The all time high I found in a quick scan through public filings was Microsoft, which in 1997 dropped an astounding 67% of their revenue growth to the bottom line.  Not surprisingly, other high fliers with fabulous business models have seen significant operating leverage in their business such as Google, which in 2006 dropped 47% of each revenue dollar to the bottom line, and eBay which had marginal profitability of 56% in 2002.

Apart from working to improve the fundamental attractiveness of your company's business model, as you grow one of the tradeoffs that a CEO (and their Board) of a high growth company faces is how to balance the trade off between investing for growth and showing leverage.  Some the examples above show the these trade-offs.  Linkedin, which actually showed 27% marginal profitability in 2010 versus 2009, is obviously now investing pretty significantly for growth.  Microsoft, on the other hand, may have under invested in 1997 when many competitors were emerging around them.  Conversely, if Linked in continues to invest heavily forever and only drop 9% of each incremental revenue dollar to the bottom line, and if they were to trade at Google's current 14x EBITDA multiple, they would need to grow their revenues a staggering 32 times to $7.7B from the 2010 level of $243M to merely meet their current value of $9.6B.   Zillow, on the other hand, at the same multiples, would only need to grow 6 times from their 2010 revenues to justify their current valuation given they have vastly higher marginal profitability.

So as your business moves out of survival mode and into significant growth mode, managing these tradeoffs should be a regular part of the conversations you have with your team and Board.


When to reach for the stars

As anyone who follow the start-up world knows, valuations for high potential young companies as of late have been trending upward (how's that for an understatement) and are fairly divorced from underlying traditional (ie revenues and earnings) metrics.  This is currently true with both "later" stage companies such as Foursquare's $600M valuation and earlier stage companies that are seeing pre-money valuations that are 1.5-2 times what one would expect to see in "normal" markets.  As an entrepreneur this naturally sounds like good news, and it largely is, although I thought it might be helpful to share some of the perspectives from the investor side as well as some potential watch outs.  

As an investor, when to "pay-up" for a compelling opportunity is one of the more difficult decisions we make on the new investment side of our daily lives.  If you do it across the board, you will end up with a portfolio that has sub-par performance, but if you miss out on great companies by being too disciplined, the opportunity cost is exceptionally high.  So when confronted with such situations as an investor, some of the things that cross our mind are as follows:

  1. Is there downside protection in terms of the underlying asset?  The best example of this that I recall is a conversation I had with one of my former partners at Greylock in discussing their investment at $500+M value in Facebook.  At the time he told me that he was unsure about the upside from there, but that he was sure given the company's user growth, early revenues, relatively limited capital raised to date and the company's strategic importance, there was no way way they were going to lose money on the investment.  On Wall Street, they call these asymmetric trades: lots of upside and low downside.  While they may not all pay off, it can be a savvy approach for an investor to take.
  2. Is the amount of capital being raised sufficient to get through important milestones?  Even if they long term upside is high, if the capital being raised at a high valuation is not enough to get the company through enough value creating milestones that allow the next round to be at a higher price, it is unlikely to be worth pursuing as the pain of down rounds,the impact on morale and other issues can be painful.  Interestingly, this thought process often leads to larger rounds, with more dilution for entrepreneurs, and creates a whole host of risks that come along with too much capital such as lack of focus and unrealistic expectations.
  3. The last, and perhaps most obvious point, is that as an investor when you are reaching in terms of valuation, it needs to be for the right reasons.  At Flybridge, we rank our investments on a host of criteria including the strength of the team, the size of the opportunity, how robust the business model is, whether there are real network effects and how disruptive the approach is.  to reach on price, we need to be convinced on all dimensions as the criteria together indicate a strong likelihood of creating a lot of value and that the company can quickly grow into the value being established.  The wrong reasons to reach are competitive pressures or investments that are viewed as strategically important for the venture firm's brand.  Our LPs don't pay us to win all the time nor do they want us to use their capital to create a perceived halo that comes from being involved in high profile companies.

From an entrepreneur's perspective, raising capital at high prices sounds like a great thing.  There are, however, some words of caution that are worth running through having had a first row seat in the last overheated market.  The first is to recognize that a successful fund raise does not equal a successful business, so don't believe your own press and take an eye off running the business lest the next round be more challenging than the one you just closed.  Second, be careful about pushing your investment partners too far.  I remember one company where we were A round investors and they raised a Series B at very high prices and the VC director that came along with that financing was extremely dysfunctional when the business hit the inevitable bump in the road.  I don't think he was a bad apple, but rather was under a lot of pressure with his partners having gone to bat for the high price only to have the company do well, but not well enough to justify the valuation.  Finally, as alluded to above, reaching on valuation too early implicitly raises expectations that you have for yourself and others (employees and investors) have for the business and this can lead to the pursuit of overly aggressive strategies too early.  So the final word is be aggressive, but realistic.