The Economics of Fast Growth and Raising Capital
The March 1st IPO of NYSE: SNAP, a company with less than $500 million in revenues, and which lost $47 million last year, exceeded expectations so handily that it closed its first trading day up 46% relative to the initial public offering price. This week’s market capitalization has ranged from $20.9 to $25.9 billion. And this for a company whose common shares will have little to no voting rights!
Once again, many scratch their heads in wonder how can this be, and whether investors are irrational. While I’ll leave that assessment to others and time itself, the example is useful for illustrating the concept of why investors support lofty valuations for companies with an almost -10% net income, and why high growth companies with access to capital don’t try to finance growth from their own operating cash flow.
The quick answer to SNAP’s IPO success is investors’ expectations for Snapchat’s growth in importance to consumers (despite serious competition from Facebook’s Instagram), that revenue will grow, and eventually the company will turn profitable – plus, there are few other IPO stocks out there to compete for the same investment dollar (itself worth a big bump to valuation).
Managing the Costs of Growth
If a company is growing fast, introducing products, expanding geographically, it probably needs to hire people. At some point, a company should expect to generate revenue per person to exceed their cost by a multiple. (If they don’t expect this, they should consider outsourcing the function or hiring contractors temporarily). But meanwhile, those people will be costly for quite a while before they bring in the revenue to pay their way. Typically, 80% of a startup information technology company’s cost is staffing.
As long as a company is adding costs in excess of what they generate by sales revenue, they’re either depressing profits or running at a negative profit, like SNAP. A company has two choices to resolve a problem that will become terminal sooner or later: finance growth through its own operating cash flow or bring in investors.
If a company doesn’t have access to capital, they’ll want their business to be profitable in the short-term, but their growth will be capped. Businesses that self-finance grow more slowly. It’s a fact of life.
If a business is trying to grow significantly and create a large market, their greatest risk is that others will see that same opportunity and access the capital to capture it. If the capital markets believe the opportunity to be billions of dollars, capital providers will seek quality investments to fund. It will attract capital so effectively that even some of the lesser quality investment propositions will get funded.
If competitors who can access capital their company cannot access are trying to grow in the same market, others’ growth will outpace theirs in the short run and capture more market share, and in the long run create a more economically attractive company to investors. That success will be self-reinforcing in a virtuous feedback loop: by gaining share their costs will drop, profitability will increase, it will be harder to knock them from their pedestal, they’ll be in a better position to attract the best employees, and they’ll have greater pricing power in the market. Yeah, everybody wants to be in that position.
So, if a company does not step on the accelerator and grow fast at the expense of short-term profitability, they’ll lose the opportunity to become a significant market participant altogether.
Consider Uber and Lyft’s current race for dominance. Quick – can you name a third U.S. automobile ride sharing platform? Probably not. I doubt anyone competing in that market is trying to grow by self-financing from their operating cash flow. I’d not want to have invested in them, if so.
If the company is growing so successfully that in each financing round it is valued more highly (an “up round”), they can continue to fuel growth without having to fund it from their operating cash flow.
Cost of Capital
Consider the cost of capital.
If one can raise $20 million at an $80 million pre-money valuation/$100 million post-money, founders are diluting their ownership by 20% ($20 M/$100 M = 20%).
If they’re raising $20 million at a $40 million pre-money valuation they’re diluting their ownership by 33% — a substantially greater cost of capital.
But, if they can raise $20 million at a billion-dollar valuation, then their dilution is so small, they should jump on the opportunity before other factors threaten that billion-dollar valuation, and in fact, raise much more money and push to grow even faster. When a good is cheap – even money – people will normally buy more of it up to a point.
NYSE: SNAP sold only 14% of its stock, a small equity give-up, so the cost to insiders for selling that stock was relatively small. By not having to give up much ownership to get the capital they needed to outrun competitors (like Facebook’s Instagram), this was clearly the right thing to do. Why even think of trying to fund growth from operating cash flow if their cost of capital (amount of equity they had to give up) is low?
But, in reality, very few people have the right background to attract that kind of capital. Otherwise, to do so the business must be already performing so spectacularly it seems to defy gravity. The few executives in this position will choose to grow fast today with the recognition that investors will eventually need to see profitability, but not right now.
This should not be thought of as an absolute, either or. For instance, many businesses have access to some capital to support growth, but not a deep well of it. In such a case, perhaps the best path is somewhere in the middle: though still deferring profitability, push ahead for a moderated growth pace at a lesser cash burn rate than the full throttle approach of companies like, say, Uber, Salesforce, or Airbnb.
The vast majority of entrepreneurs must grow within the means of their cash flow. In fact, the path to success is littered with failed businesses that grew too fast for either their operating cash flow or external investment to fund.
Expanded from a podcast interview with legendary venture capitalist, Mark Suster. He explained the concept so simply, I thought it worth sharing and expounding upon.
McGavock Dickinson (Dick) Bransford is a Managing Director in San Francisco with Mid-Market Securities, LLC, an investment bank headquartered at 11 East 44th Street, 19th Floor, New York, New York 10017. Member FINRA/SIPC. He can be contacted at (415) 294-0002 or mdb @ mid-marketsecurities.com.
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