The Economics of Fast Growth and Raising Capital
The March 1, 2017 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. And this for a company whose common shares have little to no voting rights!
While Friday’s market capitalization was $16.5 billion (August 18, 2017), down more than $10 billion from a few months ago (reflecting concerns about the company’s fundamental proposition), many still wonder whether investors are irrational to expect so much from a company like this.
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 headwinds 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. 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 capture 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.
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/$100 million post-money valuation, 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?
In reality, relatively few executives and companies qualify to attract either venture capital (private) or public capital. But, the few executives for whom this is an option will rationally choose to take outside capital to grow fast, deferring a profit objective until sometime in the future.
Most Companies Must Choose Another Path – and, More Paths Are Becoming Available
Most businesses have access to some capital to support growth, but not a deep well of it. The majority of private companies rely on bank loans for growth, but these will never fund fast-growth scenarios in which profit is deferred for years.
Some companies will qualify for various forms of private equity and/or high-yield debt investment, which will be more supportive of this type of scenario, but nothing like to the degree that venture capital or the public market might.
For most growing companies competing in a market with significant growth potential, the typical path is somewhere in the middle: though still deferring profitability, operate at a moderated growth pace with 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.
The good news is that other financing options are becoming increasingly available for solid companies on a fast growth track. Here are just two examples:
- Private Equity – More and more private equity investors who normally would only fund investments in which they’d take majority ownership are offering “growth equity” capital to qualified companies in which they’ll take only a minority position. Effectively, this represents a structural convergence between buyout funds and venture funds, creating a new option for some companies. This is a fast-growing trend. Just two days ago I met representatives of a very large sovereign wealth fund that is most recognized for buying public equities and a recent private capital investment approaching a $ billion. To my surprise, and unpublicized, they are now selectively seeking growth equity investments too, and will even look at Series A venture rounds.
- Public Equity – The JOBS Act created a way for companies to raise up to $20 million, or up to $50 million, as a quasi-public offering but with a comparatively streamlined process.
Please contact me if you’d like to learn more.
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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