“When you are a Bear of Very Little Brain, and you Think of Things, you find sometimes that a Thing which seemed very Thingish inside you is quite different when it gets out into the open and has other people looking at it.” ― The House at Pooh Corner by A.A Milne”
Writers that can consistently and frequently write new and interesting pieces always impress me. I am pretty thrilled if I have what I consider to be one new and unique thought a month. Then have the luck to capture that fleeting moment down in writing. And, that generally turns into the Winnie the Pooh moment described above.
That previous paragraph may be an awkward way of explaining why I have been fairly quiet these days, on top of just being busy at work.
For similar reasons, reading was a bit off this month – although I did notch some easy reads.
Correct, I am a touch out of order on the Travis Mcgee series, but that does not seem to matter too much.
Here are my most influential reads for the month – in no particular order:
You’re not good at this. – “Zero percent interest rates plus fiscal and monetary stimulus with housing up 40% and stocks at an all-time high was a ridiculous policy.”
Entering the Superbubble’s Final Act – “The current superbubble features the most dangerous mix of these factors in modern times: all three major asset classes – housing, stocks, and bonds – were critically historically overvalued at the end of last year.”
Seeing Red – “Is China our enemy or competitor? The answer is yes.”
Would You Still Buy A Tesla? – “I used to be a fan of Elon Musk, no longer. The guy is irrational, and he believes the rules don’t apply to him. And he acts like he’s the only one who owns the truth, who can move us into the future, and that’s just hogwash.”
Pillow fight – “That’s like going to a Dallas Cowboys football game at AT&T Stadium, seeing 80,000 fans dressed in silver and blue with stars painted on their faces, all cheering wildly when the Cowboys score. Then, based on that experience, determining everyone across the nation is a rabid Cowboys fan and the 82,500 people at MetLife Stadium cheering for the Giants simply just can’t be real.”
Note: This is based on when I read the article, not necessarily when it was first published. Unfortunately, my backlog of things I would like to read always seems to dwarf the amount of time I can devote to reading.
Not saying that you should, but let’s assume that you might want to track maturity schedules as you termed out some cash – because rates on Treasury bills and notes are increasing much faster than bank rates.
I see a chart like this, and the value hunter in me, cannot help but see an opportunity. This fund is plumbing its all time lows.
But then I look at a chart like this, and think, well maybe all time lows when the history is only from 2010 forward, is irrelevant (maybe even dangerous) given the macro squishing that could happen if large flows / rate trends reverse (i.e. return to more normal levels).
The vast majority of interest rate history is above, not below, where we are today.
The concept of this article has been sitting on my list for over a year. Mostly because there is a high likelihood that the article, in writing, turns out to not be as good as the article as it sits in my head.
“When you are a Bear of Very Little Brain, and you Think of Things, you find sometimes that a Thing which seemed very Thingish inside you is quite different when it gets out into the open and has other people looking at it.” — Winnie the Pooh
It has been an interesting challenge to help guide a cloud-based, software as a service (SaaS) company, as its finance leader, as the normal bounds of financial rationality got blurry due to the growth-at-all-costs valuation mindset. Sort of akin to trying to teach someone to play basketball in outer space, where gravity is basically zero, and normal actions, like jumping and dribbling, are unconstrained. Why would you dribble or pass the ball, when you can float the entire length of the court? The biggest challenge is not getting tangled up in the lights attached to the roof of gymnasium.
Here are some examples, where traditional decision-making is challenged, when attempting to analyze a growth-at-all-costs situation with a traditional financial framework:
How should we think about pricing optimization? Lost deals carry a huge opportunity cost vs. small price increases.
How should we price software and services? No one seems to care about services, except the auditors since services do not generate ARR, so that is going to drive some decision making and incentive plan design.
What are the margins on services? Why bother with this boring and antiquated view of things.
Should we care about the efficiency of internal operations? That seems like a distraction; we should focus on growing ARR.
Which parts of the business should we invest in? Clearly those that produce new ARR, at the expense of virtually everything else.
How should we think about investments in infrastructure, security, compliance, etc.? Has it cost us any ARR yet?
How should sales commissions be structured? Theoretically, a sale is worth 10x+ ARR on the deal. Are you really going to pay more than the first year of the deal is worth to the sales rep, etc. Seems irrational, but the valuation math indicates maybe you should.
What is an acceptable Customer Acquisition Cost? This is basically the same question – but adding in other broader sales & marketing costs. And if marketing spend is generating leads and leading to closed deals, the answer approaches an unbounded solution.
How much should we invest in launching a new module or product? Well, as long as the cost is below 10x+ the future ARR, I guess we should go for it. Let’s ignore the fact that the cash flow from the new product won’t cover development costs for…[insert optimistic assumption]…years. Hell, why even build a financial model anyway.
How should you respond to customer issues? Well, the math says protect ARR at all costs.
What if more growth makes your valuation on ARR go up? Oh crap, the model went circular and unbounded. Better break out Solver.
This is certainly not an exhaustive list, but should serve as some insight into the challenges of managing one of these businesses in this environment. To be fair, this is not entirely a valuation driven problem. The economics of software businesses play a role too. When marginal costs are close to zero and the gross margins of a business are 80%+, there are few “bad” customers or “unprofitable” products.
I am an engineer by training. I believe that trade-offs exist in every decision. And, that is healthy. Under the current valuation regime, there has been a dearth of trade-offs.
So, as the valuation pendulum swings from growth only metrics, back toward more dreary metrics (cash flow and return on invested capital), expect some issues to arise. Just like an astronaut returning from a long stint at the International Space Station, getting used to gravity may take some time.
Over the last number of years, investors and managers of software businesses have been making decisions under this valuation framework revolving around ARR valuations and growth. That has likely led to some choices that will look less robust in a different valuation paradigm. It will take some time to uncover and unwind those. It might take even longer to change the mindset of those investors and managers, if that can even be done. In the dotcom era, there were few pivots. Many of those businesses could not or would not change their models, and you know how those ended.
Every situation is unique, but here is a real life case study – from Freshworks – a member of the IPO class of 2021. I think you will look back on this and see they timed this one pretty well.
“We believe that we are early in addressing our large market opportunity and we intend to continue to make investments to support the growth and expansion of our business. We have a track record of bringing new products to market and scaling these new products over time. As of December 31, 2021, we have two primary products with over $100 million in ARR, Freshdesk and Freshservice.” – 10K
Highlighting is mine. Revenue up year over year ~$121 million; costs up ~$270 million. Sales & Marketing costs up ~$127 million alone. So, yes, I would hope that you believe there is a large market opportunity to capture. The real question is does this business model work, if you care about something other than top line growth?
The cash flow picture is not good.
Large market opportunity, high growth, but not currently monetizing any of that well.
And, that is the question I wrestle with the most. When is the operating leverage and cash flow going to show up in these businesses, if ever? How is the switch going to get flipped?
There’s a large market opportunity. Ok, good. The business is growing at a high rate. That’s great. But operating leverage is nowhere to be seen, since you are plowing most of the cash flow back into the business – mostly into commercial operations to generate that growth (separate topic: be careful around the assumptions about steady-state cash flow in a growing subscription business – it may not be what you think it is – as it can be distorted by customers paying invoices upfront). When sales & marketing spend essentially equals gross profit, what is the point?
What is the catalyst that causes the managers of the business to turn off all that sales & marketing spend to increase profitability? Why would they ever do when slower growth would likely crush the valuation (of their stock options)? But at these valuations, the cash flow of the business would take decades to cover the acquisition cost of the business. You Cannot Eat Growth. This feels like a never ending cycle; until the cycle is ended by exogenous forces. In the dotcom days, the cycle was ended by running out of cash one day.
I found this funny commentary on the situation:
“If you’re curious about where all the billions of dollars of venture and IPO capital are being spent by all these Software as a Service startups, I have figured it out. The answer is in my inbox. Every day five spam emails about signing up for this enterprise software or that – control your employees’ spending, track your employees’ benefits, a million different versions of PEO, etc. They’re basically taking all this money, divvying it up into $85,000 starting salaries and paying saleskids one year out of college to hit small business owners on LinkedIn or try to guess at the email addresses of people like me. It’s cold calling but lazier.” – Reformed Broker
A common way to think about these businesses is the “Rule of 40”. In the Rule of 40 (https://www.thesaascfo.com/rule-of-40-saas/), managers are supposed to try to keep the sum of year over year ARR growth + EBITDA margin at or above 40. The result is that faster growing businesses can be less profitable, while businesses that see slowing growing should prioritize profitability. Although even that is getting bastardized (i.e., see Weighted Rule of 40). A concern I have here is with these recurring revenue business, the income statement benefits / suffers from a huge accounting effects vs. cash flow (see EBITDA Is Not A Good Proxy For Cash Flow ). Many items, like revenue and contract expenses, are recognized over years, making the income statement less responsive (i.e., misleading) to current events.
The winner takes all? Yes, I guess this is a fair point to raise. Cloud-based software is disrupting the landscape.
“It’s also interesting just how long this can take. If you live in Silicon Valley, it would be natural to think that cloud and SaaS are old and done and boring, but this chart from Goldman Sachs, showing a survey of big company CIOs, suggests that less than a quarter of their workflows are in the cloud so far, and they’re moving slower than they expected.” – Benedict Evans
And we could be in the early days of cloud disruption – if it really is a disruption.
However, winner takes all means that only a handful of companies will grow into these valuations. Some companies will be worth it. But, the average cloud-based software company likely will not be the winner taking all, according to the definition of average. So, the situation becomes similar to the investment profile for venture capital – one of your portfolio of ten might be a blockbuster; the remaining nine will likely lead to mediocre returns or even losses. These companies become moonshots.
That might produce acceptable returns if you have a portfolio of these companies. Which is a much different proposition than if you are managing a single business – a portfolio of one as I call it (this most definitely violates the Kelly Criterion).
I have joked in the past that I like to follow bubbles. I worked in software and moved to San Francisco in 1999. After graduating business school in 2005, I bought my first house and joined Wachovia’s investment banking platform eventually ending up on the Leveraged Finance team just in time to get a front row seat to the Great Financial Crisis. So, I have a few scars.
And like most humans, I seek to find patterns, whether they exist or not. So take it with a grain of salt that I see a pattern here, which reminds me a lot of the business models in the dotcom days. Where valuations were predicated on growth metrics, without much regard to the long term sustainability of the underlying business model.
This appears to be a developing situation and I will continue to watch the developments unfold with a lot of curiosity. But the pendulum has swung pretty far in one direction over a number of years, and lots of capital has been allocated and is being managed under that paradigm, and it is likely to take some time (not a quarter) for adjustments to roll through. In fact, my sense is that a lot of folks are still in the denial stage.
“Remember that everyone has opinions and they are often bad.” – Principles (pp. 375)
The second time is a charm.
I tried to read this book, Principles by Ray Dalio, back in 2019 and failed. Unsure why. It might have been a little too deep or hit a little too close to home. I also happened to be buried neck deep in work.
However, the second attempt was much more enjoyable and successful. There are some really interesting personal and organizational concepts presented throughout the book.
“There is almost always a good path that you just haven’t discovered yet, so look for it until you find it rather than settle for the choice that is apparent to you.” (pp. 38)
“I felt about this fork-in-the-road choice the way I felt about most others – that whether or not we could have our cake and eat it too was merely a test of our creativity and character.” (pp. 72)
“And it reminded me that when faced with the choice between two things you need that are seemingly at odds, go slowly to figure out how you can have as much of both as possible.” (pp. 63).
Sometimes I tend to react fast. Or make fast decisions. Or jump to the outcome that I think is most likely. Or just, in general, want to come up with solutions quickly.
This is a good reminder to go slow. Get creative. Look for options.
Figure Out Where You Are Rather Than Try To Forecast The Future
“In other words, rather than forecasting changes in the economic environment and shifting positions in anticipation of them, we pick up these changes as they’re occurring and move our money around to keep in those markets which perform best in that environment.” (pp. 42)
This made so much sense to me. I know enough about forecasting to know that you really should not base much of your income on your ability to forecast market movements. But really understanding where you are in the market cycle and continuing to adjust to new developments really makes a lot of sense. Easier said than done.
Identify & Solve Problems
“Most people would rather celebrate all the things that are going well while sweeping problems under the rug. Those people have their priorities exactly backward, and there is little that can be harmful to an organization.” (pp. 473)
I love to solve problems. Which is good, because as an executive in a small company, I seem to be faced with a constant stream of them. The philosophy that problem identification should be rewarded vs. punished is important in a company. And problems should be made visible, so they can be solved. Each problem solved makes you that much better.
Recently, there have been a number of articles comparing the performance of those investors who left a portion of their portfolio in “safer” assets coming out of the Great Financial Crisis (GFC) versus those who took a more aggressive posture and were mostly or all in equities. I will pick on this one:
I get it. If you look at asset performance over the last ten years or so, the returns of U.S. equities look fantastic. Holding anything but U.S. equities has been dilutive to portfolio performance.
Be careful though just focusing on the results of the last decade and making the leap that holding mostly U.S. equities was a good decision. Or that should be your strategy going forward. That would be called “resulting”.
“Resulting” is a poker term that refers to our habit of judging a decision based solely on the outcome it produced. – Thinking In Betsby Annie Duke
A good outcome is not necessarily the result of a good decision. And vice versa.