As many of you know, in the past I’ve done a series of posts deconstructing the S-1s of VC-backed internet startups going public. A few years ago this was sort of a novelty… not that many startups were going public and not that many bloggers or mainstream journalists took the time or had familiarity with combing these SEC filings. But now there’s a lot of info reported and a number of good, thorough analyses of S-1s as we enjoy a quiet but very real “boom” in the tech economy.
Twitter’s IPO has garnered a ton of attention in the tech and popular press. So their revenue figures, pre IPO financing and ownership, and other info is all widely available. I thought I’d provide a little analysis of Twitter based on their S-1, but also strive to put it in a broader context of other consumer internet businesses and where we are in the current tech cycle.
Three Ways to Make Money On the Consumer Internet
I authored a post seven years ago (geez… time flies!) on the three ways to make money on the consumer internet. The emergence of mobile platforms has broadened the array of internet-enabled businesses somewhat, and overall it obviously marks a massive shift in computing platforms. But at its base level, ubiquitous computing or “mobile” hasn’t actually changed that much from the desktop web when it comes to fundamental business models.
Again there’s three fundamental ways to make money in consumer-facing internet businesses: you can sell people stuff in a physical realm (e-commerce), you can indirectly monetize consumer attention (media or ad-based), or you can provide online software & services that consumers pay for (premium services). There’s different flavors or derivations of these… e-tailers and marketplaces are both e-commerce businesses but differ in operational model, growth patterns, and profit margins. Games monetized via in-app purchases are a premium service. But at the end of the day I’m a simple guy and subscribe to Occam’s razor… all else being equal, the simpler explanation of something is generally better.
Twitter Is A Media Business
Despite it’s long-standing protestations, Twitter is indeed a media company. If this were a math class, I’d just say the proof is evident but if you want some data on Twitter’s 2013 YTD revenue here you go.
So Twitter is a media business given nearly 90% of their revenue is advertising and the company expects “data licensing revenue to decrease as a percentage of our total revenue over time”. Facebook is a media business. In an unconventional way, Google is also media business, though their consumer “attention” is intent-based rather than time-based. TripAdvisor and Yelp don’t get as much hype as Twitter or Facebook, but they too have built very large audience/media businesses.
If Pinterest and SnapChat turn out to be big businesses, they’ll be media-based businesses. That’s why some smart investors believe they’re worth $3-4B each despite being pre-revenue. Instagram hadn’t built a true business (e.g. revenues –> profits –> cash flows) yet when they were acquired, but they had built a very successful product with great potential to build a business.
Value of Media vs E-Commerce vs Premium Services
Tomorrow we’ll know Twitter’s market cap definitively, at least near term. Since they upped their IPO pricing range to $23-25/share the offering will imply a market cap of $12-14B, but where it will stand after the first day of trading is anyone’s guess and most of the guesses are $15-20B+.
Why are media businesses so valuable? Well it’s not clear that media businesses, in aggregate, are inherently more valuable than e-commerce or premium services companies in aggregate [see Note 1 below regarding categorization]. In the consumer realm, there are more e-commerce companies that will go public this year than media-based startups. For e-commerce you have RetailMeNot (not a traditional e-tailer but still e-commerce nonetheless), Zulilly (great analysis here by Greg Bettinelli), and of course Alibaba on the horizon. There are also a bunch of other e-commerce companies which may have the potential to go public in the not too distant future like Wayfair, Fab, One Kings Lane, and others. But with the exception of Alibaba none of these will businesses worth $10B+ (I plan to do a detailed analysis of Alibaba when they file).
There haven’t been any consumer internet companies with premium service business model to go public in 2013 here. The last one to do so was arguably Zynga, as gaming is a category consumers have clear willingness to pay for, and Supercell had an M&A exit which valued the whole company at around $3B. But there are several premium services business waiting in the wings with potential to be standalone public companies like Dropbox, Evernote, Spotify, and others. And of course Netflix has been public for years but has enjoyed stupendous momentum as a public company in the past 12-18 months.
So there’s arguably more e-commerce and premium services companies that have gone public in the last 1-2 years than media/audience businesses. But with media-based businesses, the distribution of outcomes is markedly different in part because the value capture by new disruptive startups is different. Google, Facebook, and Twitter have each created a new audience-based paradigm and thus have created and dominated a new segment of advertising. Prior generations of media companies typically get little or no share of the new ad markets that are created, meaning the lion’s share of value flows to these new innovative platforms making them exceedingly valuable businesses.
While there are many new standalone companies that are built in the e-commerce and digital premium services segments, a lot of value is also captured by legacy players in each category. Amazon dominates e-commerce, but Nordstrom, Wal-Mart, et al have non-trivial e-commerce businesses of their own. Similarly for every Supercell and Zynga, there’s also big mobile gaming franchises built by legacy publishers like EA.
Growth IPOs Are Back
One other way to put Twitter’s IPO, and other consumer & B2B IPOs recently, in context is the broader macroeconomy and investing environment. A couple things factor into this.
1) Skepticism of Startup IPOs is Behind Us – A few years ago there was exceptional dubiousness of new technology companies, which along with the tech crash of ’01-02 and recession of ’08-09 strongly contributed to the IPO drought from 2003-2010. Yes there’ve been high profile missteps for Facebook’s IPO and companies which have underwhelmed like Zynga and Groupon. But the broad success of both consumer and business facing companies new to the public has meant the prevailing bias against tech IPOs has been replaced with a healthy balance between enthusiasm and skepticism. Investors can debate valuation, but it’s patently obvious that Facebook, LinkedIn, Workday, TripAdvisor, and many other startup IPOs of the last 1-2 years are great businesses.
2) Growth is Prized – We live in an unusual time where the confluence of near zero yields, QE, underlying technology innovation, low macro growth, and worldwide demographic shifts have produced an environment where growth potential is especially prized by equity investors. The tables below show year over year growth rates based on last quarter’s reported results followed by stock price over the last 12 months for a group of companies all of which have seen 100%+ rises in share price. To be fair the broad equity markets are up strongly over this time period, but clearly growth has been strongly favored. And for what it’s worth, a lack of growth or the departure of former growth has been penalized by the market as well (just look at Zynga).
So viewed through this lens, it’s pretty clear why Twitter will be valued highly tomorrow… it’s a media-based success in an environment ripe for high growth consumer internet businesses. I wish all of those involved with Twitter very well.
Note 1: Most consumer internet businesses can be put into one of the three buckets pretty easily. LinkedIn is a little unusual in that it’s essentially a B2B SaaS business, a consumer premium services business, and a media business all wrapped together. One could argue Groupon is a “media” business in that they “sell” the attention of their consumers to small businesses, but I think of Groupon really more like an e-commerce business… they directly facilitate transactions and their gross margins work like a commerce rather than a media company.
I believe we’re going to look back in 2-5 years and realize that we’ve been in a once a decade boom for internet & software startups.
It doesn’t feel much like a boom actually. The macroeconomy has been stuck in a tepid recovery in the US, a period of decelerating growth in emerging markets, and a double dip recession in much of Europe. In the tech sphere, a good bit of air was let out of the tires when the hype around some consumer-facing internet companies proved transitory. Remember when Groupon and Zynga were each going to be worth $20-30B? Facebook’s IPO was obviously a debacle, and in the private investment sphere valuations from the seed through late stage have declined for the most part from their peaks in late 2011 through early 2012. And of course the US government is shutting down today…
But if you look past all the reasons why it doesn’t feel like a boom, you start to see some compelling evidence:
- Ubiquitous Computing (aka Mobile) Surge is in Full Swing - Again at NextView we think of this computing platform wave as ubiquitous computing rather than simply “mobile”. But we’re now 5+ years into the hardware cycle for smartphones and 3 years into the cycle for tablets. Software revenue trails hardware slightly and ad revenue always takes a couple years to shift, but even here the results are astounding. Facebook will do $7-8B in revenue this year, essentially none was from mobile ads last year and now >40% of their ad revenue is from mobile ads.
- Cloud Computing Strength Accelerates - “Cloud” gets thrown around as much as mobile without really parsing the underlying trends. At the application layer you have a massive shift of on-prem software going SaaS, a trend started over a decade ago with Salesforce but accelerating dramatically in recent years across nearly every software category (HR – Workday, Marketing – Eloqua, Marketo, Marin Software, ExactTarget, Engineering/IT – Rally Software, ServiceNow). At the infrastructure level companies are creating all stuff which will power cloud-based applications and services and keep them secure.
- IPO Market Is Strong - All the companies I just mentioned in cloud computing have gone public within the last 12 months. In September 2013 alone there were 6 tech IPOs (FireEye, Ring Central, Violin Memory, Applied Optoelectronics, Benefitfocus, and Covisint). The last two weren’t traditional VC backed startups, but rather growth equity and a corporate spin out, but nonetheless innovative tech companies are clearly being welcomed by the public markets again. And of course Twitter filed confidentially for their IPO in September.
- IPO Market Is Rational - I say now is a boom and not a bubble, because crucially all of these are rational businesses with significant revenue (typically $100M+ annualized, if not substantially more), strong growth rates, and profitability or at least a clear path to it. This is not ’98-99 when pre-revenue companies were IPO’ing. And as I’ve mentioned valuations in the private investment sphere have largely rationalized in the last 12-18 months.
- More Ways Than Ever to Raise Startup Capital - Plenty has been written about AngelList’s new funding & model (good summary here), as well as crowdfunding more broadly. But it’s clear that the capital needed to launch a software-based business has never been lower, and there’s more ways than ever to obtain that capital.
This boom will play out over a longer time frame, and perhaps a little slower than the ’95-00 boom & bubble cycle. Maybe the current boom started 12 months ago or 18 months ago but we’re still pretty early in. I’m not a Pollyanna either… the business cycle hasn’t been eliminated and the process of creative destruction means for every startup that becomes a big business, many more will die and some existing giants will wither.
But in my mind there’s little doubt we’re in a tech boom, and just as the last boom didn’t feel self-evident until ’98 or ’99 I suspect this one may not until 2015 or 2016. The US government last shut down in 1995 and 1996. It’s purely a co-incidence of course but in ’95 Netscape went public, regarded by many as the seminal moment of the last tech boom, and in ’96 Yahoo went public followed by Amazon in ’97 and eBay in ’98. So don’t lose sight of the tech boom that’s underway now amid all the rest of the news…
We all woke up to the news that Microsoft is buying Nokia for ~$7B (ok, not the carrier infrastructure biz but the main part of Nokia that anybody cares about). This isn’t totally out of left field since they’ve had a close partnership for a year, but I tweeted my reaction:
What Microsoft needs is a near death experience so that they can reinvent themselves as an enterprise cloud company. Big tech has long had a history of phoenixes rising from the ashes… think near death of Apple which in the long run came to dominate mobile computing, or IBM which went from a dying “Big Blue” to todays “THINK” which dominates tech services and much server-side computing. And there are plenty of non-tech companies whose near death experiences catalyzed remarkable transformations (Ford under Alan Mulally, Continental Airlines under Gordon Bethune, et al).
In the late ’90s Microsoft was the world’s most valuable company and dominated virtually every category of software that mattered, and even some that didn’t matter that much (e.g. browsers). To be fair to Microsoft they’ve done some laudable things in the past decade like creating a respectable (still distant #2) search company in Bing, being both dominant and innovative in console gaming (Kinnect, Xbox Live, etc), and acquiring some interesting companies (Skype, Yammer). And Microsoft’s Azure strategy has given it a strong position in public and private cloud computing.
But the company has fundamentally been playing catch up for most of the Ballmer era, and arguably has done a mediocre job of it. While I’m sure Hollywood would love a story like “Bill Gates returns to Microsoft and makes it into a radical innovator”, that’s simply not going to happen. And the reality is that Microsoft isn’t exactly near death, with healthy profits and cash-flow from Windows, Office, and cloud services. MSFT has more billion dollar software franchises than you can shake a stick at (Dynamics in SMB CRM, Sharepoint, etc).
As interesting as Bing, Xbox, Skype, and other consumer services may be they don’t make much money. And the consumer hardware businesses (Surface, Windows phone) have flopped big time. Doubling down on consumer hardware with Nokia seems like a terrible idea to me… MSFT will continue to struggle in these categories and not make much money in them. It would probably take a near-death experience for Microsoft to realize that being awesome in something is better than being mediocre in everything. The path to being awesome in something would look roughly like this.
1) Hire transformative CEO to replace Ballmer. This seems like a no-brainer but Ballmer and the MSFT board might lean towards a less risky path. Names like Stephen Elop of Nokia, John Donahue of eBay, and internal candidates (Satya Nadella, Steven Sinofsky, et al) are mentioned. Microsoft is an enormous ship and reinventing the company would be non-trivial for anyone, so I don’t think the choice is an obvious one. Remember Lou Gerstner ran American Express before taking the helm at IBM in 1993. But all the other phoenix-risen stories above are intrinsically linked to a strong leader willing not only to take the riskier strategic path but also willing to persuade and cajole a large organization that path was necessary.
2) Divest the consumer facing businesses in mobile hardware, gaming, and online services. Xbox could probably be a pretty good standalone business but MSFT will never be a leader in phones, tablets, or search. Microsoft doesn’t need the cash… despite limited growth and paying a substantial dividend, MSFT still generates good cashflow and has >$70B on it’s balance sheet. But the company does need to become more focused in its strategy, operations, and personnel.
3) Triple down on cloud infrastructure & services with Azure and acquisitions. At the 90,000 foot level platforms matter if you want to be in the end-user device business. But the next 10+ years of computing can be roughly described as cloud + pipes + device platforms. Apple, Google, and Samsung are winning in the latter but Microsoft can dominate the former as a software and service “platform” for enterprises and infrastructure providers.
And I specifically mean cloud infrastructure rather than the application layer. It would be silly for Microsoft to buy a bunch of SaaS companies to compete against Oracle and SAP. Microsoft already has a dominant position from server OS to private/public cloud services so they should build on that that organically and through acquisition. Want names? Small ball would be acquisitions of companies which help manage and power cloud applications and there’s lots to choose from here: stodgy old guys like BMC to recently public ServiceNow or Splunk to privately held startups (MongoDB, et al). The transformative play would be for VMWare, which would probably require buying EMC at the same time (divest the storage hardware but keep storage software, RSA, etc). A bunch of people smarter than me about enterprise cloud could probably gin up even more names than I did in thinking about this for 60 seconds.
FWIW, I don’t predict this will happen. I think Microsoft will continue to lead in a few areas but muddle along in so many more. I suspect they’ll pick a smart and competent replacement for Ballmer, but not one who will transform by shrinking then re-focusing and growing again as an enterprise cloud world-beater. I’m rooting for Microsoft and you never know…
I was having breakfast this morning from someone I know from the LP world. We were talking about what’s “working” in the broader VC ecosystem and this person expressed their enthusiasm that today there are a range of different models that are producing attractive returns for LPs.
Historically there was just one model… VCs had to invest in the Series A or B round of a startup, own 20%+ of the company, and be one of the primary capital supporters of it through exit. That model still works for quite a few firms, but now there are also some different models producing attractive returns. One example is seed/micro VCs who own far less than 20% (often <10%) of companies but are typically investing at the earliest stages and out of smaller funds, both of which can produce superior returns on a cash on cash multiple if done well.
There’s also select late stage VC investors, either as a dedicated late stage fund or as part of a broadly diversified large fund, again who often own far less than 10% of the companies they invest in but where they can still produce good multiples in shorter time frame again if executed well. Neither of these models is brand new, but they have emerged more distinctly in the last 5-7 years meaning there’s now realized returns to support the attractiveness of these seed or late-stage models in addition to the “traditional” own 20% early stage model.
But while there’s multiple models working in the VC ecosystem, it remains acutely true that there is no subprime model for VC. I’m fond of saying this phrase though I must give credit to Peter Thiel who coined it back in the early PayPal days 10+ years ago. The point is that unlike various consumer credit markets where subprime lending does indeed work, trying to apply a comparable model to VC is typically disastrous because startup outcomes follow a power-law distribution rather than a normal distribution.
In consumer credit (credit cards, mortgages, car loans, etc) a subprime approach works. You could argue some forms of subprime consumer credit are predatory or usurious in nature (e.g. payday lending). But while lending to borrowers who are less desirable (from a creditworthiness and ability to repay standpoint) will result in greater loan losses than lending to “prime” customers, as long as you price this credit accordingly (higher interest rates, fees, etc) and do a good job underwriting and managing the portfolio it can be a rather profitable enterprise. There are both specialty lenders and large banks that have built big, successful businesses in subprime lending. [see Note 1 below re: subprime crisis of 2008-9]
So why doesn’t the same model work in VC? The subprime analogy for venture would be to invest in the somewhat less desirable startups (in terms of team, mkt oppty, product, etc) but to price one’s investment capital appropriately. Put plainly, the subprime model of VC would be to invest in the mediocre startups at a low valuation. Or to focus solely on getting the lowest valuation as an investor, which by definition will price you out of the most desirable companies which typically have substantial demand for their equity. Or to invest in mediocre startups at a low valuation but hope to “manage” this portfolio to better than expected outcomes.
In theory this would work if the ok, not great startups had good, not great positive outcomes. But we all know that is in fact false… the power law distribution holds. The great startups produce 10X+ returns for their VC investors, the mediocre ones struggle to return capital or minimize losses. Even if you get a super low valuation, investing in a company that raises $20M in VC capital and sells for around that much doesn’t produce a good return. That’s what the middle of the startup outcome distribution tends to look like.
So if there is no subprime model for VC, is the corollary that valuation doesn’t matter or as some have said there are only 5-10 startups per year that “matter”? Well in a way investing in the best companies is in fact more important than valuation, though valuation still matters in certain respects as I’ve discussed before. And the answer to the second corollary in fact depends on the definition of what “matters”.
I can’t speak for Marc Andreessen but I suspect when he said only 5-10 startups a year matter, he was looking at it through the lens of a very large “platform” VC fund like AH or others that are several billion dollars in size. Indeed for groups like these to produce a good fund level return, they by definition must be investing in the companies that are ultimately worth $5-10B or more in enterprise value and there are only perhaps 5-10 of those per year (maybe less). But for a traditional early-stage VC with a $200-300M fund a single exit of $500M-1B really “matters” in terms of returning a huge portion of the fund. For a seed VC fund it might be even smaller depending on size and strategy. So “matters” is relative and while there aren’t hundreds of startup outcomes per year that “matter” there are probably many dozens. But there still is no subprime model that works in venture…
Note 1: Readers may feel that the subprime mortgage collapse which led to the financial crisis of 2008-2009 implies that subprime lending does not indeed work. The subprime mortgage collapse had many interrelated factors at work – easy monetary policy, lax underwriting standards, misleading credit ratings, fraud (at all levels from consumer to originators to securitization), uninformed investors buying MBSs & CDOs – all of which became self-reinforcing in a vicious cycle to inflate a credit bubble. This produced an obviously bad outcome. But the fundamental premise of subprime lending (lend to the less creditworthy but demanding higher interest rates to compensate for defaults) remains sound and is working today, just as the bursting of the Dutch tulip bubble doesn’t mean that tulips are valueless.
I’ve been doing some thinking about the future of cars and the impact of the internet. A large part of this is just some idle thoughts, a small part is driven by my love of cars, and a small part is thinking about what potential opportunities for innovation & investment might stem from this. I started jotting this down about a month ago but Google’s acquisition of Waze was a good prompt to finish off this post.
When people talk about “internet” and “cars” people usually think of internet-connected automobiles for the purposes of infotainment. Connected cars arguably started with GM’s launch of the OnStar telematics service in the mid-late ’90s, though in essence this remains a private network which was originally run over analog cellular and satellites rather than open internet. Today you can buy an Audi or a Dodge Ram pickup with a wifi hotspot (connected via mobile broadband) and you’ll see similar capabilities from other manufacturers in the next 1-2 years. Internet & software giants like Google (Google Maps now powers Audi nav systems) and Microsoft (Sync infotainment created in conjunction with Ford) have been hard at work to remain at the leading edge of innovation here.
But to me infotainment is really just a small part of the internet connected car story. We’ve had internet in our cars since the rise of smartphones, and arguably it’s been as much a safety hazard (distracted driving while texting, emailing, etc) as a positive transformation (navigation, music, etc). And outside the confines of the chassis, the internet has had more of an impact on the car industry from the basic (internet research is the most influential component of car buying today) to the transformative (ZipCar, Uber, etc).
So what will ubiquitous connected computing mean for the 100+ year old automobile? My thoughts here are still at the 60,000ft, macro-economic level and not at the micro startup opportunity level but here are a few.
Diagnostics & Maintenance – The computerization of cars is several decades old at this point and was driven by a multitude of factors, mainly safety and environmental concerns (reduced emissions from electronic control of combustion). With chips running large parts of cars came basic diagnostic tools like the “check engine” light to OBD ports. This has led to a broad transition away from many consumers doing their own maintenance and repair work to few doing it. With internet connectivity integrated by the OEMs, you’re going to see real-time monitoring and diagnostics which should favor franchise dealers or factory-owned service centers (e.g. Tesla) even more for repair work. The independent shop won’t go away just as do-it-yourself repair didn’t disappear with electronic fuel injection, but franchise dealers & factory service centers will take an increasing share of the maintenance market.
Driverless Cars Change Definition of Car “Owners” – We’ve all heard of or seen Google’s driverless cars and forward-thinking manufacturers are already planning for this day whether it’s 5 or 20 years in the future. And to be fair ubiquitous connected computing is but one of the enabling technologies for driverless cars (computer vision, AI, etc). But in a world of driverless cars, the notion of who “owns” or can “drive” an automobile can change dramatically. I don’t just mean that people are going to share cars, though that will undoubtedly be true in densely populated areas.
Driverless cars could actually increase the number of cars on the road, both because the safe density of cars on the road can be increased, but also because of expanding the universe of drivers and societal preferences. In a world where a human isn’t the primary operator, you will have more visually impaired or physically handicapped persons driving themselves or more elderly persons or even children. A 9 year old could hop in a driverless car and drive themselves to school for example. Also if driving wasn’t time-consuming or stressful (e.g. you could read, work, play, etc in your car w/o needing to pay attention to the road), some people might choose to live further away from their work even if there weren’t good mass transit options available to them. The average American’s daily commute is just under an hour (round trip), so in aggregate that’s potentially a lot of incremental time when they might be doing email, web surfing, playing games, or communicating with friends. And commuting 2+hrs daily is less of a big deal if you can use that time for work or leisure.
Cars as a Utility – As someone who’s passionate about driving and cars, this is a potential trend that saddens me a little but seems inevitable nonetheless. The more connected our automobiles become and the more detached we are from the physical act of operating them, the more cars will become a utility for most people. People will still race cars (just as they still race horses), and a small number of people will dedicate time and resources to owning and caring for cars (just as they still do for horses).
But when internet connected computers control much of the operation and maintenance of vehicles, my hunch is that people in general and younger generations in particular will view cars as a utility rather than as a pursuit in and of themselves. The thrill engendered by aesthetics, performance, or luxury will probably be muted except for a hardcore passionate few. People will seek these in other consumer goods and cars may become less differentiated. In the 50’s and 60’s, a drivers license and car ownership were the central focus of most teenagers. Teenagers today, and certainly the ones coming of age in decades to come, probably won’t place similar emphasis.
Cars as a Media Platform – Again I think infotainment is only the tip of the spear but cars have been a media platform for many decades, since the advent of AM radios. Internet connectivity is turning them into a more individualized and more comprehensive kind of media platform. Radio as we know it won’t die, but audio services that are personalized and on-demand will proliferate in the near term (like Spotify now working with Ford Sync) which will mean targeting more like web/mobile ads. And longer term streaming video, games, and other media will become a bigger part of the auto platform both near term for traditional “passengers” and longer-term with autonomous cars. People will of course still whip out their smartphones and tablets in the car, but I anticipate manufacturers will find better ways to integrate connected media like cached storage via your work/home wifi connection or Slingbox type functionality with your home DVR.
The car is over a century old and how it’s propelled, who drives it, and other key aspects will change here in the 21st century. As a result younger generations’ attitudes about cars and personal identity are already changing. But autos will remain incredibly important in the internet age which is something you can only say about a handful of other transformative technologies from centuries past.