On What We Are Doing Wrong

Posted on: October 20, 2019
Posted in Strategy

In April I wrote a post about startup capital efficiency, before the Uber IPO and WeWork debacle, that was at the top of Techmeme and Hacker News. It’s a worthwhile read for the simplicity of what I communicated at the time.

The lesson and takeaway is though they don’t lead with it, investors do care about capital efficiency, and the entire video of how your company is doing since inception will be played. And outside of pure growth, capital efficiency is the most powerful leading indicator for whether you are going to be successful in the future. Not enough appreciation these days goes into this simple equation.

This week reports surfaced that We’s value dropped to $8B. Although I have filtered out much of the pile-on noise about its freefall and feel for my friends there, one comparative anecdote repeatedly riveted in to my neocortex—$8B (after $5B in additional cash) is less than 10% of the valuation Goldman was seeking in its IPO, just 60 days ago.

Where did this all go wrong? Who can outrage culture blame, because I need to know NOW. Are the Goldman bankers stupid, frauds, or were they temporarily fooled as well?

When I moved to NYC from Silicon Valley I tricked both Goldman and Morgan Stanley in to giving me jobs. I wasn’t destined to be a good banker but I was equally adept at fooling these firms to hire me and look back on that as a satisfying time in my marketing career.

It required me understanding not finance really, but how to tell a story, something that is my strong suit. GS and MS – as people in industry fondly self-abbreviate – are opposing thumbs of corporate culture, so getting offers from not one – but both – was hard to pull off. I changed the tone in my voice, the color of my tie, and how I explained an S4 merger statement. I was the only one at Columbia that year with an offer from both firms, and maybe the only one at all ivy MBA schools.

The reason was simple: I knew what to say to make these people believe a vision I was authentically selling but that I hadn’t caught up with yet. Investment bankers getting intoxicated on vision isn’t fraud. These are advisors getting paid to get drunk off a high terminal growth coefficient in a spreadsheet.

The problem with Goldman’s 10%-of-EV whiff (90% erosion in EV) on We is that you are no longer selling a vision at the growth stage, you are selling cash flows. It goes like this:

But first, let me take a step back to set the stage on how fundraising really works. Contentious statement alert: financial models for early tech companies are made up. End of story.

Before some journalist tanks my burgeoning career, I started talking about all this in a podcast before the We debacle outlining why revenue models are made up at startups. For the uninitiated it’s an eye-opening listen on how capital efficiency and fundraising really work (1-15 mins in, the rest definitely more interesting as it’s about good ole’ tech).  

In short: revenue models are completely made up in early stage startups. All the top firms agree with me on this; though they may not be apt to publicly agree. This has nothing to do with startups having low ethics. Huh? Please explain Gangster Steve.  

The place where modeling revenue is aspirational is at the vision stage. Series A-ish companies have zero idea how revenue will materialize, so they model revenue doubling every year for five years, while the cost model for how they will spend is real (this is pretty easy!).  For revenue, dream big. It should be obvious 95% of these models don’t pan out: if every Series A backed company made their model they’d be public within 5 years.

But—this applies to early stage startups.

The astounding thing here is Goldman created a made up model for a massive growth stage startup, in fact the company which raised the most private capital of all time! Can you imagine being the analyst who made this DCF model at Goldman, or the MD signing off on it? It’s sheer insanity. Not the law breaking type, but the ethically and mentally ill one.

Back when I wrote this post and did this podcast, I was like why aren’t people talking about this capital efficiency stuff?

Turns out dreaming is addictive and nothing is illegal about bankers putting a high terminal growth coefficient in to a spreadsheet — changing that one variable alone will make excel endorse any company that isn’t efficient with capital.

Goldman doesn’t like detractors, so I am now officially off the invite list for their annual private internet company conference where I saw Neumann headline in 2016 . Oh well. I have plenty of problems, but tie colors and banker dinners aren’t one of them.

One point of passion for me I think people are starting to realize now around how all these tech valuations are ‘sold’, is that the tendency to model growth has gone too far out of control. It’s less clear today than ever how capital will equate to cash flows. When companies raise money, only one thing matters: can they generate free cash flows and ultimately return money to investors.

As I’ve said before in Silicon Valley’s Information Asymmetry Problem, tech today is a safe haven where polarizing extremes can live in harmony because certainty doesn’t exist, and certainty is at odds with leverage and risk. Rules are created, then broken again gleefully.

My macro point which is critical to realize is that the Valley has a weird way of branding things when they are established and applying a ‘rule’. There exists a massive information asymmetry gap around what influential people in the Valley speak and give recommendations about, and where in the risk cycle that idea lies.

Professor Galloway is now talking about margin and grouping all kinds of companies together in his predilection for margin. Margin is now the honey nectar of the Gods.

You have to hand it to Galloway who played this call perfectly. He has probably made the next phase of his career off of it and teaches a masterclass in marketing yourself.

But this is not new.

Nothing has changed. Markets reward efficiency. How efficient is the business at producing cash flows, the limit of this being a return to shareholders (investors). That’s always the long term goal. The short term proxy being free cash flows.

If you are building a business, you need to think really deeply: do you know how to return money to investors yet? Early startups often don’t have a product customers are paying millions of dollars for, and the answer is no. This is why their financial model is sprinkled with fairy dust.

The ‘problem’, if you want to label one, in the Silicon Valley mindset today is there’s a post for the naysayer, the optimist, the builder, and the stadium-level-seat activist. Who knows where the high leverage margin exists in a world of flowing capital and low rates of return?

Very few do.

Yesterday’s world was about marketing. Today we live in a world that’s about marketing your marketing. Everyone is searching for a growth arbitrage in ways that leverage the whole hell out of the system.

What if SoftBank was one big experiment on determining what is – and is not – a tech business?

Maybe Professor Galloway will reach out to me after this post, and we can sit down 1-1 and talk about the algebra for what-is-tech happiness. That would be fun. Tesla certainly is a tech company, and I’ll be writing a post that explains exactly why they will win autonomy soon. Hey, I can market ideas well too.

So where do we go on what’s being deemed by some a return to capital efficiency? There isn’t one. The smart people know that to get a return on capital today, you have to do it the old fashioned way: be right. And while marketing the hell out of yourself or your company can extend the time it takes to figure things out, that too has a tendency to catch up with you.

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