The Rule of Negative 40

As you start to truly scale your software startup, you’ll probably start to hear investors talk about the Rule of 40.

Simply put, you take you growth rate and subtract your EBITDA margin. If it’s above 40%, you’re in good shape. If it’s below 40%, you should start figuring out how to cut costs.

For example, if you’re at $5m in revenue and growing 100% (expecting to hit $10m in revenue next year) but losing $6m in the process (negative 60% EBITDA margin), you’re okay. Lose any more than that, and you’ve got to dial back on spending. Here’s a recent post with some great charts looking at how public SaaS companies conform to the Rule of 40 from the smart folks at Volition Capital: https://www.volitioncapital.com/news/the-rule-of-40-growth-profitability-and-the-tortoise-and-the-hare/¬†

The Rule of 40 is wrong for fast growing companies

My guess is the Rule of 40 comes from the fact that a mature software company should expect 20% EBITDA margins and likely will be growing 10% (which would equal 30% combined number for the Rule of 40), and because investors always want to push you, that becomes 40.

However, as long as you are burning money to drive growth, the Rule of Negative 40 is a much better metric.

Here’s why:

For every dollar of additional revenue, you are adding, at a minimum, 6x that in additional company enterprise value, given the low end of SaaS valuations. If you go from $10m in revenue to $20m in revenue, your valuation, theoretically, goes up from $60m to $120m. You should be willing to spend up to $60m to add that $10m in revenue. With the Rule of Negative 40, you’d be willing to have a -140% EBITDA margin to support 100% growth, or in this case, burn $14m. That’s still over a 3x return on the $14m investment ($60m gain in value for $14m of spend).

There’s one caveat:

The rest of your P&L needs to be at the right ratios.

If you’re overspending on G&A (office space, free lunch, HR, execs, etc) or your gross margin isn’t 75-80% or anything else is structurally unsound, the theory goes out the door because you aren’t able to cut your way to 20% EBITDA margins if you wanted to stop growth but improve margin.

I’ve put together a quick spreadsheet to demonstrate this, if you want to make a copy and play around: https://docs.google.com/spreadsheets/d/12gI2cmF899Pa1l0J4hZh867aVsNGMPRJ7IBG4xa7SbM/edit?usp=sharing

Note, there are obviously plenty of other factors that play into why you might want to be more conservative with your burn relative to your growth, including, most importantly, your ability to raise the capital needed to fund that growth.

Would love to hear your thoughts on the new Rule of Negative 40!

Why You Need to Have a Billion Dollar Idea to Raise Venture Capital

I remember in the early days of Beyond Pricing, I always hated when a VC would focus on how we could become a unicorn.

We had a great idea, the market needed it, and we were growing! Heck, we probably had product market fit! Why wouldn’t you invest us!

Turns out, there’s some pretty basic math behind why a venture capitalist needs to hear a plausible story about how, in ten year’s time, your company could be worth $1 billion.

Venture Capital is an Asset Class

The first thing to recognize is that a venture capital fund, to those who invest in it (LPs), is just one of many other funds or other places to invest. These LPs can be university endowments, family offices, wealthy individuals. But they are all measuring the venture fund based on its returns compared to other places they could put their money. A very common benchmark is what you could make by just putting your money in an S&P 500 index fund. While that varies from year-to-year, the long-term averages is around 8% annual return.

So if you’re going to invest in a venture fund, which is inherently more risky than the S&P, you’re going to hope to get a decent premium to that 8%. By most standards, a decent VC annual return is 10% after fees, or 12% before the standard 2% annual fee VCs charge LPs. Moreover, the average fund will last 10 years. A little bit of simple math shows that the total amount of cash returned to the investors after 10 years needs to be over 3x the invested capital to hit that annual return target (1.12^10=3.1x). So a $100m fund needs to return $300m to make its investors a small premium over the S&P to account for A LOT more risk.

There’s been a lot written about VC math here and here but you can see both in the examples in those posts and in this spreadsheet which you can download and play around with, there’s almost no reasonable way to get to 3x without at least one $1 billion company in your portfolio as a seed investor. And if a fund can’t get to 3x, the investors were likely better putting their money in the S&P.

(Note: all of these analyses are oversimplified back of the envelopes and don’t model out the full impact of dilution and many other things that move the needle slightly one way or another)

With a fund with 20 companies (which is fairly typical), you would need two companies to sell for $300m, three for $100m, and four for $50m (along with some smaller exists or returns of capital, though that doesn’t affect the outcome much). Nearly 50% of your portfolio would need to sell for $50m or more. The actual average is closer to 10%.

A more likely (and still unlikely given the low percentage of VC funds that actually hit a 3x return) scenario if you’re lucky is to have a single unicorn, one that sells for $100m, and two that sell for $50m. In that scenario, over 75% of your returns are from the unicorn (which matches the general power law in venture capital)

So How Do You Show You Could Be Worth $1 Billion?

This is where TAM (total addressable market) comes in and why it matters. Basically, you’re trying to show, if everyone bought your product, how much revenue would that be. Then make some sort of assumption about what a reasonable market share would be (reasonable being the operative word; you should know what market share the most successful company in your space has and don’t assume anything more than that or risk losing credibility).

For instance, for Beyond Pricing we showed that globally, vacation rentals do about $180 billion annual in revenue. We charged 1% of revenue for our product. So our addressable (for our first product) was $1.8 billion. Given our first-move advantage, the tendency for vertical software products to achieve much higher market share than horizontal products, and the lack of well-funded competitors, we thought 10% market share was (justifiably) reasonable (and probably low). That would come out to a path to $180m in annual revenue.

You basically need to answer the question the VC has around what they need to believe for you to get to a certain amount of revenue. If they believe that’s doable, you’re in business!

The final question is, what amount of revenue equals a billion dollar company. I’ve written a bit about that before, but the key is knowing what the typical price-to-sales ratio is for your industry. In software, depending on your growth rate, that’s typically 6-10x revenue. If you’re building a venture-backed, billion dollar company, you’re probably growing on the fast end, so a 10x revenue multiple is reasonable, meaning you need to show a believable path to $100m in revenue.

That’s the magic number you’ll often hear a VC ask you.

What if there’s not a clear path to $100m in revenue?

If you can’t show that path, you probably have a really nice business but shouldn’t take on venture capital. There’s plenty of other ways to fund your business, but, as you can see from the math, venture capital just doesn’t make sense.

A Back of the Envelope Guide to Estimating Any Software Company’s Revenue (+ Growth)

As I was building Beyond Pricing, very early on we wanted to focus on building a company based on the right ratios.

One of the best ratios I came across was the revenue per employee.

This is a great measure of how efficient you are. Both Tom Tunguz and Jason Lemkin have written great posts about this.

The main takeaway is you should target $200k revenue per employee.

Fast growing companies who are burning capital might dip down to $100k revenue per employee, but anything below that is likely not going anywhere fast and will soon run out of money.

So how do you estimate a software company’s revenue? Multiply employees by $100-200k.

Typically, the more mature the company, the closer to $200k they will be. This isn’t always the case (we definitely bucked that trend at Beyond Pricing).

Let’s look at a couple examples, using LinkedIn.

Braze has around 500 employees. They’ve been around a while, so are likely closer to $200k per employee, which would mean $100m ARR.

Source: LinkedIn

And look at that. That’s exactly what they’re at: https://www.braze.com/perspectives/article/braze-tops-100-million-arr

Looker as around 900 employees. We’d expect them to have around $180m ARR if they were at $200k revenue per employee.

About a year ago, based on employee growth rates, they had around 650 employees. Back then, they claimed to have $100m ARR. That puts them right around $150k revenue per employee, right in the middle of our range. If we use that number to update our estimate, they’d be at $135m ARR, right around the $140m Cowen estimates.

One final example with a disclosure that I know the founders but don’t actually know their revenue. Clubhouse recently raised a Series B and has around 50 employees. I’m going to guess their ARR is right around $5m.

This is further supported by a couple posts about average ARR for different rounds (here and here). tldr; Series A: $1-2m, Series B: ~$5m. I’ll let Kurt and team confirm or deny ūüôā

As far as growth, in general, I’ve found revenue growth to typical be 50-100% higher than the employee growth shown on LinkedIn. For instance, looker had employee growth of around 40% according to Linkedin from 2018-2019 but they reported 70% ARR growth. This more or less matches what I saw at Beyond Pricing as well.

By the way, this is often what analysts at venture capital and private equity firms are looking at. So don’t be surprised when your employee growth rate is above 50% (meaning you’re likely 2x-ing or more) and your employee count is approaching 50 to get those calls from Series B investors. I know we did!

A final note: this is only for US-based software companies. They don’t really apply in other countries where labor is much cheaper or other industries, where average wages are much lower.

How to Value a Company Based on Revenue

As I’ve been doing more and more angel investing, I’ve started to dust off my valuation chops from my investment banking days.

One common difficulty is valuing a company that currently is not profitable.

If we assume a company is growing revenue at the same rate as the overall S&P 500 (5% or less), they should expect a P/E (price to earnings) ratio of 15-20x.

While the historical average has been closer to 15x, the last 3 decades have sustained a 20x or so multiple.

So how do you figure out what the revenue multiple should be?

The easiest way is by figuring out what the average profit margin is. For software companies, this is typically around 20%.

Revenue multiple = P/E multiple X profit margin

For instance, for software companies:

20x * 20% = 4x revenue multiple.

The key to understanding revenue multiples is understanding that different types of businesses have different abilities to produce earnings. Some, like software, are high-margin (20%+ net income margin) while others are low margin (e.g. retail at 5%). A high margin business commands a higher revenue multiple because more of that revenue will turn into earnings. For instance, both Oracle and Target have about a 20x P/E multiple. Target, however, trades at a 0.8x revenue multiple because its net income margin is only about 4%. Oracle, on the other hand, has a 24% net income margin (6x that of Target) and trades at a 4.8x revenue multiple (6x that of Target). Funny how that all works.

So what profit margin can you expect at scale?

Mostly likely, you’ll end up around where the average is for your industry. Here’s a quick analysis: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/margin.html

If you can’t pinpoint where your company falls on that list, find the closest comp that’s a public company and look at their financial statement.

For instance, Away, the luggage maker, can look to Samsonite. They made around an 8% profit margin the last couple of years (source: http://www4.samsonite.com/_investordocs/20190415140343_E_Lux%20Consolidated%20Financial%20Statements%202018%20(Final%202019-04-15).pdf).

If you take a 20x P/E multiple (though Samsonite’s is closer to 15x), they imputed revenue multiple based on 8% profit margin is 1.2x revenue.

Away reported that they expect to double the $150m of revenue they had in 2018 for 2019, putting them at $300m. Based on the revenue multiple above, they would be worth about $360m, if they immediately stopped growing.

That would suggest their latest valuation of $1.4b was 4x their current value (source: https://www.forbes.com/sites/amyfeldman/2019/05/14/at-a-valuation-as-high-as-145b-valuation/#5bf917d933d7_)

In another post, I’ll talk about the “growth multiple” and how it relates to future cash flows. This will explain why paying 4x for a fast growing company isn’t crazy. In fact, it’s often a steal.

As a final note, if a startup can show how they realistically can have outsized margins at scale versus the traditional public comp, that will drive a higher revenue multiple as a function of a higher future expected profit margin. While many startups claim to be able to do this (direct to consumer, new way of manufacturing, etc), this rarely is the case. See Casper’s recent filing as a great example.

How Much is a Tech-Enabled Property Manager Worth?

With Sonder and a long-tail of others raising large amounts of money for “tech-enabled” hospitality, many in vacation rentals and venture capital are wondering whether these businesses deserve the kind of valuations they are receiving.

This will be part of a larger series of posts about valuation of startups in general.

A quick primer on how companies are valued.

Companies exist to produce cash flows (eventually) and at the end of the day, are valued on how much cash flow can be expected in the future. Whether using a DCF (discounted cash flow) analysis or a P/E ratio (price-to-earnings) or EBITDA multiple, a company is worth the free cash flow it will produce for its owners or shareholders.

The long-term average P/E multiple for public companies is around 15x (source: https://www.multpl.com/s-p-500-pe-ratio).

Sometimes this will go up, either due to market exuberance or stronger than average growth rates, because higher than average growth rates mean that future cash flows will be great than normal and thus the ratio of price to current earnings goes up to account for those higher future earnings.

Growth rates average around 5% (source: https://www.multpl.com/s-p-500-sales-growth)

Earnings and growth can explain the majority of valuations (faster growing companies like Okta or Zoom command a greater P/E multiple than slower growing companies like Oracle).

However, when a company doesn’t have any earnings (like most startups), how can you value it?

One way is a revenue multiple.

The key to understanding revenue multiples is understanding that different types of businesses have different abilities to produce earnings. Some, like software, are high-margin (20%+ net income margin) while others are low margin (e.g. retail at 5%). A high margin business commands a higher revenue multiple because more of that revenue will turn into earnings. For instance, both Oracle and Target have about a 20x P/E multiple. Target, however, trades at a 0.8x revenue multiple because its net income margin is only about 4%. Oracle, on the other hand, has a 24% net income margin (6x that of Target) and trades at a 4.8x revenue multiple (6x that of Target). Funny how that all works.

One last note on valuation. Growth matters. Oracle has flat growth. Others like Zoom and Okta have much faster growth and trade at much higher P/E multiples (perhaps too high…). I’ll dive into how much growth matters to revenue multiples in a future post.

So how do we value a vacation rental property management company?

Because there are no Marriotts or Hilton’s of vacation rentals (and because the business model is still quite different), there are few publicly-traded comps to guide us toward what the relationship between earnings potential and net income margin are. However, there is one great comp that gives us some insight: Sykes Cottages. The company recently sold to Vitruvian Partners for $480m (source: https://skift.com/2019/10/29/sykes-cottages-sold-for-480-million-in-a-bet-on-tech-led-short-term-rentals/).

They disclosed they have around $87 million in revenue, $25 million in EBITDA, and 18,000 homes in the last 9 months. If we annualize that, it’s $116m in revenue and $33m in EBITDA. Without knowing their tax and interest exposure but guessing it’s minimal, their P/E ratio is about 15x. That’s pretty good! Much better than the 3.5-5.5x that smaller management companies can expect (source: https://www.vrmintel.com/what-is-my-company-worth-a-back-of-the-napkin-analysis/). However, their EBITDA margin is a fantastic 28%! That’s Oracle-level and much greater than most real estate asset managers in the US that are publicly traded.

I would assume this is best in class. As such, their 4x revenue multiple is a good high water mark.

One important thing to note is that Sykes is a traditional manager, so its revenue number is presumably the commission they make, not the total bookings they manage. This is supported by the fact that their revenue per property is around $6,400/year which is about 25% of the $25,000 per year of rental income you’d expect from their highly seasonal markets. (I’ll let Graham correct any of these assumptions, of course!)

I note this because the revenue numbers reported by folks like Sonder are total bookings numbers because they use master leases and so get 100% of booking revenue, not 20%.

So if revenues aren’t apples-to-apples and there is no profit, what else can we use?

One common metric is price per property managed. For Sykes, this came out to around $28,000. Another recent comp was Vacasa’s purchase of Wyndham’s vacation rental unit. While revenues weren’t disclosed, we know it sold for $162m and had 9,000 properties, which comes out to $18,000 per property (source: https://www.vacasa.com/news/vacasa-finalizes-purchase-wyndham-vacation-rentals)

If we use the Sykes value per property, then Sonder’s recent raise at a $1 billion valuation seems rich for 8,500 properties (source: https://www.businessinsider.com/sonder-has-reached-unicorn-status-with-its-newest-fundraising-round-2019-7)

Assuming they could achieve the same profitability that Sykes does and get the same value per property, they’d be valued at around $240m. However, Sonder has grown 4x in the last year while Sykes took 4 years to quadruple in size. Basically, Sonder will have grown into that valuation within a year, which sounds actually quite reasonable.

In a future post, I’ll outline how much of an impact growth has on valuation and why investors pay a serious premium for fast growing companies.

One final thought to bring it back to apples-to-apples comparisons of revenue and how we can compare revenues from traditional management-fee based companies to the new master lease model. Sykes, if we assume they charge a 25% commission on average, has a profit equal to about 7% of booking revenue (25% commission * 28% EBITDA margin). Sonder reported they will have $400m of booking revenue this year. If they were able to achieve the same profitability as Sykes, that would be $28m of profit, which, at the 15x P/E ratio we discussed earlier, gets us to a valuation of $420m, based on current revenue and properties. The reason for the much higher number? The revenue per property that Sonder appears to be claiming is closer to $50k vs $25k which we assumed for Sykes.

As a bit of a sanity check, I had a chat with my friends over at C2G Advisors, who see a greater number of deals than anyone, most likely. Just as the 20x EBITDA for Sykes and larger companies is much greater than the typical 3.5-5.5x they see for smaller, 50-200 property companies, so, too is the valuation per property.

(As a side note, this is common through company valuations. SMBs are valued at a much lower multiple than larger companies because there is more risk and an SMB is more fragile than a very large corporation. This is part of the reason why larger companies like Vacasa and Sykes can unlock a lot of value by buying smaller companies. If they buy at 5.5x EBITDA but get valued at 15x EBITDA, the deal is instantly accretive even without improving profits.)

Depending on the location and annual bookings for a property, typical ranges they see are $5k-$15k. One key insight from Jim and Jacobie at C2G is that the great equalizer between managers in all markets is the % of booking revenue they capture. When you combine that with their EBITDA margin, you can actually get to EBITDA as a % of booking revenue, which is a great equalizer across traditional managers but also the Sonder-types. In an example they said was typical, a manager might capture 37% of booking revenue as “their” revenue and from there, achieve an 18% EBITDA margin. If you do the math, that comes to an EBITDA margin of 6.5% of booking revenue. That’s pretty darn close to what Sykes seemed to be showing!

As an additional caveat, traditional property managers in the vacation rental space earn revenue not just from commission (a % of booking revenue, typically around 20-25%) but also from fees and other ancillary products they sell where they keep 100% of the revenue. This can amount to 12.5-25% of the booking revenue. This type of “ancillary” revenue is becoming increasingly important, following a trend I saw in airlines decades ago as ancillary become upwards of 30% of revenue at places like Ryanair. In addition, some of the best performing managers will see EBITDA margins from 20% to as high as 30%, which would bring their EBITDA as a percent of booking revenue to upwards of 10% in some cases.

One last fun bit of math. If a property does $30k in annual bookings, you would expect it to do around $2k of EBITDA (based on 6.5%). Stick a 3.5x EBITDA multiple and that gets you $7k per property, right in the range C2G mentioned above. Funny how that works.

The caveat to all of this is the question about whether “tech-enabled” property managers who are now primarily taking out master leases on properties can achieve that level of profitability. While comparisons to WeWork rattle the investor community, if you look at a WeWork competitor, Regus, which has been around much longer, they have a 4% net income margin, which while less than the 7% of booking revenue we see from Sykes is still in the ballpark (source: http://investors.iwgplc.com/key-financials/income-statement).

In summary, for a fast-growing tech-enabled vacation rental manager, it’s reasonable to be worth 1.0-1.5x booking revenue or close to $30k per property.  And for those growing 4x per year, it’s not a crazy leap to get to 2.5x of booking revenue.

But keep an eye on those costs!

(As a side note, WeWork’s “corrected” valuation of $7.5b is 2.5x their $3b in revenue…funny how that works out! (source: https://techcrunch.com/2019/10/21/report-softbank-is-taking-control-of-wework-at-an-8b-valuation/))

Note: this post has been updated to reflect the Sykes numbers were for 9 months, not 12 months.

Why Square’s Valuation May Be Too Low

Square recently raised another $150M from investors at a $6B valuation.  Talk about this valuation being outrageous and Square running out of cash and being the first of many tech companies to fold in the coming tech bubble apocalypse has been floating throughout the blogosphere.

But before we start hoarding our money in gold and Bitcoin, let’s take a look at other comparable public companies in the payment technology and payment processing industry.

Payment processing is a complex ecosystem with merchant acquirers, payment processors, payment networks, and all kinds of steps between the merchant and the bank that issues the credit card.

If we just look at the largest merchant acquirers, the field is dominated by large financial institutions like Chase, Bank of America, Wells Fargo, and Citi.  The biggest non-bank is First Data but they are owned by private equity firm KKR, who knows a cash cow when they see one.

As for public companies, the largest are Vantiv, Global Payments, and Heartland Payments.  These are companies that have been around much, much longer than Square.

It’s been estimated that Square processes $30B-$40B in transactions. ¬†For comparison, here is the approximate transaction volume and market cap for the public comps:

Vantiv (NYSE: VNTV):  $600B / $6B

Global Payments (NYSE: GPN):  $200B / $5B

Heartland Payment Systems (NYSE: HPY):  $100B / $2B

Obviously, a lot more goes into a valuation than simply the volume of transactions processed, but it’s a decent proxy for understanding whether Square’s valuation is sensible.

Looking at the comps, the valuation / transaction volume ratio ranges from 0.01 to 0.025.  For Square, this would equate to a valuation range of $300M-$1B.

But as any investor knows, you pay a lot more for a fast growing company than for a slow growth company.  Most of these public companies are growing at annual rates of 5-10%.  Reports suggest that Square is growing at 50-100% YoY.

If Square continues to grow at 50% YoY from a base of $30B in transaction volume, it will surpass the $200B annual volume that Global Payments has in 5 short years. ¬†That’s a lot faster than it took them.

One other data point.  Vantiv recently bought Mercury Payment Systems from private equity company Silver Lake Partners for $1.65B.  Mercury processed $30B per year in transactions, the same as Square.  It took Mercury 13 years to reach that point and Square has done it in 5.  The valuation / transaction volume ratio for Mercury, which is much more similar to Square than the other public comps, since both companies were payments technology companies instead of the actual processors, is 0.055.  At current growth rates, Square will match that ratio in 3 short years.

Time will tell, but investors may be kicking themselves in 3 years for not having the foresight to invest at such a low valuation.

Full-disclosure:  I previously worked at Mercury Payments.