Tech company IPOs and their performance on the public market have been all over the news in 2019. The newest crop, including Uber, Lyft, and Peloton (not to mention the WeWork fiasco), as well as upcoming offerings from Postmates and Airbnb have kept both professional investors and casual observers on their toes.
Private companies that were easily raising money in the private markets at 8x, 10x, or 20x their revenue have been entering the public markets and getting hammered, with valuations as low as 3x their trailing revenue.
What’s going on?
The question is: what type of tech company do investors seem to value most—a fast-growing company, one with strong unit economics, or one with operational profitability?
Ideally, the company with all three attributes is the most valuable. But in a lightspeed market, one attribute gets frequently sacrificed for the other.
So what kind of tech company rises to the top? We looked at valuations and performance data of over 60 tech and tech-enabled companies to get a more precise answer, determine whether there has been a shift in perspective, and whether investors are more pessimistic now than they were over the past five years. And most importantly, is it time for investors to be fearful, or is it time to be greedy?
Experts have a variety of hypotheses about how investors value tech companies. Dan Primack of Axios believes complicated business models take a valuation hit as investors prefer tried-and-tested business models, such as enterprise SaaS. Fred Wilson of Union Square Ventures says it’s simpler than that: It’s margins and revenue quality that matter the most, and only true software companies with software margins could demand a 10x revenue multiple, whereas tech-enabled companies would require lower multiples. Finally, we must consider revenue growth in our equation for the correct revenue multiple (i.e. correct revenue multiple = revenue growth + revenue quality + operating margins), wrote Crunchbase editor in chief Alex Wilhelm.
Let’s investigate these theories further. We’re interested in the levels of relative valuations as measured by revenue multiples (or “EV/Rev”) vis-a-vis key operational performances such as gross profits (“GM” or “GP”), EBITDA margins, and growth (as measured by three-year revenue growth).
To ensure the data we’re using is reliable and representative, we used a few guiding principles to select a sample population and to avoid looking only at a handful of recent IPOs:
- We selected a basket of 60 “Tech” and “Tech-enabled” companies across nine different industries. We’ll refer to this basket as “Tech Companies.”
- We selected Tech Companies that have been public for at least two years from the date of this report (and some for longer).
- We relied on more robust regression models, for longer periods of time and more data points.
When we look at these Tech Companies through a statistical lens, we can paint a more nuanced picture of the public market’s reaction to performance, according to the specifics inherent to each subset.
What follows is a summary of our findings.
1. Unit Economics are inherently different across industries and very consistent within an industry.
We looked at Tech Companies’ GPs for each industry over the last five years. GP varies by industry (in the range of 40%–80%), but is fairly consistent within industries. This makes a certain amount of sense—you would expect companies to get their unit economics locked down by the time they go public. The top-margin industries vary in GP from ~70%–80% (Cybersecurity, Digital Media, Travel, Marketplaces), whereas lower-GP industries hover in the ~40%–50% range (Electronics, Ecommerce), with the rest in between.
On an industry level, there are few surprises. For instance, software by nature can derive more margin from scale than from a physical offering, which is impacted by manufacturing and distribution costs that scale right alongside market share.
The important thing to learn here is that the variance within an industry is not particularly broad. Margins achievable by one cybersecurity company resemble those achievable by any other, and that holds true in every industry.
But while the margins for each industry have stayed relatively consistent, the market’s reaction to those margins has not.
2. Consistent Unit Economics DOES NOT equal consistent revenue multiples.
Across the past four years of our sample, investors awarded certain industries higher valuations for every dollar generated (i.e. drift in EV / Revenue), specifically in the Software Solutions, FinTech, Marketplaces, and Gaming industries.
Conversely, investors are starting to give lower valuations for every dollar generated in certain other industries: Digital Media / Social, Cybersecurity, Travel, Electronic Equipment, and E-commerce.
Valuation multiples give us a glimpse of how investors are thinking about the future of a company. Viewed one way, investors are implying that, all else equal, revenue generated by companies in the first category will lead to more revenue and/or better margins in the future (and thus, the investors “value” each dollar generated more, leading to a higher EV/Sales).
Investors curious about the performance of new or upcoming IPOs may want to think about these market trends in relation to the industry in which each IPO company operates.
That said, industry won’t paint a full picture of the public-market performance for any given tech company. Valuations are derived from a mix of factors. To understand how these factors co-contribute, we need to dig deeper.
3. Growth vs. Gross margins vs. EBITDA margins: And the winner is?
There’s a saying in software development: Quality, speed, or cost: Pick two.
The same could be said for tech companies. Growth, unit economics, or profit: Pick two.
Only rare companies with strategic and core advantages are able to produce incredible unit economics and grab market share fast, without having to run endless losses (Facebook comes to mind). Most companies grow extremely fast at the expense of unit economics or profits. We saw this happen with WeWork’s unit economics and with Uber’s profits.
Investors are getting savvier, though. Companies can’t simply bill themselves as tech-adjacent anymore, in order to score 10x revenue-multiple valuations. Just having a new business model, a unique industry, healthy margins, or operational profitability won’t cut it anymore. In order to have extraordinary valuations, a company needs to be extraordinary. They need it all.
In reality, most can’t have it all. The question then becomes: when tech companies make the choice between growth, unit economics, or profit, how do public market investors react?
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