October 24, 2011
Inspired a bit this morning by Fred Wilson’s MBA Monday’s series, I’m dishing up a little remedial finance education:
I’m sick and tired of talking about revenue. Sure, I like companies that have sales as much as the next guy, but I think we need a little reality check in how we talk about early stage tech companies.
One of the commonly heard explanations for why the current frothy tech environment is so different from the late 90s goes something like this: “but hey, these companies have real revenue!” And indeed, a great many of them do. But that doesn’t automatically mean that they have business models that will work (see this ridiculous pre-IPO pumping of LinkedIn from Yahoo Finance, nary a mention of profit or business model to be found). And it certainly doesn’t mean that comparing two companies from different sectors on the basis of revenues makes any sense. Yet I hear entrepreneurs and investors alike regularly doing just that, as if a comparative discussion of revenue created an apples-to-apples conversation.
I can understand why this happens, and I’ve no doubt been guilty of it myself. After all, almost all the conversations I have with entrepreneurs and other investors are about companies that are not yet profitable – many of them years away from there. So we need something else to focus on, and thus turn to the top line, lazily comparing companies as if all revenue were created equal.
Surely we’d never compare Amazon & Google on the basis of revenue. They’re about equal on that front ($40B vs. $35B trailing twelve months), but Google is worth 80% more because it’s got a MUCH more profitable business model.
By the same token, we shouldn’t just talk about Groupon’s revenues vs. Dropbox’s vs. Eventbrite’s. Totally different businesses, totally different margin structures.
Let’s look at three successful publicly-traded technology businesses from different sectors. All are in the same ballpark revenue-wise, but with very different business models. We’ve got Intuit, (software), Juniper Networks (network infrastructure equipment and services), and Garmin (GPS devices and applications). And to make it interesting, we’ll throw in a traditional retailer (retailers are amongst the lowest margin businesses), Dick’s Sporting Goods.
Talking only about revenue totally masks the really important stuff, like business model dynamics and how they drive profitability. Investors are generally pretty good at recognizing this and digging deeper, but many of today’s entrepreneurs completely gloss over it, or somehow just don’t get it.An overly-simplified exercise, for sure, but you can see clearly from this example the folly of comparing businesses based on revenue. We’ve got only a 40% range on revenue, but that leads to a 200% range on gross profit, a 300% range on EBITDA, and a 350% range on market cap.
So I’d like to ask that we shift our conversations in StartupLand to focus on a much more important metric: gross profit. Sure, it’s not perfect, but it’s a lot better than revenue. It strips out the first and biggest place that business model differences can hide – how much does it cost to make and deliver those widgets you’re selling.
If you have to talk about one number for a high growth but still unprofitable tech company, I think it’s the one. So I hereby declare myself a gross profit guy.
I applaud today’s entrepreneurs for being dramatically more revenue-oriented than their counterparts of 10-12 years ago. But I would implore them to step up their focus on the profitability of their underlying business models, and focus there even more than revenue. For those of us in the investment community, or for the journalists and bloggers who shape so many people’s thoughts, we should provide some leadership on that front by talking at least in addition to revenue, about gross profit. That, at the end of the day, is what’s going to drive your ability to get profitable. Or not.