This post was originally included in our Quarterly Letter to our LPs in Q4 2013.
The Importance of Business Model Purity
We speak with thousands of investment opportunities a year, and on average will invest in only a handful of these companies. Much of our job is about culling down the opportunity set, which allows us to better manage our time and identify the companies that might be a good fit for Lead Edge. One vector we use to evaluate companies relates to thinking about their business model purity.
Business model purity is the ability of a company to drive revenues in a consistent, repeatable manner, while exhibiting the confidence to forego lower quality or distracting revenue opportunities, which could detract from the long term value of the business. When we evaluate business model purity, we try to identify companies that have exhibited this purity in the past. On a go forward basis, we try to seek out companies playing in large enough markets that they can continue doing the same thing they’ve done in the past moving forward, while meeting our future growth objectives. Perhaps the best way to emphasize this trait is to identify the types of red flags we typically see from many companies as we evaluate them after an initial call.
Example #1: Attractive Aggregate Growth Hides Low Margin / High Margin Mix
One of the most common Business Model Purity Issues we see is when a company portrays themselves as a growing software business, but a peek underneath the hood reveals something totally different. In the software ecosystem, this typically has to do with a company buoyed by a significant amount of low margin professional services.
As an example, one of our Associates recently brought us a profitable, bootstrapped software business, which was growing at 60% annually. On its face, this was an exciting proposition, but what was apparent beneath was that the company’s overall revenue mix was unattractive. Out of $10m of total revenue, the business had $3m of software revenue and $7m of services revenue. The services gross margins were ~45%, but were shrinking, as the company continued to give away services for lower prices in order to fuel their product business. The services business was growing at ~80% per year, while the software business was only growing by 25% per year, off of the aforementioned lower initial base. The CEO, realizing what he had, was hesitant to share this deeper information with our Associate, as he wanted to push for further conversations with our firm. By sharing only a piece of the truth ($10m of revenues, growing 60% annually, with strong gross margins), he was able to secure a further conversation.
As I mentioned before, some of the major issues we deal with in this regard include software vs. services mix. Other key issues would include companies that sell pass-through hardware (i.e. a company resells $50k worth of servers at a 5% gross margin with each $50k software package they sell). Overall growth can look nice, but what is the value of the 5% gross margin revenue? We believe that the value is actually less than $0, because it distracts the company’s focus and will likely never deliver anything to the company’s bottom line.
Example #2: Emerging Business Model Underpins Recent Growth and Future Assumptions
Simply put, we like backing companies that are already doing well, and will use the financing proceeds to continue doing what they’ve done in the past. Often times, companies will discuss their excellent historical progress in order to reel us in at first, but then switch gears to talk about how new business lines will materially impact future growth. This is a red flag to us as it might signal either material difficulty or market size issues in the core business model. On the positive side, it could signal an exciting opportunity in a new business model, but if that transition is early, it could prove to leave the company in limbo. We talk internally about not backing early stage risk in late stage companies. Due to the fact that they’re late stage, they’ll want a premium valuation, but due to the fact that emerging business models are typically early, they pose more risk.
We were recently shown an opportunity in the marketing software sector, where this dynamic played out. The company had grown from ~$6m of 2012 revenue to ~$12m of 2013 revenue. Bookings had grown from $10m in 2012 to $15m in 2013. Initially, this company seemed well within our strike zone, with an exciting financial profile. After further review, however, there was more than met the eye. Despite 50%+ growth in bookings, the new SaaS bookings actually declined between 2012 and 2013! The bookings growth all came from a larger book of renewals, as well as a new business line related to advertising. This advertising business, which was nascent in 2011 and minimal in 2012, gained some steam in 2013. The issue is that this revenue is largely non-recurring and the margins are less predictable. Additionally, most of the revenue gained in this business line was “low hanging fruit” in which they upsold these services to their existing customer base, further magnifying the unproven nature of this business line’s sales metrics. While at first we saw an exciting growth business, after a deeper look, we saw a quickly stalling core SaaS business of some scale, being buoyed by a much smaller growth business line that they have less history selling in the first place. The question we were left asking was, “what happens when they’ve penetrated their SaaS customers by selling ads, and they need to go out and win new business?” While the answer is inconclusive, and will only be solved in the future, it was our opinion that the movement into the new business could be exciting, but in the short term, was a band-aid for a SaaS business that had hit a bookings speed bump. The business wanted to be valued as a high-growth asset, while we would view it as a pivoting project with significant risk. The company’s projections included meaningful increases in SaaS bookings, but the larger driver for growth was the advertising piece. It is difficult for us to underwrite this growth, given that 1) in our experience SaaS bookings growth doesn’t often stall and then accelerate and 2) the advertising piece is today a $2m business that has been sold solely to the existing customer base. There is a price for this asset, but not a premium one.
We meet these issues on a daily basis, and they’re often not easy to spot. Companies will try to present themselves in the best light, and it is our job to evaluate sources of growth on both a historical and go forward basis. Again, while transitions could prove fruitful, more often than not they’re an indication of hitting a market sizing ceiling or difficulty in an existing model.
Example #3: Unproven Geographies Underpin Future Growth
Often times when a company is transitioning to new geographies, it could transmit mixed signals to us. Out of the few examples we outline here, this is the one we’re most likely to still invest in, though we have to be careful picking our spots.
Often times, we’re evaluating a software companies with strong historical growth in one geography, that are looking to start selling in a new geography. If bookings have stalled in the existing geography, this could be the first red flag that the company is entering this new geography for necessity rather than opportunity. We want to back companies that are entering new markets because they truly see opportunities. Therefore, when companies are entering new geographies, we ask the following four questions:
- Is this the first time the company has experimented with a new geography?
- If it is, we’ll be more cautious, as we want companies who have done this before.
- Is there an executive coming to the new geography for some period of time to instill company culture?
- If there is a large geographical entry, it is imperative that an existing company leader moves to the new geography for some period of time in order to make sure there is cohesion between the culture of the new office and headquarters.
- Are there identified new hires in the geography that know the nuances of doing business in that region?
- If the company fails in entering this new geography, can we foresee enough growth moving forward in the core geography for the business to be an interesting opportunity for us?
- This is perhaps the most important question we ask. Essentially, we’re saying, “if the company continues doing what they’ve been doing, can we make an acceptable return?” If the answer is yes, then we’re all for geographic expansion.
Make no mistake about it. We like to think constructively and out of the box, but as we build our portfolio, we need to swing at pitches that we believe are in our defined strike zone. As we continue to evaluate new businesses, we take great care in focusing on investing in growth companies that themselves exhibit great focus. We’d estimate that 80%+ of the businesses we talk to have business model purity issues, and no matter how compelling, we must be discriminating and remind ourselves that “most opportunities are a threat to our focus.”