I’ve been working in software now for more than 15 years, and one of the most common questions I’ve heard is, “How do these privately held software companies achieve ridiculously high valuations when they are losing massive amounts of money?” These companies are often dubbed “unicorns” because, like those magical creatures of fantasy novels, they represent a future promise of disruptive technologies and explosive growth. Unicorn valuations have been a hot topic in the industry, and every software startup hopes to become one someday. But the reality is that there is more than one way to generate shareholder value in software, and some might be better than others. Here is my take on some different business models that drive shareholder value. I’ll bet you can place your company into one of these buckets.
The first way that a software company can create shareholder value is to become a consistent cash-flow producer like a company such as CA Technologies. A reliable company like this experiences low year-over-year revenue growth—not necessarily because it is poorly run, but because the markets it serves are established, mature, and have low growth. This kind of firm also delivers a product that is typically sticky with high switching costs (a product that customers really need that’s hard to replace, such as mainframe computing software).
A golden goose business may also choose to do tuck-in acquisitions to offset declines from its core revenue streams. Typically, this kind of company will push operational efficiency to drive costs down consistently and improve profitability to generate cash flow each year. Shareholder value is delivered via predictable cash flows in the form of dividends and share buybacks to investors year after year.
The key risk with this alternative is that the cash generator has a shelf life, and there’s often limited upside to this investment. At some point, the reduced investment in technology and the market to achieve profit targets could catch up with this model over time. I characterize this model as being too risk averse. If I were to throw stones at this model, I would say that hiring and keeping innovators or growth-driven managers engaged in a business like this is tough. Solid operational managers thrive at a golden goose but the culture risks being less innovative and a little too “stable.”
A second way to create shareholder value is to deliver hyper annual revenue growth. The unicorn often grows 40% or more per year and focuses on capturing market share fast in emerging, disruptive markets. The growth is at all cost, profit and cash flow be damned. This kind of company creates shareholder value because its revenue growth rates are highly accelerated, leading investors to believe that someday (likely many years away) the organization will make a profit and deliver cash flows. Alternatively, the investors, often venture capitalists who are fueling these fantastical beasts, bet on a future takeout (i.e., that a buyer will purchase the firm at some crazy revenue multiple).
In fact, venture capital investors have told me over the years that an early-stage company that makes money is not executing. Remember that venture capital firms expect that more of their investments will lose money than ones that will make money, but the gamble is that those very few “home-run” investments will make up for the numerous losers. This model works very well for the venture capital industry as well as senior executives of the home-run companies. It doesn’t work so well for the executives and employees of those companies that perform less than exceptional. It’s like 36 people placing a bet on a roulette wheel. One winner gets a 35 to 1 return and is covered on the news; 35 losers go home broke.
HubSpot is a great example of the hyper grower. HubSpot’s revenue grew from $181 million in 2015 to $271 million in 2016, an increase of 49%. But the firm lost $44.7 million in 2016, after losing $46.1 million in 2015. In 2017, the firm’s market cap is more than $2.6 billion, which shows that investors believe in the company’s potential to produce future cash flows. I suspect that this view is more likely connected to cash flows from an acquisition by a larger market player.
The recent acquisition of AppDynamics by Cisco for $3.7 billion on the eve of their proposed IPO is one example. This valuation was something like 15 times revenue. I find it hard to believe that AppDynamics could have ever achieved enough annual cash flow as a standalone business to justify anything near a market capitalization of $3.7 billion—so they sold and they rightfully should have. This is by far the most common outcome for unicorns. Not many become Facebook or Google and stay independent; the odds are deeply against them.
A downside to pursing this strategy is that the shareholder value realization is heavily dependent on the merger and acquisition landscape. In an economic downturn (or even in slower growth environments), the hyper grower can face many hurdles. Another challenge arises because of the hyper grower’s tendency to develop a culture around rapid revenue growth and rapid spending increases with no concept of profitability. Establishing the financial discipline to maximize profitability is often difficult. In fact, the rapid growth and rapid spending culture can make a unicorn overly focused on driving growth at any cost and cause its decisions to be fiscally irrational.
I characterize this as a “swing for the fences” approach. You see the home runs advertised on the news but not the numerous strikeouts that occur when you take this approach. For example, FreeMarkets was a company valued at something like $13 billion in 2001 only to sell a few years later for $500 million to Ariba after the economic climate changed.
Unicorn company culture is generally focused on growth, fun, beer, and candy. People typically job hop quite a bit are not at all concerned with the long-term strategy of these moves or of setting bad precedent. The reality is that most of these companies will never survive long term as a standalone entity. Executives are hoping for a sale and likely will be very pleased with the outcome, financially. Their customers and employees? Well, that might be a different story depending on the buyer, the price, and the number of people and products displaced as part of the buyout.
A camel is called a ship of the desert based on its strength, resiliency, and brilliant design for their environment. A company that creates value for its shareholders by delivering scalable and predictable growth is a “ship of the desert” in the economic world. These kinds of companies increase revenues at rates that can be consistently achieved (10% to 20% ore more annually) AND increase operating margins as the company scales. They focus on large, growing markets that are both durable and sustainable. These companies weather the many inevitable storms and droughts because they balance revenue growth and profitability. In many ways, this kind of company is a great option for shareholders who are looking for a producer of a predictable, ongoing return on their investments. A company in this category tends to have high customer retention rates but also possess a competitive solution that supports existing customer expansion AND attracts new customers to drive long-term revenue growth.
Executives running businesses that fit into this profile could fall into a trap. They might, by mistake, become like the companies in one of the first two categories. By either managing costs to an extreme or by shooting for unachievable hypergrowth, executives can unintentionally lose their balance and reshape the business outcome to the detriment of shareholders. From my experience, the primary driver when making this mistake is an inappropriate assessment of risk.
When balancing growth and profitability, ensuring that rational decision-making and objective risk assessment occurs throughout all levels of management is critical. Almost every company can achieve some level of balance but few maintain their long-term place in this category.
Companies with more of a balance tend to not hit extremes culturally, which means the workforce has stability but not complacency, energy but not mania. Mid-term views dominate this model. The challenge is to ensure the company has a mix of personality profiles, including innovators, process deployers, orchestrators, and optimizers. This kind of company needs different skills for different activities to keep the balance.
Remember that a desert can be 120 degrees Fahrenheit during the day and below-freezing the same night. Only perfectly created creatures can thrive through the economic cycles of today’s reality.
Ken Stillwell is chief financial officer, chief administrative officer, and senior vice president of Pegasystems, a customer service platform provider.