As Constellation:PE::Shopify:VC

10/30 OpenView Capital Markets Roundup

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To begin, a brief analogy. I wasn’t good enough at most sports so I took up rowing. In rowing 99.9% of time is spent training and just a tiny percentage actually racing (races are <6 minutes long and often there are only 6-8 per season).

While returns on all that training are initially high, eventually they diminish to near zero – personal records in races improve by tenths of seconds vs. ten second improvements in the early days.

But with what I knew about building fitness I was able to identify and assess investments of time elsewhere that had large potential payoffs as improved personal records. More specifically, I could invest an hour a week in each cycling, yoga, and meditation and even though 2/3 did nothing, core strength from yoga enabled me to row 1% more effectively than everyone else and improve personal records by whole seconds again vs. just one tenth if all 3 hours a week had gone to rowing instead of other options over a period. If personal bests are a company’s valuation and time a company’s capital, enter assessing the value of a company’s real options. As Michael Mauboussin notes, “a company with real options has the right – but not the obligation – to make a value-accretive investment.” When a leading company with a smart management team plays in uncertain and evolving markets, they have asymmetric information flow that allows them to assess and exercise the best real options.

Small bets with capital from a company’s capital flywheel that have massive potential payoffs (the Black Scholes equation is thoroughly confusing, but it proves out that any deep out of the money, volatile call option for a growth company is incredibly valuable)!

Take Shopify as an example. This week Shopify announced merchants can now use TikTok as a channel to grow their business. And also “reported $191M of net income in Q3 2020. $133M (or ~70%) of that came from an ‘unrealized gain on equity investment’.” How much greater could Shopify’s future cash flows be because of these (and other) real options? Right now the market is likely assigning billions of value to the option that is Shopify’s new TikTok partnership for merchants.

In his What’s Hot in Enterprise IT/VC blog Ed Sim acknowledged the valuation environment and recent declines in prices: “The bear case comes from companies like SAP and Fastly whose stocks got pummeled this week on weak earnings and expectations. It also comes from a friend who invests in growth and public companies who told me his 5 year outlook on IRR for tech stocks was in the high single digits. So either the profits and expectations on valuation are all pulled forward or there needs to be a major adjustment in the long term growth model. So which is it?” He goes on to acknowledge that most large enterprise SaaS buyers are still struggling with basics and more and more tech investment is going to be required over the long term.

It is still so early – many of the solutions that will address companies tech needs haven’t even been created yet! And in order to support valuations (extend growth models) SaaS companies must start assessing more real options (new solutions).

This is the quantitative support for my pleas for M&A. Just as many adore Mark Leonard for his capital allocation prowess I believe we’ll look back at Shopify and a few other high valued public SaaS companies and recognize them for their ability to constantly deploy capital into venture-like “scale up” real options (well positioned businesses can scale up through cost-effective sequential investments as their market grows) as M&A and/or strategic investments. As Constellation:PE::Shopify:VC.

CY2021 Planning and Competitive Analysis

As 2021 planning progresses, I wanted to re-share “What is the GDP of Mongolia.” In the thick of uncertainty in March and April, Dr. Peter Attia wrote about the 95% Confidence Interval – the range of values that we can be 95% confident contains the exact value answer for a specific question (i.e. what is the GDP of Mongolia could be 0 to $100T, but that is a big range). Take this exercise and yet again apply it to the 2021 financial models you are building. More specifically, use it to evaluate the each input to the model – conversion rates, deals per rep, retention, cash bookings timing, etc. In financial modeling our ranges are narrow, and outputs (i.e. new ARR) are highly sensitive. Our level of confidence shouldn’t change though – we should still be 95% confident that our range of inputs will drive the output. Outside of the hard data inputs, this mental exercise is a useful sanity check on any claim or bet we make. As it relates to planning, I could read Michael Porter's Competitive Advantage until my eyes bleed, but there are a bunch of other great resources out there as well, including: Competition Demystified by Bruce Greenwald, Certain to Win, Only the Paranoid Survive by Andy Grove, 7 Powers: The Foundations of Business Strategy, and of course Wardley Maps. In the spirit of continuous rapid improvement, there are always new or different resources out there to help augment our approach to approaching strategic planning and assessing, in this case, defensible competitive advantage.

Market Update

SVB released their Q4 State of The Markets Report this week and highlights include (1) VC-backed companies extend cash runway to new heights, (2) VC funds sit on record dry-powder reserves, and fundraising remains strong, (3) and 78% of VC-backed Tech IPOs YTD occurred in Q3, and 44% occurred in September. As companies find themselves in a better cash position than ever before, VCs sit on more capital than ever (and are likely soon to raise more given the sheet number of exits in Q3), you can understand why the fundraising environment is so frothy at the moment. The markets did not have a good week – or a good month. All indices we track finished the month down (SaaS Index -0.02%, Dow -3.46%, NASDAQ -2.38%, and S&P 500 -1.96%). Despite many trying to rationalize the lack of performance as the market is finally acknowledging the upcoming election polling (and the perceived winners policy) I want to again note that there isn’t much that should change as it relates to software equities. As was noted in “The dog is buying stocks”, the simplest explanation is no one knows what they’re talking about, still. Just as in July it was decided retail traders were impacting the markets, months later Softbank’s impact was revealed.

Economic Data

The big news this week was GDP. As CNBC noted, “US GDP booms at 33.1% rate in Q3, better than expected” – and yes, the headline is fantastic! Dumb math would suggest that after a 3.4% fall in Q1 and a 31.7% fall in Q2 that economy is almost back on track. But let's think about how the math might actually work. A 31.7% decline requires ~47% growth to return to normal. And the sum of the of the Q1 and Q2 annualized declines in GDP this year would have required 51.6% growth in Q3 to get back to even. GDP is down 3.5% - which the headlines don’t tell us. So then the question becomes, what parts of the economy aren’t active that are representing the delta between 2019 and an economy operating at -3.5% of prior output? How do we not only close that gap to complete the recovery but also ensure that our country is back on its prior GDP growth trajectory? We need to understand what is still shut down and if these losses to the economy permanent or temporary. If permanent, what other activities can take their place? We still don’t know if the recovery is months, years, or decades long. Congress can’t agree on stimulus but what is worse as a country we can’t seem to just agree that the first rule of virus economics is that controlling the virus is the only way to sort out the economy. I grow increasingly worried that millions of people are in a world economic hurt and the worst for them is yet to come. Many lives will be severely negatively impacted over the coming years. Math is hard, and exciting headlines obscure reality of the situation that is improved, but still not great.

Note, a prior version of this post misrepresented the current deficit.

What Else We’re Reading

A Field Guide to Driving Change. Above the Crowd: The Lost Essays. SAP clobbered.