Equity value

Warren Buffet once said:

Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.

This is a useful way to understand the meaning of “equity value”. You learn in finance that equity value is the overall value of a the stock (i.e. equity) of a business, which in turn is the present value of all future profits. Of course with startups the future is extremely uncertain, leading to a huge variance in valuations.

In perfectly competitive markets, all profit margins tend toward zero. So equity value is a function of the degree to which you can make your market inefficient by making your business hard to copy (so called “defensibility”). If your defensibility depends solely on having superior people, you have what VCs call a “service business.” In a competitve labor market, service businesses tend to have low margins and therefore low equity value. A popular saying about service businesses is “the equity value walks out of the building every night.”

Different types of tech businesses exhibit different relationships between capital, revenue, profits, and equity value. Enterprise software companies tend to require lots of capital to get to scale but command high equity values once they do, partly because enterprises are risk averse and like to adopt the most popular technology, leading to winner-take-all dynamics. Adtech companies tend to be quick to revenue but slower to equity value, and sometimes risk becoming service businesses. The equity value of consumer internet companies vary widely, depending on their defensibility (usually networks effects and brand) and business models (e.g. transactional vs ad supported). Biotech companies require boatloads of capital for R&D and regulatory approval but then can generate lots of equity value, with the defensibility coming primarily from patents. (Patents introduce market innefficiencies, but, proponents argue, are necessary to create sufficient incentives for entrepreneurs and investors). E-commerce companies generally require a lot of capital as well, since their defensibility comes mostly through brand and economies of scale.

http://twitter.com/mordyk Mordy Kaplinsky

Chris, Any thoughts on hardware and chip companies?

http://www.cdixon.org/ chris dixon

I think you have to divide consumer from enterprise (and of course chips are enterprise). They are similar to software consumer/enterprise, except hardware tends to require more time and capital, specifically working capital for production (although less applicable to semis since you can outsource production).

http://twitter.com/mordyk Mordy Kaplinsky

Thanks!

Anonymous

So what’s Amazon? Why is its equity so expense?

http://www.cdixon.org/ chris dixon

Investors believe that scale eventually pays off in e-commerce.
http://twitter.com/#!/chrishuntis/ chrishuntis

and amazon is more than an ecommerce play. they address a multi-billion dollar “cloud” computing market, and ebooks (via kindle).

i) they hold people’s payment details, opening up easier access to other markets. ii) own other online properties such as IMDB, audible, love film (look at the their footer to see the rest).

they are a beast of a company.

Anonymous

But is the beast worth 100x paltry earning?

http://twitter.com/#!/chrishuntis/ chrishuntis

i think it’s certainly debatable.

google finance has its P/E at ~178.

would i buy it for that? i’m anti-stockmarket, so no.

Anonymous

Excellent post. I guess you can also make an argument about the US’s current “equity value” is due to the fact that the economy is too service business oriented.

http://www.cdixon.org/ chris dixon

Yeah although you should distinguish two senses of “service”. Wall Street is generally called a service although those firms do seem to have defensibility via scale, government regulations etc.

http://twitter.com/#!/chrishuntis/ chrishuntis

economic moats can also include switching costs and cost advantage.

the value of the economic moats aren’t only shown in equity value, but also in price–as price premium–resulting in larger margins.

http://www.cdixon.org/ chris dixon

Agree. Switching costs are high in enterprise software for example.

I’m assuming equity value is a function of margins.

Anonymous

Interesting to think about enterprise vs consumer investments in this way. Perhaps on the enterprise side with initial distribution costs coming down (via fremium, self-service models like box, yammer, etc) combined with SaaS in many instances having lower switching costs than on-premise software, this dynamic will change in the future with single players becoming less dominant (and therefore different views on valuation in the earlier stages).

http://www.cdixon.org/ chris dixon

It’s definitely true that a lot of interesting new enterprise companies are traveling “bottom-up” through organizations. As you point out, this lowers sales/marketing costs but could cut both ways if they lower switching costs too. I think these companies hope to benefit from lower switching costs but then get lock in with all the additional “enterprise features.”

FAKE GRIMLOCK

GRASSROOTS ENTERPRISE MODEL BENEFIT FROM NETWORK EFFECT.

IF EMPLOYEES CAN ADOPT ON OWN, CAN ALSO IGNORE YOUR ORDER TO SWITCH.

http://twitter.com/#!/chrishuntis/ chrishuntis

#Enterprise2.0

http://twitter.com/#!/chrishuntis/ chrishuntis

there’s the concept of selling products vs solutions

http://www.businesspundit.com/products-vs-solutions/

i understand it as, enterprises often get sold solutions, and consumers products. that makes sense if you think about the companies: imagine facebook customising each users app.

in the link it says about the solutions being integrated; this creates switching cost. it also goes on to say:

“because the solution is customized, competitors find it difficult to bid against it or even to compare its price and features with those of their own products.”

Anonymous

Service companies are traditionally thought to have high margins, often as high as 30-50%. They bill employee time to clients, and are often able to pass on variable costs as well. At least in law firms and design shops, the two service models I am intimately familiar with, margins are good. On the other hand, I know larger industrial companies that are very successful with margins of 5% or lower. Commodity businesses have low margins. Service biz should have high margins or you’re doing it wrong.

http://www.cdixon.org/ chris dixon

I don’t think those are the real margins because the profits are distributed to partners. Could you run a law firm that dividends 50% of revenues to non-employee shareholders?

Anonymous

Hm, yes, that is a good point. The old rule of thumb for law firms is that 1/3 of gross is for the rent, 1/3 for employee salaries, and 1/3 is profit. To compare a partnership to a corporation in terms of calculating margins, maybe you ought to deduct the “reasonable salary” of partners from the gross.
At the end of the day, though, service partnerships will still have higher margins than many other types of businesses. Probably lower margins than Google.

http://christianbusch.blogspot.com christianbusch

Nicely written post, Chris! One additional layer to this would be to consider perception vs reality of a business – e.g. was Buddymedia a services business or an enterprise tech business when they sold? Multiple suggest the latter..

http://www.cdixon.org/ chris dixon

From what I know, Buddy Media was an enterprise SaaS business. Hence the multiple made sense to me. But you hit to key issue and there were knowledgable who debated that exact point.
http://twitter.com/#!/chrishuntis/ chrishuntis

perception vs reality ripples through all of life, imho. from plato’s cave, to marketing, to UI design, to equity valuation, to our identity online.

to get the best value for their equity companies tell a ‘story’. and if you believe every word you get facebooked.

FAKE GRIMLOCK

ROCKET DO 1 OF 3 THINGS:

1. GO FAST ENOUGH ACHIEVE ORBIT
2. GO FAST ENOUGH GO FOREVER
3. COME BACK DOWN

ONLY INVEST IN FIRST TWO.
http://www.justanentrepreneur.com Philip Sugar

Two interesting points to me are scale and brand.

Scale does give defensibility. Interestingly I’ve been debating lately if it actually does more in low margin businesses than high margin ones.

Traditionally everybody loved high margin techology businesses because you could really make money once you got rolling. Back of the envelope if it took $10M to get the business going and you could sell each piece of software for $100k and make $90k gross margin, once you hit profitability you start to mint money. The problem is that everyone looks at that $90k and is willing to go after it, and the challenge is the cost of starting is coming down.

If you have a low margin business like Amazon it takes $Billions to build the giant warehouses (they are putting in a million square foot one near my house and it is impressive) and you only make $5 on a $100 sale. The benefit however is $5 doesn’t look too sexy, and as you get bigger and bigger people look at that and say why do I want to go after them.

Brand also interests me because it has a value but is never put on a balance sheet. Take HomeDepot with Nardelli or Sears with Lampert. For a while you can treat your employees like shit and beat your suppliers so they sell you crap and you will make more money than you did before. Long term however it kills your brand. GM and Honda would be another example.

http://twitter.com/lchamberlin Luke Chamberlin

Sears has such a fantastic brand. They invented the mail-order catalogue, then moved their business to brick-and-mortal stores over the next century. When the internet came along, they were in the perfect position to return to their roots as America’s mail-order source. They could have been Amazon. What a shame.

http://www.facebook.com/profile.php?id=100000203865539 Anthony Carbonaro

Hello Mr. Dixon,

My name is Anthony Carbonaro, and I am a
young Entrepreneur, or at least hope to be. I’m 17 years old, and just
graduated High School and will be attending College this fall. I plan
on majoring in Computer Science and minoring in Business. I am
wondering if you would like to mentor me throughout my first major
business venture?

Thank You
-Anthony Carbonaro

http://www.cdixon.org/ chris dixon

That’s what I try to do via blogging

Why don’t you email me when you are ready to start a business. You did the first thing right: majoring in CS.

http://blog.kwiqly.com/ James Ferguson @kWIQly

For the record – It’s what you do do !

http://www.facebook.com/profile.php?id=100000203865539 Anthony Carbonaro

I have had a business idea for about 3 months now, but am in need of some help. Where can I find your email. Or you can email me AMCarbonaro@gmail.com
Thank You

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http://www.facebook.com/profile.php?id=201831 Kevin Gao

Thanks for the great post Chris. Maybe the quote explains why Buffett doesn’t invest in high-growth tech companies, given how founder-dependent they can be?

Unrelated, have been reading your blog for awhile. Would love to chat about turning your content into a great ebook if you’re interested. We’ve done similar books for Brad Feld and Forbes, among others. Let me know if you’re interested in learning more, thanks Chris!
http://twitter.com/lchamberlin Luke Chamberlin

There is a saying that the US Navy was “designed by geniuses to be run by idiots”.

Reminds me of Buffet’s quote.
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http://twitter.com/RoCSpeaks Return on Change

Chris – What are your thoughts on crowdfunding for startups soon?
http://blog.kwiqly.com/ James Ferguson @kWIQly

>>In perfectly competitive markets, all profit margins tend toward zero

This is true of economic profits but technically it is correct to say “In perfectly competitive markets, all super-normal profit margins are zero”. There is no need to “tend to” zero because a perfectly competitive market responds instantly – arbitrage of all trends is immediate.

Also normal profit does include “the profit that a business owner considers necessary to make running the business worth his while.” This includes reward for fair market risk. Thus even in a perfectly competitive market a VC could exist and expect fair return. More profitable that Gilts but more risky.

However, since knowledge is never perfect all your other points are valid.

http://www.cdixon.org/ chris dixon

Thanks – good points.

http://www.facebook.com/chris.maloney.731 Chris Maloney

Hi Chris,

I recently started reading your site and its been a big help. I enjoyed the 8/16/2009 article, “Ideal first round funding terms.” I am working on a Chicago-based social gaming start-up and wondered if you have any Chicago law firm referrals or should I go with one the firms you mentioned in the article.

“I personally use Gunderson and think they are great. Whoever you choose, I strongly recommend you go with a “standard” startup lawfirm (Gunderson, Wilson Sonsini, Fenwick etc).”

Thanks.

Chris Maloney – from Massillon, OH
chris@bmov.com
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Chris Dixon