Offline first, mobile enabled

One of the major trends in tech startups what Fred Wilson calls “Mobile first, web second.” Instagram is a great example of mobile first. They barely had a website – it was all about the mobile app.

The excitement over mobile-first apps is justified. Smartphones have unleashed a wave of creativity, resulting in entirely new categories of applications. But to me an even more exciting trend is what people have been calling (for lack of a better phrase) ”offline first, mobile enabled” apps.

For example, Foursquare is primarily about improving your offline experiences (meeting friends and finding new places to go). And it couldn’t exist without smartphones (ok, Dodgeball existed on feature phones but had a fraction of the utility). Similarly, Uber couldn’t exist without smartphones. The Uber apps (one for drivers and one for customers), while essential, are all about enabling for the car service. Square is about making payments more convenient and giving small businesses better analytics. The mobile app is just an enabler.

It seems natural that the first wave of mobile apps would be about improving core smartphone apps (e.g. photo apps) or porting apps from other devices (e.g. games). And there is probably a lot of interesting innovation remaining there. But the really massive opportunity is dreaming up new ways that the little computers loaded with sensors that we carry around with us everywhere can improve our real-world experiences.

Revenue vs margin

Three years ago, Fred Wilson wrote a great blog post called When Talking About Business Models, Remember that Profits Equal Revenues Minus Costs. The point he made was both simple and profound. The simple part is summed up in the post’s title[1]. The profound part is that high growth, early-stage tech companies often have a choice about how to become exceptionally valuable businesses: they can focus on growing revenues at the expense of margins, or margins at the expense of revenues.

Most recent successful tech companies seem to have chosen the former: growing revenues at the expense of margins. Again and again, we see S-1 filings with revenues growing rapidly but profit margins that are low to negative. The same is true for the rumored financials of private companies. I think I understand why they made this choice, but wonder if it was a mistake.

To understand why these companies made this choice, you need to look at their formative stages. Many of them raised money from VC’s at multi-hundred-million to multi-billion dollar valuations, often before the companies were profitable or had even settled on a business model. In most cases, the companies and investors were acting reasonably[2]. But the end results might have been to unwittingly commit themselves to revenue over margin growth.

Why? Money has its own inertia and somehow always seems to get spent. Some of this spending is reasonable and even necessary (infrastructure, defensive expansion to international markets). But then there are harder choices. For example, do you invest heavily in sales and marketing to grow your revenue faster? Do you stay open and try to become a platform and therefore force yourself to experiment with new business models? Or do you become closed to “own the user” and therefore benefit from existing business models like advertising? Fast revenue growth seems to be the best way to justify your valuation. But the next thing you know you have a high cost structure that requires you to raise even more money and grow revenue even faster.

The root cause here is a deeply held belief throughout the business world that exceptional revenue growth is more likely than exceptional margins. For example, if you talk to professional public market investors and analysts you’ll often hear statements like “that’s a low margin industry” – implying that every industry has “natural” profit margins which companies can only defy for short periods of time. This belief is also reflected in public market valuations for recent tech IPOs: companies like Groupon that put revenue over margins command very healthy valuations.

The problem is that this deeply held belief in “revenue exceptionalism” over “margin exceptionalism” is a hangover from the industrial era. Unlike industrial era companies, information businesses tend to be deflationary, shrinking the overall revenue of an industry. They also tend to have network effects (and complementary network effects), making them more defensible and therefore higher margin than non tech businesses. Given this, why do companies continue seeking revenue at the expense of margins? Fred made this same point in his original post, but people didn’t seem to listen.

 

[1] Companies (like all cash generating assets) are ultimately valued at a multiple of present and projected future profits. The historical average P/E ratio of the DJIA is about 15, meaning that (on average) if a company is generating $100M in profit, it is valued at $1.5B (Fred prefers to use a 10 multiple, perhaps to be conservative?). One way to understand this is to imagine that companies dividend out all their profits every year. If you bought something for $1.5B and it dividended out $100M every year, that would be a 6.6% annual return.

[2] Why are these high-priced financings reasonable? From the company’s perspective: your traffic is growing so fast you need to invest millions of dollars in infrastructure. Meanwhile copycats are popping up in other countries. You don’t know if the financial markets will suddenly dry up. Someone offers you, say, $50M for minimal dilution. Seems like a reasonable hedge. From the investor’s perspective: the history of venture capital shows that almost all the returns are generated from big hits like Amazon, eBay, Facebook and Google. (As Paul Graham once put it: “The difference between a bad VC fund and a great VC fund is one big hit”).

Money managers should pay the same tax rates as everyone else

Steven Schwarzman is the CEO of the Blackstone Group, a multi-billion dollar money management firm. He is worth billions of dollars, and isn’t afraid to spend his money lavishly:

He often spends $3,000 for a weekend of food for Mr. Schwarzman and his wife, including stone crabs that cost $400, or $40 per claw.

Mr Schwarzman pays a lower tax rate than police officers, firefighters, soldiers, doctors, and teachers. This is the due to the fact that money managers’ “carry fees” are treated as capital gains instead of ordinary income.

Last week the House passed a bill that would partly close this loophole. Sadly, with few exceptions, VC’s are lobbying against this bill, arguing it would hurt innovation, small businesses, and lots of other good stuff.  As one prominent VC recently said:

[H]aving those higher taxes be levied against venture capital investments in small businesses strikes me as self-defeating when it is the single largest job growth area.

The argument seems to be that this tax will hurt small businesses. The phrase “small business” is chosen deliberately by VC lobbyists: most people, when they hear it, think of hard working immigrants pursuing the American Dream. In reality, the only thing this bill will hurt are money managers. As Fred Wilson says:

Changing the taxation of the managers will not reduce the amount of capital going to productive areas. The sources of the capital; wealthy families, endowments, pension funds, and the like, will still put the capital in the places where they will get the highest after tax return. And these sources of capital, if they are tax payers, will still get capital gains treatment on their investments in hedge funds, buyouts, and venture capital. And the fund managers will still have to compete with each other to get access to that capital and their incentives will still be to produce the highest returns they can produce, regardless of whether they are paying capital gains or ordinary income on their fees.

As Fred also argues, removing this tax break will encourage more people to go into jobs that produce tangible goods:

We have witnessed financial services (think asset management, hedge funds, buyout funds, private equity, and venture capital) grow as a percentage of GNP for the past thirty years. The best and brightest don’t go into engineering, science, manufacturing, general management, or entrepreneurship, they go to wall street where they will get paid more. And on top of that, we have been giving these jobs a tax break. That seems like bad policy. If we force hedge funds and the like to compete for talent on a more level playing field, then maybe we’ll see our best and brightest minds go to more productive activities than moving money around and taking a cut of the action.

Fred is absolutely correct. For me, though, removing this loophole just comes down to basic fairness. A fireman who runs into burning buildings shouldn’t pay a higher tax rate than a financier sunbathing on a yacht eating $400 crabs.