Who Cares About Profits Anyways?

Have you ever had a moment where it felt like all the pieces of a puzzle fell in place?  Where suddenly a number of things that previously didn't make sense came together into a beautiful picture?  I had that moment years ago when a venture capital friend of mine explained their valuation model.  At that moment everything clicked.

My friend explained that valuations were anchored to information.  To obtain the highest valuation you had to have no revenue.  Without revenue a VC could value the company based on their imagination.  But once you had a dollar of revenue you were suddenly valued on sales, which would always be dramatically lower.  If a startup was crazy enough to earn an operating profit their valuation could fall again once they were measured on this metric.  And if a startup wished to just shoot themselves in the foot they'd report net income, a ghastly number that would force them to be valued on an earnings multiple, just like those old world public companies.

When I looked at the world through this lens it made sense for companies to give their products away for free in return for users or hits.  Just imagine the sales from all those users, and those imaginary sales are extremely valuable!

The name of the game appeared to be to raise equity capital from venture capitalists who saw these metrics and dreamed of sales one day.  Founders could continue to grow their vanity metrics while being funded from equity and eventually sell out to an old world company that saw the same vanity metrics and same imaginary sales.  Sometimes it worked, sometimes it didn't.

What always fascinated me though was why did startups raise funding via equity?  Equity is the most expensive form of financing available.  The answer of course is that most startups fail and banks aren't willing to underwrite github repos and sticker covered Macbooks as collateral for a loan.

But for me the wheels started to turn.  According to the Modigliani-Miller theorm the most efficient capital structure for a company is 100% debt financed.  What if someone could create a company that was perfectly efficient.  It would be funded entirely by debt, and they would ensure that they didn't earn a cent more than their operating expenses and interest expense.  It would be finance-theory efficient and also tax efficient.  Without profits it could be valued like a startup as a high multiple of sales.  It would be the perfect machine. 

Of course shareholders would own nothing because the capital structure was entirely debt based, but maybe some clever lawyers could create tracker shares that legally owned nothing, but allowed people to speculate on the value of the company.  Then we could merge the perfect machine with the perfect investment.  The perfect investment being a legal claim on nothing but market appreciation.

Obviously my perfect investment is very tongue in cheek.  An "investment" like this bears a strong resemblance to sports gambling in Las Vegas.  It's purely speculation.

What's fascinating to me is how the stock market, and general investment environment seems to desire companies like this vs a company that is focused on selling items for more than they cost, or generating a cash return on investment.

If the stock market continues to appreciate forever then owning shares will always be a profitable endeavor.  Of course the US market has always gone up and to the right, and no one can imagine anything else, but what if.... What if there were a period of time when stocks fell and didn't recover a few days later?  What if we hit a sideways market for a decade?

The market used to reward companies paying dividends to shareholders out of profits.  A company might pride themselves on decades of unbroken dividends.  Employees would be granted shares in retirement accounts and dividends on company shares were a sort of bonus.  They were also an incentive to work hard for their employer.  Any improvement in efficiency could lead to larger personal bonuses themselves.

The idea of dividends fell out of fashion once executives learned they could buy back shares while issuing options to themselves and get rewarded by the market.  There are a few companies that are net buyers of shares, but it's really hard to eat buybacks. 

It's fascinating that when someone enters into business themselves on a small scale that they are expected to make a profit very quickly.  One a small scale if a company can't generate profits they can't stay in business.  A landscape company might not be wildly profitable, but if they expect to stay in business for more than a season they need to be slightly better than break even.

At scale the market doesn't care about profits or dividends anymore.  Shareholders don't care about receiving a portion of the profit themselves as long as shares appreciate, or management announces they will repurchase shares.  As long as things are up and to the right the system continues to work.

In a sense venture capital is a cheat code for small businesses to escape the shackles of profit expectations and play in the larger market playground.

Maybe I'm old fashioned, but it seems to me that this might not be the healthiest system.  Instead it seems to be a fragile system built on slights of hand and confidence.  That doesn't leave me sleeping well at night!

There's a part of me that longs for the "old days" when companies were focused on earning money, and then rewarding shareholders with a cash return for holding their stock.  I doubt those days will ever return, but I can imagine..

1 comment:

  1. They will come back. Just need to wait for the washout of this current cloud/e-commerce/dtc cycle to roll over. There will be some big winners, but a lot of losers, and the many investors who hold the losers will shift preferences towards more cash profit generating companies. Then it will get old after awhile, at preferences will shift back. I simply think this current cycle is extended because those shifts mentioned, cloud/e-commerce/dtc, had a huge runway ahead of it.