Valuation Fundamentals

The 10+ year period of near-zero interest rates caused a lot of investors and leaders to deemphasize the fundamentals of valuing companies. As I’ve written many times, we know that a company’s value is equal to the present value of the amount of cash you can take out of it over time. That is, the amount of cash you can take out of the company over time discounted to present-day dollars. When you’re in a zero-interest environment, there is no discount rate. When there’s no discount rate (or no risk-free way to make money), investors take more risk to find a return, thus the overflow of money into venture capital and other high-risk investment vehicles during that period. When there’s no risk-free bar to clear to find a return, an investor is more open to non-traditional investments. When interest rates are high and low-risk treasury bills are paying out 6%, in order to invest in something risky, the investor has to be comfortable that any investment will exceed 6%, causing money to flow out of venture capital and other high-risk investments.

When the risk-free rate is very low, investing gets hard because there are no guarantees, so you start to use proxies and benchmarks for future returns. This was particularly true in SaaS which really emerged in a big way during the 10+ year period. Things like Rule of 40 and 35% EBITDA margins and 70% gross margins became solidified as proxies for investable software companies. We needed those proxies because they provided guidance for what to invest in in a world where almost anything “could” be a good investment.

Now that investors have raised the bar on what they’ll invest in and there are real questions about the future of SaaS margins due to the emergence of new pricing models and pricing pressure from AI duplicating SaaS products at a far lower cost, it’s time to return to the fundamentals of valuation. Remember:

Growth is just a proxy for future cash flows.
Gross margins are just a proxy for future cash flows.
Operating margins are just a proxy for future cash flows.
Net income is just a proxy for future cash flows.

None of them alone can tell an investor the amount of cash they can take out of the company over time.

Now that we’re back to desirable risk-free rates, and CIO budgets have tightened, and high interest rates have squeezed company margins, it’s time to be more flexible and get back to the fundamentals of valuation. There are numerous ways to get there that might not fit with the traditional SaaS benchmarks we’ve used as a reliable guide over the last decade.

Company Ambitions & Personal Ambitions

Interesting conversation on the Ben and Marc show on the difference between personal ambition and company ambition. You always want your team to have the company's ambition in mind and for them to get to a place where that's their top priority. Of course, very few people can completely prioritize the company's ambitions over their personal ambitions, so to some degree, this is always a bit of a tradeoff.

When someone asks me the best way to be successful inside of a company, I always point to the notion of putting the company’s ambitions ahead of your own. The irony in this is that this actually propels you forward personally more than the alternative. This is true for a few reasons:

1/ It increases the chance that your company will be successful and you'll wear that brand and benefit from it for the rest of your career.

2/ People will view you as a great leader who puts the company's needs first. You'll be admired and respected and people will want you in the room. These people get promoted.

3/ It makes you a better operator in that you're getting better training by learning how to successfully operate a company more quickly than people that are busy playing politics.

Prioritizing your company’s ambitions over your own always seems to have the ironic outcome of a faster path to achieving your own.

Incentives, incentives, Incentives

"Show me the incentive and I will show you the outcome" - Charlie Munger

I’ve found that when you think understanding incentives is really, really important, you still don’t understand how important it is. When you find yourself in a difficult conversation or challenging situation with an employee, a customer, a partner, or a vendor, pause and make sure you understand the incentives of all the stakeholders. It almost always gives you instant clarity and gets you unstuck.

Good Conversations & Good Selling

As a sales leader, I’ve often told my teams that, while I want to close every deal we can, it’s perfectly fine if we don’t, as long as we understand exactly why the buyer didn’t buy.

As a seller, I used to have this mindset during sales conversations: I wanted to be sure that if the buyer didn’t buy, I could explain why in great detail to anyone who asked.

The trick here is that forcing yourself to understand why a buyer didn’t buy also forces the right sales behaviors. You have to do a bunch of good things to be able to do this well. You have to:

• Talk to the right people.

• Understand their role.

• Understand their decision/buying process.

• Understand their incentives and priorities.

• Understand their problems

• Understand what other solutions they have.

• Understand what they like/don’t like about the product.

• Understand how they view the competition.

• Understand how they think about ROI for the product.

You can’t understand these things if you’re not having good conversations. And good conversations are the thing that drives sales. Sellers should be less interested in making the sale and more interested in deeply understanding the mindset of the decision maker, regardless of the ultimate decision. This mindset, repeated over time, leads to better and better high-quality conversations. And better conversations = higher win rates.

Beware Of The Warm Intro

Jen Abel from Jellyfish posted this great Tweet the other day.

When a friend or colleague makes an intro, you feel somewhat burdened to take the call, to be nice, and to make it seem like the intro makes sense and that there's a deal there. But so often, this isn't the case. Sure, the person making the intro has the best of intentions in mind, but often, they have no idea whether a partnership between the two organizations being introduced actually makes sense. And they're often doing it to build up their own social capital in the hopes of leveraging that capital for themselves down the road. This is ok and sort of the way humans work, but it's crucial not to get fooled by the false momentum that comes from these connections. This is particularly difficult when the intro is centered around a more ambiguous partnership or when it comes from someone more senior than you. It takes real discipline to drive clarity and prioritize the opportunity appropriately.

Warm intros should be qualified and disqualified using exactly the same criteria as a cold outreach. Don't get caught up spending time with someone who is happy to take your call but ultimately doesn't have a high-priority problem that you can solve. 

Humility & Truth Seeking

I've always placed a lot of value on people who are humble. I've written about it here. I've always thought about humility in the context of getting better at what you do. If you have the humility to know that you aren't the best at everything, that drives you to improve. And of course it makes you much more fun to work with. 

I had a conversation with someone the other day who pointed out another reason why humility is such a great attribute: it's a signal that you see the world clearly. If you have the humility to see your weaknesses (which we all have) and to understand that whatever success you've had required the support of lots of luck and lots of support from other people, then you see the world more clearly than someone that doesn't. And an undervalued skill in the workplace is the ability to see the world clearly. To seek the truth.

An executive's job is to make good decisions. You can't make good decisions if you're not seeing the world as it is. Being able to see the world as it is might be the most important thing an executive can do. Often once you know the truth, making the decision is often the easy part. Humble people are naturally better at this. and this is just another reason why that value is so important in the workplace. 

Rule of 40 vs. Real Cash

It seems like whenever we go through a shift in the economy, the fundamentals of finance become increasingly important. During the near-zero interest rate environment we had for more than a decade, growth was rewarded in an outsized way. 10x and 20x revenue multiples were common for startups. Because the risk-free rate of return was near zero, there was no real opportunity cost in investing in something risky. That drove up the value of companies that were investing in big growth. Today, this has changed quite a bit. There is an opportunity cost to investing in something that might not generate cash for a while. So, a lot of the attention has shifted from growth to profitability. Investors want to see cash get generated more quickly. The Rule of 40 (ensuring that a company's operating margin % + its growth rate exceeds 40%) has become a common way of categorizing top-tier startups in this environment. Boards are pushing company leaders to get to Rule of 40 as quickly as possible. Given so many companies are coming out of the grow-at-all-costs approach, the easy thing to do is to pull back on investments, project a conservative growth rate, and drive down costs to make the company's operating margin high enough that it gets the company to 40+ in the next year or two.

This is a potentially short-sighted approach, especially for earlier-stage companies with small revenue. Returning to the fundamentals of finance, we know that the value of a financial asset is the present value of the cash that you can take out of it over its lifetime. Forecasting these cash flows is done using a discounted cash flow model. Revenue multiples and the Rule of 40 are crude proxies for understanding the present value of future cash flows. The danger of the Rule of 40 for smaller companies that aren't generating significant cash flows is that they underinvest in growth to achieve a higher operating margin at a point in time but never get to a point where the company generates high amounts of actual cash.

The Rule of 40 measures a point in time calculated using the % growth rate and the % profit. But companies are not valued on what they're doing right now. And they're not valued on their growth rate. And they're not valued on their profit margins. They're valued on real amounts of cash generated in the future. Rule of 40 can be a useful metric for investors to gauge the health of a business. But that has to be tempered with an understanding of the investments the company is making today to drive future real cash flows. 

One good way to manage this is to classify revenue and cost projections into two buckets. 1/ Core: revenue that will be generated from investments made in the past, and 2/ New: revenue that will be generated from new investments. Leaders need to really understand the future cash flows associated with their core business and whether or not that will produce adequate cash flows relative to expectations. That provides the input needed to throttle investments in new initiatives. The core should get more profitable and the new stuff should drive lots of new revenue. Blending the two and optimizing to a short-term metric runs the risk of severing the company’s execution plan from what’s best for investors over the long term.

The Best Books I Read in 2023

I skipped this last year for some reason. But I’m back with the best books I read in 2023. Some business, history, longevity, investing, and a little golf. View past lists (2017 through 2021) here. Enjoy!

1/ Killers of the Flower Moon: The Osage Murders and the Birth of the FBI by David Grann. In the late 1920s, the Osage Indians in Oklahoma were the richest people in the United States. This wonderful book chronicles terrible crimes committed against various tribes and the formation of the FBI that ultimately solved and exposed the atrocities. You forget that the FBI (and police departments in general) are a 19th and 20th-century phenomenon. Apparently, they just made this book into a movie. Looking forward to it.

2/ Going Infinite: The Rise and Fall of a New Tycoon by Michael Lewis. The story of Sam Bankman Fried and the collapse of FTX. I knew most of the story before reading this one so I didn’t learn all that much but Michael Lewis is just so good. More people would read if more authors wrote like him.

3/ Greatest Game Ever Played, The: Harry Vardon, Francis Ouimet, and the Birth of Modern Golf by Mark Frost. I’ve been meaning to read this one for a long time. The story of a young caddie who wins the US Open in Brookline, Massachusetts, against all odds. Tremendous read.

4/ Outlive: The Science and Art of Longevity by Peter Attia MD. Sort of a bible for those interested in longevity (we all should be!). He dives deep into what he calls the Four Horsemen, or chronic diseases of aging: heart disease, cancer, neurodegenerative disease, and type 2 diabetes. Fun fact: for every human over the age of 100, there are about nine billionaires.

5/ The Intelligent Investor: The Definitive Book on Value Investing by Ben Graham. I read this because I saw that Warren Buffett said that chapters 8 and 20 are the “bedrock of my investing activities for the last 60 years.” The whole thing is good. Lots of fundamental truths investors need to know.

6/ The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit by Aswath Damodaran. A great primer on how to value companies. It's sort of a textbook, but it doesn’t go too deep and is a relatively easy read on the fundamentals of companies at the earliest stages to post-IPO.

7/ When Money Destroys Nations: How Hyperinflation Ruined Zimbabwe, How Ordinary People Survived, and Warnings for Nations that Print Money by Phillip Haslam. An excellent history of the inflation crisis in Zimbabwe where the government was forced to raise interest rates to over 5000% to bring it under control. So many factors contributed to this crisis, not the least of which was the terrible wars in Zimbabwe that took so many men out of the workforce and forced the government to provide enormous amounts of government assistance, contributing to massive increases in prices.

8/ A New World Begins: The History of the French Revolution by Jeremy D. Popkic. I guess I never studied the French Revolution in school because this was mostly new content for me. Just a fascinating time in history and such an important step forward for liberal democracy across the world.

9/ The Managerial Revolution: What is Happening in the World by James Burnham. A fascinating and important book written in 1941 on the shaping of society that has turned out to be very true. Burnham argues that capitalism is dead and that it has been replaced not by socialism but by a new economic system called managerialism — rule by administrators in business and government.

10/ Principles: Life and Work by Ray Dalio. Really solid insights and perspectives from the founder and CEO of Bridgewater Associates. He talks a lot about truth-seeking, which is so critical to be successful in business. He pushes the reader to be “radically open-minded” and have a genuine worry that their ego might be getting in the way of seeing the world as it is and making the optimal decision. Great read.

Selling Software vs. Selling Work

One of the most interesting aspects of AI and how it'll change the workplace is how it might disrupt the large SaaS players and the SaaS model itself. The SaaS business model typically is set up around licensed "seats," where a SaaS company sells an individual seat to an individual employee to give them access to the software. The idea is that the software makes the employee more productive, and that gain in productivity is 2x to 5x the cost of the seat. This formula has led to the emergence of thousands of successful SaaS companies and hundreds of billions of dollars in market cap.

AI changes this quite a bit. Unlike SaaS, AI doesn't just make an employee more productive. It does the actual work of the employee.

As an example, if AI could triage patients coming into a hospital and connect them to the right next step (a specialty referral, an inpatient admission, a prescription, etc.), that's not making the healthcare provider a little more productive, that's opening up a nearly unlimited capacity to triage patients because the Ai can do it significantly faster 24 hours a day. 

This is very different than making an employee 20% more productive. And it's different from replacing an employee with a machine. It's taking ownership of a work product and removing caps on output. Try to imagine doing this across multiple areas of work inside of a company. All kinds of limits to growth and productivity will be removed, and companies could be infinitely more valuable. 

Coming back to the notion of SaaS and selling seats. The AI company would never sell this way. The ROI isn't centered around increasing employee productivity, it's centered around doing jobs with nearly uncapped output. It'll be interesting to see how this impacts the SaaS business model that has become so prevalent over the last several years.

What Artificial Intelligence Is Not

With all the hype around AI, I’ve seen the media and investors get a little bit sloppy with the definition of AI and have been calling things AI that aren’t AI. When there’s a big trend like this one, there’s a temptation to attach things to the trend that shouldn’t be attached to the trend. I’ve heard it’s hard to get meetings these days with top VCs if you’re not talking about AI in some form so founders are certainly incentivized to stretch. It’s worth defining what it actually means and what things are software versus AI.

Software that is not AI is running off of mid-20th-century technology. It effectively acts like a digital calculator. A programmer codes the software to do something, and the software behaves accordingly. The software is not thinking. It can’t do anything it wasn’t coded to do. If the software makes a mistake, that is the fault of the programmer who coded it.

Ai is much different. Ai mimics human intelligence. It can do more than what it was coded to do. ChatGPT describes itself this way:

The ability to learn, adapt, and generate contextually relevant responses based on patterns in data is what elevates it from traditional software to the realm of artificial intelligence. It's a software that, to some extent, can exhibit intelligent behavior and respond dynamically to various inputs.

One way to think about this is that software makes the human mind more efficient while AI mimics the human mind. From an investing perspective, this difference is really, really important. As this technology develops, given the massive productivity gains from a technology that can do the job of a human infinitely more quickly, 24 hours a day with no breaks could cause us to totally rethink how to value companies that create and/or leverage this technology.

Some VC Insights

This recent episode, 20VC Roundtable: Is the Venture Model Broken? was one of the best I’ve heard in close to ten years of listening.

I found myself jotting down a few notes. Listen to the whole thing, but here are some of the highlights:

• VCs tend to jump to the “next big thing” (Crypto, AI, etc.) because that’s how you get markups on your investments. But, by definition, the “next big thing” isn’t contrarian and, in theory, wouldn’t be where the outsized returns are. There is an interesting conflict for VCs between showing a good markup and getting actual returns.

• In venture, patience is an arbitrage.

• The true outlier investments, in theory, are the cheap investments. That’s because they’re truly contrarian, and nobody wants to invest in them.

• Pre-product-market-fit, stay as lean as possible. If you get ahead of the market, the team will have built things that aren’t perfectly aligned to the market, and they’ll develop opinions about what the market needs based on what you have and what’s been built. Slow that down and make sure the market is pulling and you’re not pushing.

• When you have product-market fit, your next customer should be marginally more attractive than the last one. e.g., you shouldn’t have to be straining your offering to get more customers. At some point, everyone should want it.

• Often, a company’s go-to-market is better than its product-market fit, and you can fool yourself into thinking you’ve found it.

Two Rules For Negotiating

There are two rules for negotiating that are absolutely essential.

1/ Be able to make the other side's argument as effective or (ideally) more effective than they can. If you can't do this, then you’re lacking empathy for the other side which is very dangerous. If you can’t do this, then you likely don't truly understand the issues at hand, which means you won't be as effective as you could be. Never negotiate without doing this. 

2/ Internalize your BATNA (best alternative to a negotiated agreement). A lot of people know what this is, but very few do it, often because they don't even want to consider the idea that they won't get a deal done. You have to go there. If you don't play out the worst-case scenario in your mind, internalize it, and understand that if you can’t get a deal done the sun will still come up in the morning, you are in a much weaker place. Get comfortable with your walk-away position. 

These are two simple things that very few people do consistently. Following these rules will make you much more effective at getting to a deal that works well for both sides.