Marginal Value add

Revenue is vanity, profit is sanity & cash flow is reality" Avnish Bajaj & Rajinder Balaraman dive deep into how margins relate to valuation.

Rajinder:

Hi Avi, today's topic is about margins and you know, we joked that most VCs actually don't add enough value, so we've creatively titled this one Marginal Value Add. Hopefully it will add some value to the margins discussion. This podcast is something we've been meaning to do for a while and, and multiple events you know, triggered this finally happening. Now this crisis has obviously gotten everyone focused on economics, fundamentals, you know, unit economics, et cetera. And then know, Bill Gully was also in the news this week and that reminded me of his post from a few years ago. All markets are not created equal. And then Fred Wilson also wrote this post a few days ago titled not all cross margin is the same, so it's very timely and which brings me to my first question is unit economics back in fashion and, you know, looking across the businesses that we have invested in, has the narrative changed?

Avnish:

Yeah. Good to be back Rajinder, I hope everybody is getting used to lockdown. Sadly, I'm in Mumbai. You're in Mumbai and Salonie is in Mumbai, this will probably go on sounds like a till June. Getting used to it and figuring out new ways of doing old things. By the way, with reference to Bill Gully and Fred Wilson and let's include a link to that “All revenues is not equal” I keep sending it to founders and I guess Fred Wilson’s post. Is unit economics back in fashion? Yes. Probably for another 18 months and to go up again. So look is doing what you're doing fundamentally adding economic value. Well that's probably second. why does it go, why do you think it goes out of fashion? It, it comes back into fashion generally for about a year to two years, then goes back out of fashion for two, three years and the cycle repeats, right? Last cycle was 14, 15. The cycle before that was 10, 11. In both those cycles, unit economics was out of the window. Then 12,13, it came back 16,17, it came back 18,19 went away, 20th It's back. Why do you think that is happening?

Rajinder:

Maybe some part of it is just a overall funding market link.

Avnish:

So, if you have a business, absolutely. So if you have a business and people are giving and you have the acquired customers and that's your metric and people are giving you money free, free to give it to customers to acquire them, what would you do?

Rajinder:

Load up and take as much as I can.

Avnish:

So look, when valuations go like crazy funding environment, I'm going to make a little bit of a controversial and contract point, its rational behavior, unit economics going out of the window for some period of time. Sadly, maybe rational behavior. If I was an entrepreneur and I've been an entrepreneur, if I was being given money for free in Germany today, that has been given a negative rates what would I do? I would go and acquire as many customers as possible, right? So it's actually rational behavior. Has that changed? Of course, because funding environment, I mean even irrespective of Covid, starting with we work last year, funding environment was blowing up. The minute cost of capital goes up and it'll come up again. And the rest of this video cast, the minute cost of capital goes up, we want to see are you getting the returns for that capital? But if cost of capital is very low, you're not focused on return for the capital and unit economics is fundamentally returns on capital. So yes, it's back. I tell you, the only thing that I worry about, when I said its rational behavior as an entrepreneur, I would do it. Maybe I wouldn’t in my, in my current of that maybe first time around I would have, because it teaches bad behaviors both to your customers and to your company and you start thinking that this is the new normal, this time is different. This is how business are build. That's the challenge, right? So I can argue that on a financial basis it's rational behavior because capital is cheap and it's VM. When I say that in the venture environment, I mean you can raise hundreds of millions of dollars and billions of dollars of valuation without real, real traction, then money's free. But it does teach wrong behavior. So, and I don't think you can, it's a switch that you can flip on and off like you're saying is a packet fashion. Imagine the pain that the company has to go through. I've seen in so many businesses where excessive subsidies were being given, there's a serious pain at the consumer level and at the company. So yes, it's back in fashion, It should be the way that businesses are built. But I could also argue that in bubble times where capital is very cheap, people just walk to customers are not, not building businesses.

Rajinder:

Nope, hear you see it all around. I think we just getting a little more detailed on definitions here, when people start this whole evaluation conversation, some people started at kind of the revenue GMV, You know, at that line. And you know, in this environment, you know, people are more focused on, you know, unit economics and margins, but within margins there's different kinds of margins as well, right? So there's, there's call it take rate or you know, gross margin in some cases. And then you go down to, you know, contribution margins. And then of course within that there's, you know, CM1, CM2, you know what do you really care about or what should founders really care about?

Avnish:

Yeah, so I think we should do some definitions for each, but before we go there, and I guess you can't do it right now on your zoom, but I would love for you to have Googled IFRS or Indian gap contribution model. All these are gimmickry. All of this has been created by the internet ___9:47. If you were to Google this term, the contribution margin in the true accounting and financial sense, by the way, is contribution margin and our sense, and we'll come to our world because we have to live in our world and we have to create proxies in our world is contribution margin greater or less than gross margins?

Rajinder:

Less then.

Avnish:

In reality, contribution margin is greater than gross margin. So contribution margin is a concept in accounting that says your revenue minus your real variable costs. Gross margin for example and in the manufacturing sense, for example, would also deduct direct labor, contribution would only deduct the raw material costs and maybe the machining cost and stuff. Right? So believe it or not, none of these terms are in the accounting or financial world anywhere. A go to Investopedia and we should include links to this, We should include a link to contribution margin in Investopedia. Google it, it doesn't exist. So it has been invented by the internet. I use it, you will use it. And the reason we use it is because in the, in the internet businesses you are often underwriting future cash flows. You are saying Kabhi na kabhi paise banega, because you can't underwrite it, but you can't underwrite that. So in order to get proxies for those future cash flows, all of these margins have been created and frankly, I have learned some of them only over the last five, six years from some of the later stage investors who tend to use it more. Because remember later stage investors are trying to underwrite profitability and in the absence of current profitability they need proxies for future profitability. So if I have a one line description of contribution margin in the internet world, it is proxies for future profitability. Okay. Now within that, let's define, so gross margin. Best way to think about it for me is how much hard work does it take to get right? If my gross margin is very high, 80 90% not as much harder or I have created such a value prop that I'm able to really price it way above my my costs and now gross margin is revenue minus direct costs, which would include raw material like we said, but also things that may not seem direct direct, so to speak, like direct labor, but it is generally include. Then you have to go to the next level. Now let's say you were comparing an internet company that is delivering a goods to you versus an internet versus an offline company where you're going and buying something directly from the company for the sake of simplicity. In the case when it's delivering, you're paying the company's also bearing payment gateway charges, they're bearing logistics charges, they're bearing charges for returns you know, stuff like that. By the way discount, I have the removed at the top level. For me, the net revenue line, there should be a gross revenue line which would be netted off the returns and discounts any better net revenue line, which is also what people don't do. So now you go down to contribution margin one, which is gross margin minus these other costs like logistics, like payment gateways. Maybe sometimes it's related to some positive returns, but for me it would have gone above that line. So clearly contribution margin one becomes important. You can have, I will tell you that if you were to sell something below cost when you have higher market share than somebody who's not. Yes. Right. So negative growth by the way, you will find in the bubble eras, companies with negative gross margins getting. Next is if you were to sell something where it costs you more to make that product and deliver that product, but you are still selling it below that cost, would you have a lot of customers? Yes. Those are all CM1 negative companies, believe it or not, people still fund them. It comes down to what does it take to grow this business? In internet businesses, it's generally the variable cost associated with digital marketer. So for me it goes down below that and says, okay CM1 minus digital marketing is CM2. And then not to belabor the point, you take out brand marketing and it comes to CM3, which has contribution margin and then you have your fixed costs and CM3 minus fixed costs as well. So sounds very complicated. If businesses are not positive, none of us would have to deal with this. It is a proxy for these things. Now my question to you is, which business would you invest it assuming you can't get evened up, positive big CM, Do you think you want you?

Rajinder:

I mean I would say CM1 makes more sense to focus on really, if you believe that the category is one where you know, the repeat is going to be really strong because then over a period of time you see, you know, leverage come through on the marketing spend that you are spending upfront and you know, you're are acquiring users. But you know the repeat will be strong. So I guess that's what most companies today probably

Avnish:

So in a bubble. So I, I hear the argument, I think it's a little bit dangerous. So I'm a CM2 believer, I'm not a CM3 believer because CM3 remember includes brand advertising, but advertising I can see as very long payback. And I think if you get, if you dock a company for that too early, you may not be doing the right thing. CM1 basically says I can make money but I don't know if I can grow. Now I can see your argument and I think the way people, I would do that or way people do that is then you use CM1 in conjunction with the LTV to CAC. Right? So if you have very high LTV to CAC, I am okay with CM2 being negative. Right? Because you're up front spending a lot but your cohorts are very strong. So if you're doing CM1 level investing or same one level and then analysis, Lee's look at cohorts and LTV to CAC if you are doing, if your CM2 is positive, you don't even need to worry about because it's paying back immediately. So that's how everything for so long explanation. But these are all proxies for future profitability and once that venture capitalists have to use because we don't have precedent for profit.

Rajinder:

Super helpful. You know, one of the traditional arguments against focusing on margin early has been that, you know, margins should increase with scale. And with higher market share as you grow. How do you think about that in a, given the India, you know, context and income distribution in India and how companies, you know, once you get into kind of the next income segments, you know, can you really kind of command that margin?

Avnish:

So I, I can argue both sides. I don't have a clear easy answer but I think it's very nuanced and situation specific. But let me at least lay out the concerns. So the negative side of saying don't. So if you want to not focus on margins early in the analysis, I questioned product market fit. See we, we take three types of risk, we take product market fit risk, we take scalable product market fit risk and then we take the scalable profitable product market fit risk, right. Margins are to solve the third issue, Right? And you are saying you're solving if you're, if you're focusing early to solve the third issue, you know it's maybe correct. My argument would be I may get a false positive on the first issue in the second issue, which is product market fit and a scalable product market fit. If somebody is giving other things below cost and below their ability to make money, they may show a lot of traction. But the minute you switch that off, do the customers run away? which is why we all know that discount driven customers are the most disloyal customers, right? So therefore I would say that's why for me, CM1 is a red line. CM2 may or may not be a red line. It depends on LTV to CAC, So if you're asking me to take a CM2 risk, I would want to see enough history in the company to know that LTV to CAC would work. So the answer to your question is, if you don't focus on these things, are you getting wrong signals on product market fit? Okay. That's the one side of you. On the flip side of the argument is there are things called network effects. There are things called operating leverage. That's the reality of the world, right? So if I look at the OLA’s of the world they have serious network effects and operating leverage. I know people think they know, but the reality is they're by pricing power, their pricing power has gone up with time, right? So where I probably net out is I'm going to look very, very closely at this 10 X user experience, network effects, all of those kinds of things. If I would take a fund that was margin baad mein dekhte hain, right for that I would really believe that this business is often, this is the old classic, Facebook's, Google's so on and so forth. Right. Very, very few businesses like that, very few. Like if they have, they are, then you're right. Then you should be looking at other metrics which are more user related. But other than monetization

Rajinder:

I like his framework PMF, Scalable PMF, Scalable profitable PMF. When she found a start thinking about the third one, what's the right point in the company's journey to start thinking, should they start thinking from day one or _____

Avnish:

Boss I’ll tell you we have done a bunch of these investments with repeat founders. What is the one, one thing that we have discussed internally that differentiates them?

Rajinder:

I mean, they've, they've they're really focused on a business model and GTM because

Avnish:

Profit pools

Rajinder:

Yeah.

Avnish:

They are chasing large profit pools. There in lies your answer and which is why I think, so obviously they are thinking it was like a scale hogaya, I don't, if I were to start a company today, I would say, I don't know if I can scale it, but if I can scale it, I better be able to make money. I mean that would be tragic to be able to scale a business and never make money. Right? I mean airlines is a good example. So I would really say it depends. Now it doesn't mean that I was having a debate with somebody internally actually, it doesn't mean that unprofitable businesses won't become large, right? Lot of them, the biggest venture returns globally have been made on initially unprofitable businesses that became large, but they were generally 10 X experiences. And ultimately valuations are the, a present value of future cash flows by definition, right? So you really need to believe that that 10 X experience is creating more, is creating network is creating this. If I believe that, I will not create worry as much about profit. And I'll say hojayega because if I've really, really captured a user, I'll figure out a way to monetize it. Look at, let's take a random example of this. Let's look at WhatsApp. It's been covered anywhere that Mark Zuckerberg does not want to monetize it. In fact, there's an article recently that he disbanded the team that was going to be monetizing like what's he thinking? But look at what has happened with the recent announcement on ___. What's that? They are finding other reasons. So if you really have a 10X experience, you will find a way to monetize. Those are few and far between. The mistake people make is assume everything is there.

Rajinder:

Avi, we get this question all the time from founders, how is this companyvalued at 10 times revenue, while I am being valued at 1 time revenue?

Avnish:

So I think, look, the, going back to our margins discussion, there is a very, and this might be a slightly longest answer. What are businesses that are created in the public market ultimately value? What are the stock price?

Rajinder:

Earnings free cash flow.

Avnish:

Stock price in finance 101 is present value of future cash flows. You don't know future cash flows, no individual investor can figure that out. Actually, no institutional investor in can figure that out. So the proxy that's used is price on the market. Price earning multiple as an asite is actually benchmarked to interest rates that exist in the in the treasury market. Just people may not know this, but which is why when interest rates go down, stock prices go up because E by P is the yield of a stock and P, So inverse of P is the yield of the stock, so minute interest rates go down yield you know, stock prices go up because people, people hunt for higher volumes. So now what, how is this relevant to venture capital? None of these companies have E how do you, how do you value them? So again, people start going up in the PNL and start looking for proxies to value. You know, there is that saying that revenue is vanity, Profit is sanity and Astro is reality. The reality is in our business, we move away from reality to ____. And in the worst of the bubbles, you actually get GMV. I mean, I've lived through the.com bubble. As an investment banker, maybe we're valuing things off unique users. So that's the ultimate of a model. And by the way, that's a great indicator as you're watching valuations and when people start moving away from cash flows earnings to start talking about other things you know a bubble is just hitting. So when companies does simple rule, very keeping it very, very simple and people don't think that this is technically accurate because it will, Companies are valued that generally one time their growth rate in P, okay, it's called the _____multiple and affect multiple. One is the simplistic way of looking at it. So you can, assume company going 20, 30% will be valued at 20 to 30%, now you look at the margin of that company. If the margin, if the PAT margin profit margin is 10%, you multiply 20, 30 by 10%, it's two to three times revenue because PAT margin is on premise. If that company is growing 30, 40%, you can make it three to four times. But remember big assumption growth rate and PAT margin. Now the now, because I don't even have a PAT margin, I have to keep going up in my income statement and take proxies for that PAT margin, okay, so what people do, they go all the way up to that level and what generally happens, what I find, which is the whole Fred Wilson article, Is gross margin tends to be the convergence. So if you say eight to 10 times gross margin because it's a proxy for what will flow to the income statement and no PAT margin, you are kind of going to converge on the revenue. So when you tell me a company is valued at 10 times nine to 10 times revenue and it's growing fast, my guess is that company has 80 to 90% growth. When you tell me a company has is valued at one time revenue, my guess is that company has 10% gross margin and that likely means that that company is calculated is calculating or using GMV as a revenue metric and 10% is a peak. So I think the single convergence for me that what I've started using is eight to 10 times gross margin is where value, which is why the quality of revenues critical. This is for companies that can grow 40 to 50%. Your company is growing faster try this multiple, your companies growing slower try this multiple, bubble environment try this multiple. I think that's how I look at it.

Rajinder:

So some models earn more margin because they are more full stack and you know, to create that 10X experience we might need to go full stack. How do you triangulate margins and multiples then in the context of you know, capital intensity because going full stacks sometimes means doing things which required more investment?

Avnish:

Yeah. So now we are going to take you just to kind of the Holy grail of all finance and investing. Even a price earnings multiple that we spoke with so what sanctity and then we moved away from it to come up with proxies. Even that's a proxy, the real value of a company is It's return on equity. You are giving me one rupee. I mean this is if you were investing in a company, which is a, if you're putting the money in a bank, you get your fixed deposit and we discussed earlier, which is why these things tend to be so benchmark for industry, right? You're getting a fixed deposit rate. If you're giving a company money, you want to see what that company can earn on it. That's not resonance. That is return on equity. If I put one rupee into the company, the difference between equity and price earnings is one is market cap and one is network when it's called book value and when it's called money, right? So complicating just putting one thing out that P is equal to P by B * B by E. So that is your price to book multiple and divide it by return on equity. So why does it matter? Why it matters is the question you asked, there is a link we should include to another finance term, which is a DuPont ratio, which is how does a business actually make money through margins, times asset turnover, times leverage, right? So the answer to your question is if you give me a business that's very low margin, let's say it's a 10 to 15% gross margin and this connects back to Fred Wilson's email, when will I, when does that business become an investible business and generate enough return on equity when its assets can turn very fast or if it can add leverage, right? Leverage is scary. I'm not going to go there. Although MBFC has kind of work on that principle, but they are regulated. If you look at a business-like CountryDelight, like it's a low gross model, although it's still pretty high, 40% gross margin. But if you were to take up staples, groceries, business, it'll be 10 to 15% gross margin. How many times do you buy groceries? Probably six, seven times a month, right? In your case might be 20 times, I'm just kidding. So that's the key. Why do Kirana stores make sense? They don't make that much margin, but the thing's turn very, very fast. And which is why it's things like Geomart and some of these things coming in. Imagine what it does for them. Inventory goes down, turnover goes up. Return on capital, the capital is cycling very fast, right? So businesses that are low margin can make good return on equity. If the asset turnover or an inventory turnover is very, very fast, right? Your capitalist turning very fast. If I'm making 3% a month for 12 months, I'm 36% I might be better off and component, but whatever. So in those kinds of businesses you have to adjust. And I think you've said this about the 10X experiences before. You have to just believe that your experience is such that people will keep coming back and kinara stores _______geography, they will close connect. But the OLA, UBER business model is that right? Four, six, eight times and they are making much higher margins turning ultimately these businesses will be very profitable.

Rajinder:

Yeah, that's a good point. Continuing with that train of thought. You know, there are, there's a new generation of marketplace models that are emerging where the margin expansion actually happens through a variety of additional services. Could be credit, could be software, could be subscriptions, could be, you know, variety of things once have the user, you can add more.

Avnish:

It does, it changes how we look at things also. But I look, I don't, I would like to bring everything back to first principles and what we have discussed. And let me try to do that. We discussed that in the world of worldview of CM’s, CM1 and CM2 I prefer CM2 you say CM1 is good enough, we say ok CM1 plus LTV, if you have a business like what you just spoke about it has no revenue so there's no CM1, CM2 whatever LTV to CAC there's no LTV, but what's the CAC?

Rajinder:

Really no hope. Hopefully.

Avnish:

So that's how I get there, which is if you have a business that's on fire, if you're found some thin edge of the wedge in the market where you're able to get customers for free or very close to free, I'm going to take the point from monetization because you're doing something right. You're doing something that is, so if you show me no LTV, I'm going to say please show me no CAC. If you show me a business with zero CAC, I'm willing to take a ____. The problem is in the bubble days, people have CAC and if they have no LTV and, and, and then you're taking multiple funds, which personally I would never be comfortable with as an investor and would not advise as a founder. But I do believe that there are a lot of businesses and by the way, history, Facebook, completely viral social, WhatsApp, I mean that it still doesn’t have LTV, but its zero CAC, I mean how many times have you seen WhatsApp advertising anywhere? So zero CAC businesses probably are some of the most powerful businesses in the world. And they are, they are called viral businesses and stuff. So if you have a zero CAC business, but you probably don't have a business, you have a product. But if it is zero CAC, I think you can build a business around it. But make sure that you're mots are going up as users are coming in and again, they tend to be more network effect like WhatsApp and stuff.

Rajinder:

No, this is really, really helpful. And thank you for doing this Avi. So just, you know wrapping I think not all margin is equal, not all revenues equal and hopefully the marginal value add that this conversation has added to the matrix moment series is appreciated by partners.

Avnish:

Yeah. And, and I really hope that, look in this environment, everybody will listen to it, not the red and all of that stuff. I really hope that, you know, when we were back in the bubble era we come back to this and, and people come back to this and just keep those fundamental in mind because see, a Warren buffet says this, right? There's this price versus value, price is not value, we often confuse the two. I think these kinds of frameworks just help you understand how far you are, you know, in that and that at least as an investor definitely helps. But I think as a founder is also critical.

Rajinder:

Thank you.

Avnish:

Okay, thank you.