Blinded by Metrics
Blinded by Metrics
How metrics can deceive investors and operators into thinking the company is fine
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People frequently abuse or misuse financial metrics in order to paint a picture that fits their narrative. Often this is unintentional, but it can be extremely dangerous to the company if not fixed.
When misused or misunderstood, metrics can hide problems that should be surfaced and fixed quickly. Make sure every leader at your organization really understands what the metrics mean and how they should inform decision making.
The same concepts are true for investors.
If you are unfamiliar with “community adjusted EBITDA”, it is the infamous metric created by Adam Neumann (founder at WeWork) to show how WeWork could be a profitable business…
Community Adjusted EBITDA not only excludes interest, taxes, depreciation and amortization, but also basic expenses like marketing, general and administrative, and development and design costs.
Pretty amazing that WeWork can go from nearly a $1B loss to positive $233M….WeWork just had to remove all of those pesky expenses and BOOM!….WeWork is profitable, right?
I am sure Adam Neumann believed “community adjusted EBITDA” was a valid metric. He also convinced enough people that it was a good idea since they included it in their S-1 filing.
While it may not be immediate, eventually the lies of future profits from these types of metrics will be reflected in the valuation.
From a peak valuation of $47B to just $7M today…that is a lot of capital destroyed. Neumann’s creative stories and metrics that he sold to investors certainly helped achieve that $47B valuation.
While maybe not to the same extreme, software companies and investors frequently do this same thing.
Software Industry Metrics
The software industry has created a large number of financial metrics that are supposed to help inform what the valuation of a software company should be.
All of these metrics boil down to understanding the potential of companies to produce free cash flow (FCF) per share over their life. The lifetime potential to generate FCF per share is all that ultimately matters for a company’s valuation.
FCF per share potential can be further broken down into the following three components:
Revenue growth
Free cash flow margins
Shareholder dilution
Today’s post is focused on #2 - free cash flow margins.
FCF margins = FCF divided by revenue
The expectation is for software companies to be able to generate huge free cash flow margins at scale. But a lot of software companies that are unprofitable are hiding issues in compound metrics where high-revenue growth offsets the poor profitability.
Rule of 40 Score
During the 2021 ZIRP era, revenue growth alone was by far the most correlated to software company valuations. Profitability appeared to barely matter at all. We all just wanted growth, growth, and more growth.
Profits can come later after the market is captured! — Investors in 2021
As Jason says below, the craziest thing investors did was to value low gross margin businesses the same as high gross margins ones…presumably with the hope that all software companies would have incredible 75%+ gross margins at some point.
A very popular cloud company metric is the Rule of 40, which shows how companies balance revenue growth versus profitability. The Rule of 40 increased in popularity after 2021 as investors started to turn their attention to a better balance of growth and profits.
Rule of 40 Score: revenue growth rate + FCF margin
Below is the current Rule of 40 score for companies with a greater than 25% NTM revenue growth. The median Rule of 40 score for these companies is 39 versus an overall median for all cloud companies of 32.
While the Rule of 40 takes a more balanced view (weighting both growth and profits), it is a compound metric that can disguise a broken company that will never be profitable.
A company that can never generate a meaningful profit is worth approximately $0 in the long run.
Bessemer’s Rule of X is a modification of the Rule of 40 that can further disguise a broken company.
Rule of X = (Growth Rate * Multiplier) + FCF Margin
The Rule of X puts more weight on revenue growth (~2x weight on growth versus profits). Bessemer came up with this weighting by back solving how investors were valuing companies today, which theoretically also lines up with what a discounted cash flow should produce.
To be clear, the Rule of X is a completely valid metric that is tightly correlated to valuations today. But the major assumption is that strong profitability will come.
Insanely high growth at breakeven profitability will get you a great Rule of 40/X score, but is worth basically nothing if there isn’t a path to profitability.
Will Profits Come?
The majority of investors are not dumb. They look at gross margins, unit economics, etc to assess the profit potential of a company.
But…both operators and investors frequently underestimate the challenge of getting to the expected software FCF margins of 20%+ AND maintaining those margins over the long run.
Many public cloud companies have achieved high FCF margins, but these are the very best companies in the world. Also, the environment is a lot tougher now to be able to get to these types of margins.
The Rule of 40/X doesn’t take into consideration the huge risk these unprofitable (or barely profitable) companies have in achieving high FCF margins. Like in 2021 when we ignored gross margins, today many people still ignore the risk that these companies can produce a meaningful amount of FCF/share over a long period of time.
As revenue growth declines the expectation is that profitability will increase primarily because it is a lot cheaper to retain existing customers than to acquire new ones. But the ability of companies to rapidly improve profitability as revenue growth declines varies wildly.
I review the trend of the two components of the Rule of 40 and look at the relationship of their movement. I.e. how much does profitability increase in relation to the revenue growth decrease?
Then the harder question to answer is how durable is the FCF margin potential. One year of high FCF is nice, but it doesn’t create that much value if it disappears the next year.
How strong is customer retention (gross revenue retention or GRR)?
What are the expansion opportunities (net revenue retention or NRR)?
Do they have pricing power or will their margins get competed away?
Etc…
Example: Fastly is a company that was a super high growth business and hot IPO in 2021. Fast forward to today an its expected growth is just 10% with only 1% FCF margins….its growth sure fell fast-ly (see what I did there?😎) but it never became really profitable.
Should investors have been able to see sooner that it would never generate meaningful FCF margins?
There are many more private companies in this situation. The fast revenue growth of these companies slowed dramatically, but the FCF margin improvement is weak.
A lot of companies are holding on to hope of reaccelerating revenue growth so they continue to spend a lot. Most of these companies would likely achieve the same revenue growth though with a leaner team rather than trying to force something.
Takeaways
Don’t lose the forest for the trees. Metrics can blind you on what actually matters.
It’s really hard to become hugely profitable with 20% FCF margins. And it’s even harder today.
Make sure the people reviewing metrics actually understand how they are defined and what they mean.
Footnotes:
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