If you’ve been on Twitter the past few days and take part in the venture capital parts of the social media service, you’ll have seen a link or two from () discussing revenue quality. What he’s talking about, and why now, are good things to understand if you want to be current with the world of private companies.

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Let’s take a minute and understand what Wilson is discussing. He’s right as well, as we’ll see. So listen up, this stuff matters if you are in the startup game.

Quick Digression On Revenue

Revenue comes in varying levels of quality. That’s important to understand. It’s also a fact that becomes obscured when discussing startups, a market in which revenue growth is far more discussed (and championed!) than revenue ±çłÜ˛ą±ôľ±łŮ˛â.ĚýThis makes some sense, as the former is easy to understand, the latter more tricky to grok, and growth is something inherently easier to calculate and brag about than revenue quality.

And revenue growth can cover up for a revenue quality deficit as we’ve seen time and time again (, , , , etc.) That in mind, let’s listen up.

Fred Wilson

Let’s see what Wilson wrote. Here’s the key section from on the subject of revenue (condensed, formatted):

A narrative in the late stage private markets [is] that as software is eating the world, every company should be valued as a software company at 10x revenues or more. And that narrative is now falling apart.

If the product is software and thus can produce software gross margins (75% or greater), then it should be valued as a software company. If the product is something else and cannot produce software gross margins then it needs to be valued like other similar businesses with similar margins.

If that doesn’t make sense, let me help. Wilson, a venture capitalist with a pretty good track record and, more to the point for us, a propensity for writing correct things about his industry on the Internet, is arguing that revenue quality is a key factor to the value of your business.

That may sound incredibly obvious, but often firms are valued more on revenue scale (current top line) and revenue growth (pace of current top-line expansion), than what sort of gross margins that revenue generates. In case some of this isn’t making sense, gross margin is the portion of revenue that is left over after the revenue pays for itself.

The higher gross margin a company’s revenue is, the more that revenue is worth.

That is why software companies (returning to Wilson’s first paragraph) are often awarded high revenue multiples by public markets, while other industries are valued at lower revenue multiples.

Wilson’s post hit a nerve. Why? Because a number of recent IPOs that were expected to be huge successes wound up flopping (Lyft, , ), pricing lower than expected (Uber) or not happening at all (WeWork). In each case, Wilson highlighted, the struggling companies had margins lower than those usually generated by software companies.

And the public markets weren’t buying at the prices that private investors had hoped for. Wilson to add to his point, writing about the connection between valuations and margins:

Apple and Amazon were put forth as great lower margin businesses. Amazon is a roughly 25% gross margin business and trades at a little over 3x revenues. Apple is a roughly 40% gross margin business and trades closer to 4x revenues. I think that emphasizes the point that revenue multiples ought to reflect gross margins.

Many people argued that operating margins and growth rates should be the two numbers that matter most in valuing a business. I totally agree. But it is hard to have 40% operating margins if you have 40% gross margins. The truth is that operating margins will be highly dependent on gross margins. But there will be edge cases where that is less true.

Polygamy is banned in the United States, but I’d marry those two paragraphs if I could.

There should be a direct correlation between revenue quality, and a company’s constituent revenue multiple. And, the idea that a result further down in an income statement is more important than one higher up is silly (more on income statements here).

More Market Examples

Shares in Peloton, a recent IPO, fell over 10 percent today to $22.51 per share. Peloton’s IPO price was $29 per share, valuing the firm at $8.1 billion. Today it’s worth $6.25 billion. At its IPO price, Peloton was trading for 8.8x trailing revenues (its fiscal year ended June 30, 2019). Today that same revenue multiple compressed to 6.8x.

Why? Because the company’s blended gross margins are just over 40 percent. That’s miles from a software company’s 70 to 85 percent gross margin range.

Notably, both Peloton’s original IPO revenue multiple and its current revenue multiple are higher than the range that Wilson (i.e. companies with better gross margins) years ago. So it’s not like Peloton isn’t well-valued today; it is, and you could argue that even its new revenue multiple is rich for its margins.

But what about growth? That impacts revenue multiples as well, right? Yep. Indeed they do! You can think about a company’s revenue multiple in the following way:

Correct revenue multiple = (revenue growth + revenue quality + operating margins)

How much weight to give to each is different for each company; a firm with faster revenue growth can get away with a lower level of revenue quality (to some degree, for a short period of time) and secure a similar, correct revenue multiple as a company that had higher revenue quality and lower growth. A firm with high revenue growth and good revenue quality could still be dragged down (in a multiple sense) if its cost structure made its operating margins insidiously negative, and so forth.

All Wilson is arguing is that the middle term in our little faux equation should be taken into account by private investors, because public investors are going to pay it mind. It’s the opposite of an intemperate point. It just seems odd counter-narrative as there are so many unicorns out today that like to talk growth, but not margins.

We need to wrap as we’re over 1,000 words which means that I am in danger of talking to myself. To sum, then, the recent IPO issues we’ve seen from unprofitable companies with slimmer-than-software margins and slowing growth, or expensive growth, should not surprise.

They should, instead, be reminders that the basic fundamentals of business adapt to new models over time. But they never go away.

Illustration: .

To pick one example, back in February,ĚýCrunchbase News spent some time noodling on relative startup valuations using a nifty tool called annual recurring revenue to growth (ARRG). An invention of , a venture shop, the metric is an attempt to understand why startups are worth as much as they are compared to their public comps.¹

Today we’re going to take a second look the ARRG startup metric. Our goal is to better unpack its substance, flag what we missed the last time we employed it, and give ourselves a better understanding of how investors value quickly growing private companies.

Some Loose Definitions

Let’s start with some definitions and explanations. We’ll start with annual recurring revenue, better known as ARR. ARR, per , is “the amount of revenue that you expect your subscribers to pay you every year.” There are more technical definitions out there (SaaSoptics has a good one ) but Tzuo’s works. (More on Tzuo’s latest here.)

In practice, startups sometimes take their last month’s recurring revenue and multiply it by twelve to calculate their ARR. So if your company had $100,000 in recurring revenue last month, your current ARR would work out to $1.2 million. (More on slide eight.)

Next, let’s talk about ARR multiples. Leaning on the simplest possible definition, a company’s ARR multiple is its valuation divided by its ARR. So a company worth $100 million with ARR of $10 million would have an ARR multiple of 10.

Some companies have higher ARR multiples, and some companies have lower ARR multiples. Investors are sometimes willing to pay more or less for recurring revenue depending on the company in question. Three factors contribute to how investors value recurring revenue: revenue quality, revenue cost, and revenue growth.

Revenue Quality

Revenue quality refers to the margin generated by ARR. If a company’s ARR has gross margins of 90 percent, that’s quite good. And valuable! A company with ARR gross margins of 70 percent would likely be worth less than the company with gross margins of 90 percent, all other things held equal. That’s because a company with higher gross margins will likely be more profitable in time than a company with slimmer gross margins.

Revenue Cost

Revenue cost refers to the acquisition cost of revenue. If a company has to spend $1 to generate $1 in annual recurring revenue, it is likely a better (and thus more valuable) company than a firm that has to spend $2 to generate $1 in annual recurring revenue. And a company that only has to spend $0.50 to generate $1 in annual recurring revenue is better than both of our other hypothetical firms.

Revenue Growth

The faster a company is growing the more investors are willing to pay for its revenue. That means the faster your little company is expanding its top line the greater its ARR multiple will likely be.

If your ARR grew 100 percent over the past year, that’s great, but if it grew 200 percent, that’s even better. And investors buying into your company today will, all other things held equal, be willing to pay more today for your current ARR. Faster growth now implies more ARR down the road, meaning that investors may be willing to overpay for today’s ARR, but they may be buying future ARR at a discount.

There is a tension between the three. Some companies will drive up their revenue costs to increase their revenue growth. Some companies will add new, lower quality revenue streams to drive revenue growth. But in the valuation game, comparisons between companies tend to focus less on revenue quality and revenue cost because investors are more interested in revenue growth. In less-mature companies, gross margins and customer acquisition costs can be nascent, changing, or hard to parse. Revenue, however, is reasonably clear.

And that’s why the relationship between a company’s ARR multiple and its growth pace is interesting. Their interplay impacts nearly every modern software company, startup or mature tech. This brings us to ARRG.

ARR, ARRG, Argh

Crunchbase News previously covered Bessemer’s ARRG metric. The metric discounts a company’s ARR multiple using its growth rate as a weight to help bring buoyant multiples back down to Earth.

In the current boom times, venture capitalists are paying lots for growth, which, per our prior discussion, means that they are shelling out more money for present-day ARR than they might have in the past. But ARRG can take some of the bite out of the historical comparison.

Per Bessemer, ARRG is a metric calculated in the following way:

What this means is that if your company is growing at, say, 200 percent, you can cut your current ARR multiple in half. This is an interesting way to show that not all ARR multiples are made equal. (And thus, if you are an investor, that you are perhaps not overpaying for private company shares with your LP’s money.)

Bessemer used this metric in its  to show that, while private ARR multiples are dramatically higher than public ARR multiples, private market ARRG multiples are close to public market ARR multiples. This implies that startup valuations for ARR-generating companies aren’t too bonkers.

The last time we reached this point here is what Crunchbase News wrote:

The gambit at play here is that Bessemer doesn’t show the public company ARRG line in the example. Only comparing private ARRG to public ARR is a bit non-GAAP for my tastes.

What might be fun would be to show the gap between private ARRG and public ARRG multiples.

And that’s where I should have done more work.

Over the weekend, self-described “SaaS enthusiast”  asked us how ARRG multiples work for companies that are growing at less than 100 percent per year. My thought, at first, was that the formula should hold and that you just put in a smaller denominator (growth) than you would if the firm was growth at more than 100 percent per year.

But . If you put in a number smaller than 100 percent into the formula’s denominator, the company’s ARR multiple is stretched, not shrunk. So while the ARRG metric worked well for Bessemer’s effort to show that private software companies ARRG results were similar to public market ARR marks (as the startup crew under inspection was growing at far above 100 percent), it doesn’t work for companies growing less than 100 percent annually.

We can interpret the situation in one of two ways:

1. ARRG is a fun way to show that companies doubling or more each year are not too overpriced, and it is not a tool designed to interact with all private companies’ valuations.
2. ARRG is designed to reprice companies both growing more and less than 100 percent yearly, bolstering the companies that are doubling and better, and dinging companies that aren’t hitting the 100 percent year-over-year growth mark.

Either way, we left too much work on the table before. That was my mistake.

I hope this was at least somewhat helpful. My key takeaway is that investors will always talk up their book; however, when they do, we need to triple check the math as things can slip by. Shoutout to Geoff for the help.

1. As we have and discussed before, it was that perhaps startups ARR multiples should fall under a public comp’s multiple. After all, their shares are illiquid, making a discount responsible. That logic is solid, but it also won’t get you any damn allocation in 2018.