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 ±ç³Ü²¹±ô¾±³Ù²â.ÌýThis 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.

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Last week I tried to highlight a sentiment shift in the technology world. Bullishness felt ascendant once again.

Sure, venture activity was down compared to some 2018 highs in the first quarter, but the Nasdaq was popping, big rounds were landing, and the IPO market looked hot.

Things have continued in that vein. Yesterday, for example, both the Nasdaq and the S&P 500 “finished in record territory, notching all-time highs for the first time since fall and late summer,” . Given that the public markets help shape opinion in the private markets (optimism and pessimism bleed from the stock market into how private investors value companies), it’s an important moment for the firms that we cover here.

An IPO

The market warmth we just described is driving companies through the IPO gauntlet.

Yesterday we dug into the DouYu IPO filing (Remember the Huya debut? DouYu marks another esports-focused offering.), only to discover that we’d missed a different China-based technology offering targeting the U.S. markets. Say hello to , an ecommerce company with a membership component.

According to its , this is how it works:

If that isn’t clear, the company’s model depends on using lots of IRL and digital tech to link suppliers and consumers. That’s how Amazon works, with its website, services, and distribution network powering an ecommerce stack.

Yunji tallied $1.892 billion in revenue last year (cost of 2018 revenue: $1.557 billion), leading to a slim operating loss of $14.5 million. The firm grew 92 percent from 2017 to 2018, for reference, while cutting its operating loss slightly. That’s a path to profitability.

And Yunji has done all that while not raising billions of dollars. Indeed, Crunchbase has in recorded capital for the company. Some rounds that we know about don’t have listed round values, but even given that its capital thirst seems lesser than what we’ve seen from some companies.

So we’ve discussed our record and our IPO. Let’s peek at an interesting round.

A Round

A company called announced . Eightfold is a company I know a bit. I met a few of its team in San Francisco last year.

That a company with an “.ai” suffix raised a $28 million Series C is not surprising. In fact, that’s nearly the platonic ideal of a 2019 venture capital round. What makes Eightfold interesting isn’t its funding amount (though it added to , which isn’t bad at all), but rather what it’s trying to accomplish.

Eightfold wants to help big companies with what it describes as their “number one challenge,” namely “hiring and retaining top talent.” If you ask CEOs of tech companies what’s bothering them, the talent crunch is a pretty common response, so Eightfold is tackling a reasonable problem.

The economy is hot (see above), and markets are rewarding tech companies looking to reach the next level (see above), exacerbating the talent crisis. But even if there was a correction of moderate size, talent would still be tough in and around tech hubs. That puts the startup in a somewhat fun spot; unless tech is decimated in a correction, I’d hazard that Eigthfold is slightly recession-proof.

That aside, Eightfold is working in a space where there is demand, and it, putatively at least, has a solution. The combination should help it grow quickly. Sadly, the firm .

Hot Times

Taking all that together, the public markets are setting new records, tech companies of all shapes and sizes and profitability are targeting the U.S. markets, and startups looking to solve hot-market talent problems are finding new backers and fresh capital.

It’s still hot times in tech. No matter how bad things looked in December.

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