Once upon a time, in the olden days, companies started out small. They made something, they sold that something for a little bit more than it cost to make. They reinvested that bit, and grew the business. Eventually they got big enough that they went public. Their stock was valued on their profits.
Apparently, those days are over. Selling something for more than it costs to produce is overrated. Profits are for suckers.
This started during the last Bubble in the 1990’s. It became common for companies to go public while they were still losing money. Then the crash came in 2001. For a while, companies again needed to be profitable before going public. But in the ensuing decade, the public markets eased up on that restriction. For a period, companies merely needed to go public with a plan to reach profitability. Today, even that plan is no longer required. We do not have the historical data to back this up, but it seems pretty likely that the number of high-profile companies with little or no profitability is at some kind of historical high.
Scan the list of the latest IPOs, and the trend is clear. Of the last 20 technology IPOs only 3 companies were profitable in the year before going public, and many were not even close.
Call us old-fashioned, but we like profits. One of the first posts on this site covered the importance of profits. Companies that have profits control their destinies. Without profit, they operate at the mercy of people providing capital.
But clearly something has changed – the cost of capital has fallen off a cliff. Calculating a company’s cost of capital is complicated. The topic is an entire course at Business School. People get their PhDs looking at the subject, but a very rough way to calculate the cost of equity finance is to invert a company’s P/E multiple. So a company trading at a P/E of 10x has a 10% cost of equity, at 20x that cost is 5%. For a company trading at 200x, the cost of equity is basically 50bps. To put that in perspective, inflation is around 2% in the US, while the average multiple for an S&P 500 stock is 26.5X, or a 3.7% cost of capital. For the many companies going public on little or no profits, public market investors are paying companies for the privilege of investing in them.
In this kind of environment it makes all kinds of sense for companies to raise as much as possible. They are being paid to do so. There are many companies that probably ‘make’ more money from this equity float than they are making from the product or service they are selling.
We intend no criticism of any of the companies engaged in this. After all, it makes economic sense for them to do so. Most companies probably are not thinking about equity fundraising in these economic terms. Instead, they see opportunities to invest, to build market share in rapidly growing markets or grow entirely new markets.
However, there are some real consequences of this that need to be understood
First, there are a lot of new, small, private companies out there that have probably raised too much money. There is value in constraints. Having too much money creates temptations and this can lead to distraction. Moreover, it can lead companies to sacrifice commodities that are still very scarce – notably management time. The landscape is littered with companies that spent too much money on projects that failed. And while the Valley celebrates (or at least tolerates) some level of failure, these sorts of projects can cause management teams to lose focus on the core business and other things that matter. We will not name names, but our guess is that everyone reading this can think of at least a few examples of this.
Another problem with all this cheap capital is that it distorts the market. Larger, older, more established companies find themselves competing with small ‘disruptors’ who damage the economics of the industry. Sometimes that damage can be permanent. This is true not only of 100 year old companies, but also of last year’s over-funded, now fallen start-ups. The old saying holds that “Bad money drives out good”. If we strip out the moral connotations there, it is clear that this holds. Cheap equity is great for new companies, but it also devalues the equity that companies have built up over years and decades. The textbook example of this is the old Worldcom, which was able to raise large sums in the 1990s to drive expansion. It used those funds to undercut its established competitors, ruining businesses and the careers’ of many executives. Eventually Worldcom was undone by bad accounting (and fraud), but cheap capital made it all possible. Some of this is healthy, with economic benefits for some broad audience, but taken too far… well there will someday be a price to pay.
Which leads to the obvious question. When does this all end? For the moment, making a profit is non-economical. Losing money is the smart strategy, perhaps it is the smart paradigm for a world awash with technological change. But at some point, the cost of equity will increase. One of the first posts on this site was a review of capital flows. In hindsight, we were way off on the timing. Five years later and not much has changed. This cannot continue. Looking at that post now, it is clear we were too focussed on US markets. (Sorry, it was the best data set we had at the time.) We overlooked the pool of Global capital, and that pool was much, much larger than we (or anyone) realized. To really understand how these flows will change and end would entail a conversation about politics, which we at D2D are avoiding as hard as is humanly possible. For our purposes here, suffice it to say, that someday all this will change. The Fed will raise rates a few times too many. Some global shift will take place or some shock (or shocks) will occur. And when that happens the current strategy will break, and for some companies it will break in hard, uncomfortable ways.
For now, raise all the money you can grab. Just be sure to read all the fine print in those financing documents.
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