This post is by Brad Feld from Feld Thoughts
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When I was in Boston a while ago (it was very cold, so it must have been January), I had a wide-ranging conversation with Eric Paley. This was before the IPO Summer of 2019 when all conventional valuation metrics have entered the land of “suspension of disbelief” which is short-term good and long-term well-we-will-see-…-eventually
One of our conversational threads was about how to value companies. We ended up talking about using Gross Profit, instead of Revenue, to do valuation analysis.
We’ve been doing this for a long time at Foundry Group. Since we invest across a number of different themes, we’ve had to deal with very different revenue and gross margin profiles since the beginning, whether we realized it or not.
For the purpose of clarity,
my world GP (gross profit) is a dollar amount while GM (gross margin) is a percentage.
Revenue is often equated with Net Sales, which is true in many cases, but Net Sales is actually more precise a measure than Revenue in situations where you have Gross Sales or Gross Merchandise Value as the “top level” revenue number. Also, I often see GM listed as GM%, which is fine. Some people also refer to GM as Gross Profit Margin.
This is regularly confused, even in accounting texts, so depending on which business class you took, you are going to call it a different thing. Oh, and if you use Quickbooks, you’ll probably refer to Revenue as Income, unless you have the current version of Quickbooks where this has finally been fixed. Isn’t accounting fun?
Even if a lot of people realize that SaaS companies have a different gross margin profile than hardware companies, many don’t acknowledge it when playing the valuation game. And, this logic – or lack thereof – applies to marketplaces where GMV is different than Net Revenue which is different from Gross Profit, or Adtech companies which have yet a different “Top Number to Gross Profit” calculation. And, it gets really exciting when a company has multiple revenue streams that include services and derivative transaction-based revenue (say, BPS in a fintech company.)
Today, I’m seeing almost all entrepreneurs and investors in growth companies talk primarily about revenue and growth rate. They tend to adjust the multiples to try to align with a group of comparison companies, but these comps rarely have a similar supply/demand economic associated with the equity of the company in question. And, when the comps are mature cash flow positive public companies, the multiple math diverges even more from anything particularly rational.
I’ve started encouraging the companies I’m involved in to focus on Gross Profit and the growth rate associated with their Gross Profit, rather than Revenue. Try the exercise and see how you compare to the companies you think you should compare to. And think about how much more value you could be creating with the same Revenue number but a higher Gross Margin percentage …