Revisiting unprofitable businesses from the '20-'22 era (pt. 1)

Don't stop never losing money

Owning a money-losing business is simply excruciating. Your capital is disappearing and you are missing out on other opportunities you were smart enough to identify ex-ante— or simply just treasury bills. It’s enough to cloud the mind and cause terrible misjudgment.

In private businesses, throwing good money after bad is almost cliché: the friend’s restaurant as an archetypal investment disaster, the doomed consumer products business looking for a quick exit that never comes to fruition, the VC write-down to zero, the private equity dividend recap that quickly gives out under the weight of its debt load. There’s a reason most businesses fail.

Incidentally, it’s hilarious to me that something so catastrophic (100% capital loss for all investors) is almost celebrated in the VC world. As if a zero-recovery outcome is acceptable, at all for any purpose in any scenario for investment, rationalized by the dartboard-portfolio mentality of “well we’ll have a bunch of zeroes in the book but we’ll also find the next Google!” O.K. It’s fine to celebrate entrepreneurship as a process, but outcomes matter.

Revisiting this conceptually in the public market: owning a loss-making business in the public market might be even more painful. Each day the stock opens for trading and there’s a rational reason for the stock to be down- earnings power is deteriorating, employees are despondent, owners are deferential and probably trying to bail out, and leadership is probably a mess. The flywheel works in the opposite direction.

And then the SaaS business came along. Revisiting the 2020-2022 period of excess in public markets, several phenomena informed professional investment decision-making, combined with markedly higher interest rates, that contributed to the eventual collapse of the Unprofitable Tech Company (“UTC” as a catchall for anything that traded on a EV/S or EV/GP multiple in 2021).

Two concepts come to mind immediately:

1.) “Investing through the income statement” or the analysis done that separates sales & marketing spend from R&D, general/administrative, or capex spend. One category can be seen as spending for growth, and one can be considered spending for maintenance. Value the maintenance customers, add it to the value of future growth, that’s your enterprise value.

This exercise is similar to separating “growth capex” from “maintenance capex”. Separating these two categories is intuitive; if you owned 100% of the business you’d have a very solid read on which line items go in which category. I’m reminded of the apocryphal quote, “Half the money I spend on advertising is wasted; the trouble is, I don't know which half.” But this isn’t the chief problem for delineating these two categories.

Tidy-mindedness is probably the distinguishing trait between securities analysts and real businesspeople. Securities analysts want to know to the penny what percentage of a salesperson’s compensation is for maintaining current clients and what percentage is for acquiring new clients for a CAC/LTV calculation. Real businesspeople understand this isn’t really a thing. Real businesspeople understand you can’t turn off the spending spigot for new clients because the business needs to grow into its multiple. Keep showing growth to keep the stock working, keep the multiple high so you don’t have to re-strike your own options. Keep your competitors at bay by outspending them. Buy the best salespeople and lock them up with restricted stock to keep the train rolling. The business changes materially if at any point the maintenance spending and growth spending are separated. It’s just not how it works. Maybe a bank can securitize a pool of customer loans and sell it off, but a software company can’t do the same without the product deteriorating or being eclipsed by a competitor’s product.

2.) Stock-based compensation. The argument for not considering SBC an expense is as follows: the shares already show up in the diluted average share count, so SBC is redundant— just model in X percent dilution each year. Use the diluted share count when you value the business— simple! No cash changes hands- this is just an unnecessary accrual.

The argument for deducting the expense from the income statement is simply that it is a recurring expense, equivalent to salaries, that fundamentally changes the value of the business and its long-term earning power. SBC might be episodic in nature, but predictably episodic.

Of course I fall into the second camp as I believe firmly in the power of the income statement. If a business’s product or service can’t clearly and convincingly outpace its period costs, it is selling dollars for 90 cents. Why “invest” in excess of gross margin? It is effectively a guarantee of dilution: either from simple SBC to keep the cash from evaporating, or from future investors when the cash eventually evaporates.

This all sounds like revisionist history but the goal of exploring this ex-post is simply to make money— UTCs have already re-rated dramatically, and some certainly have attractive shareholder unit economics. If there are any babies in this bathwater than I would like to be well-steeped in the original analysis that got them thrown out. The analysts who bought UTCs at 4-5x their current trading prices are probably not the same ones that will recommend the stock 80% lower. So there’s opportunity out there; more to come when I actually find some!