The a16z Show - a16z Podcast: On Recent IPOs and Comparing Private vs. Public Valuations

Episode Date: November 21, 2015

It's hip to be Square right now. Or is it? How do we assess whether it -- and other recent IPOs -- went well, not just for investors but overall? In this episode of the a16z Podcast, Nicole Irvin and Stephen McDermid from our startup corp dev team -- and Andreessen Horowitz managing partner Scott Kupor -- share an internal "hallway conversation" of sorts around how to make sense of market reactions to recent IPOs, and more broadly, how to compare private vs. public valuations (and investors). Is there a method to the madness, a formula to compare these from beginning to end? Does it make a difference if you're creating a new category (like SaaS previously) or are in an existing one? Finally, we share views on the somewhat religious debate about whether public is really the new private, growth vs. profitability, and more. Especially as startups are always optimizing for so many competing things at any given time. Stay Updated:Find a16z on YouTube: YouTubeFind a16z on XFind a16z on LinkedInListen to the a16z Show on SpotifyListen to the a16z Show on Apple PodcastsFollow our host: https://twitter.com/eriktorenberg Please note that the content here is for informational purposes only; should NOT be taken as legal, business, tax, or investment advice or be used to evaluate any investment or security; and is not directed at any investors or potential investors in any a16z fund. a16z and its affiliates may maintain investments in the companies discussed. For more details please see a16z.com/disclosures. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

Hi everyone. Welcome to the A6 and Z podcast. I'm Sonal. And today we have three guests who are actually really two guests at a time because we're sort of doing a hallway conversation style podcast. That was actually some of the original spirit behind some of the original podcasts. And we thought it'd be great to share some of our internal conversations around some of the recent news around Square, what that means for IPOs in general. And just thinking more broadly, not just specifically about those companies and the IPOs, but more broadly about the nuances between public and private valuations and what it all means and how to make sense of it. moving forward. To help us have that conversation, which actually did happen, and so I'm just bringing the people that I had some internal conversations with yesterday, are Nicole, who joined A6 and Z from Morgan Stanley's West Coast Technology Investment Banking Practice, where she focused on technology IPOs. And here she focuses, she's on the corporate development team, and she focuses on the capital network and more particularly the public side of the capital network. We have Steve McDermid, also on the corporate development team and also a former investment banker, who focuses on the capital network as well, but more on the private side. And then we have Scott Cooper, who's going to actually

start off with us before he has to leave. And he's a managing partner of Andresen Horwitz. Okay. So welcome, guys. Let's just get started. Okay. So, you know, Square went public, obviously, yesterday and created all kinds of news. And, you know, but just to recap and then we're going to go in detail, right, I think the thing that kind of got people excited about the deal was you have an IPO that prices at a price that's below where the last private round, it also happened to have this, you know, feature. that we've all talked about before, which is this concept of a ratchet, meaning, you know, in basic terms that the kind of investors who came into that last private round essentially got the price reset as part of this IPO. So when you think about kind of the more meta question, which is you've

got valuations in the private market, and then you've got obviously kind of, you know, this at least initial day of reckoning that comes in the form of an IPO and you therefore have your first public price, what are the differences between the two and what if it all explains how you might find potentially private investors thinking about how to value a company differently than a public investor? I think the first place to start would be that public investors aren't actually anchoring themselves on previous rounds of valuation, and they don't have visibility into what the business looked like at those points in time, and also what the business forecast looked like at that point in time. So when you do an IPO, the company has gone through and very carefully taking a look

at the business on a go forward basis and crafted a looking forward view of the business that they're sharing with investors through their underwriting syndicate about what the business is going to look like. And there's a lot of analysis that goes into it from an investor point of view of what is the business going to look like and people take views on, you know, is there additional upside? Is there less upside? What do we think about the TAM? Tons of analysis. And those investors go through their investment committees and make a decision about are we going to participate? at what level are we going to participate and what is the price at which we'll participate? Nicole, is there some kind of formula that those investors can apply?

I mean, I know there's variables that contribute to the decision making for how you arrive at that, you know, that multiple that you come up with in the end. But how is there like a formula? Like, why is there so much of a difference? Like, why do people, I really want to get to the bottom of this? That's a great point. And probably the reason why it's such an interesting debate for this IPO, because there is no formula.

And there was a wide range of understanding. a wide range of beliefs among investors on even how square should be valued from valuation framework. Should it be a revenue multiple? Should people take a look at EBITDA multiple? And if you're going to look at EBITDA multiple, how many years out do you have to look at? And what is the actual margin you think about in terms of what the EBITDA margin might be on a mature business? But those are numbers.

So why isn't that an objective fact? Well, because people look at those, even those three valuation methodologies that I brought up, different people relied on one versus the other, some dismissed entire valuation methodologies from their thinking. And so you have investors coming in saying, okay, well, I'm only valuing the business on revenue multiple. Oh, I'm only valuing the business on DCF. I'm only valuing the business on EBITDA.

And so given those varied viewpoints, different people are coming to the table with a different view on A, where the IPO should price, and B, where it's going to trade in the days after it goes public. I think to me there's also, and Nicole, you're close, through this and I, but there's another interesting thing, at least very specific to the square deal, which is there's almost kind of two businesses that people have to think about,

right? There's kind of the core business they have today, which is effectively the transaction processing business, which maybe is, maybe that's not the right term of art, but the basic, the large bulk of their revenue today comes from largely that business. There's then kind of the very nation business, but, you know, my expectation is probably the business that people are excited about, which is, are their value added services or other things that they can put on top of that business that really kind of, quite frankly, create both a larger competitive bearer and also probably margin expansion for the company today. So do you think, you know, that kind of issue of kind of relative maturity between the two business models also impacts how investors think

about the deal? Absolutely. And I think that's actually the broader debate that investors were grappling with in this particular IPO. So do we value the company as a payments business? And that's where the majority of the revenues have come from. Or do they get a premium multiple for being a software and data platform for businesses? And really, you know, when you think about the company, that is what their future is, and that's where the growth opportunity is. But today, looking at the business, that represents a relatively small proportion of their revenues. And so the question is, you know, how much are investors going to be able to get comfortable leaning forward into a premium valuation that looks at the company as a software and data platform for business? And how much

are they going to be more conservative and value it more as a payments business? And I think what we saw is that folks, at the end of the day, everyone had their debates. People came to the table with different ways of it analyzing the business and their different viewpoints. And I think what one is something that reflects what's in the numbers today. And that is a primarily a payments business. So is that a judgment then on the earlier private valuation? Because I really want to contrast this with what's happening in the stuff that happens before a company becomes public. Like is it saying like, well, all you guys were wrong? I don't think so. I think what it does say is that public investors in this market are very discriminating. Before I give you,

you credit for a software and data business, I want to see that reflected in your revenues, and I want to see the growth there, and I want to see the proof points. So I think if you have a situation where you're coming to the table with a significant percentage of your revenues actually coming from software and data, and you can see it, you can see it in the financial statements, you can see it in the prospectus. That makes it a completely different conversation. I think we need to then better understand how private valuations happen and what factors contribute to that. I think you're exactly right. And I think that is a little bit of the potential difference between how a private investor and a public investor might look at this, right? So the private

investment thesis, I would have expected, you know, for most of the private investors who came into square was much more the software platform business, kind of this, you know, much broader and bigger vision. And that's largely just a function of how, you know, venture capitalists in general are looking for what are tremendously large standalone breakthrough ideas that certainly can have large kind of competitive scale and competitive mode, you know, at maturity. And so I think maybe that, I agree with you. I think maybe that may have been the difference. And it was, you know, I would look back to maybe Splunk is, I don't know if it's a different type of company, but, you know, when Splunk went public, they were in this transition from kind of a perpetual license

business to a recurring revenue business. And there was, in many cases, there was a bait as to, you know, what kind of forward credit would they get. My belief, at least when I looked at that deal was, I think there was enough kind of traction and enough data points that suggested this transition into the recurring revenue business was making more progress that I think is partly why, in that case, the public investors, you know, kind of were willing to give them more. forward credit than perhaps when you looked at kind of the raw P&L of Square is in terms of kind of the balance of those two businesses. I don't know if that's a good example or not, but there's probably others that are similar fashion. I think that's a great example. That was also one where

they were out evangelizing in the marketplace about a new type of market that did not exist before. And they had to get investors to suspend disbelief for a minute about a market that they understood that was smaller and the market that Splunk was going into, which was not known. It was something that they really created. And they did a really great job of convincing investors that they were headed into a much larger market than just logging. So they did a great job. Another thing that I would overlay, though, is market conditions. And so we are in more risk off markets.

And we are seeing investors want to participate a little bit less in IPOs in general than we saw during the time that Splunk went public. And so that is going to, on the spectrum of risk off to leaning for, forward into disruptive areas, I would say investors right now are a little bit more risk off. And so they're giving even less credit to a small portion of the business that is software and database. And isn't there sort of a cash 22 here where there's also, you tend to give someone a little bit more of a premium when they're more experienced CFO or more a seasoned CEO. And that's not a judgment on any of the players involved. But it seems like the market is saying, like if it's a serial entrepreneur who's already done like 10 companies and a CFO who's

taking five companies public, we're going to give them higher trust because they need to have a track record in a history. I would take a little bit of more nuanced view of it, which is I do think that it may have been in the case of Square that kind of this dual CEO role for Jack Dorsey might have had some impact on, you know, to kind of the earlier point, just, you know, how much forward credit do we want to give to the company and do we believe that, you know, this company has his full attention therefore to kind of be able to assign that forward credit? So it's possible that that may have impacted some of how the thinking was on their willingness to kind of give forward credit here. So that's actually the point that I think is really salient to me because, again, coming at

as someone very new to the VC world and to finance, I don't have an MBA background, this idea of forward credit, I think that's exactly the crux of the matter because this, when you think about something that's already proven and already working, not that it's not any less proven, of course, but there's different ways of looking at it when there's an existing market. There seems to be a way to give people that forward credit. But when you don't already have that framework, you've got to see. how things play out after the IPO and as a company continues performing to its quarterly numbers to then assign that to prove that credit.

That's exactly right. And I think that is why people continue to look at the IPO as an indicator of the health of the market because investors, again, in a risk-off environment are going to give less credit to the forecast models. And particularly, you know, when, again, when the proof points are not borne out in the numbers in environments where investors are more confident, they're going to lean forward. And they're going to say that the forecast model is actually conservative. And we actually think that the company can do better. And that's where you see valuations rise up significantly after an IPO because investors are leaning forward and saying, okay, the models has 50% growth. But we actually think it's 70% growth. And that's what the

market calls whisper numbers. Got it. Okay. So actually then just to help us kind of understand some of this terminology, like it seems like an art and a dance and a game. Like there's like these videos that are produced on the IPO road show. You guys. you're talking about whether they're highly produced or how they all look and whether you like the video or not, which honestly I'm kind of laughing about because I'm like, are you freaking kidding me? Investors are making decisions about a company based on a video? Like this is part of like what I was thinking. But that said, what are, can you quickly do a lightning round around some of the terms like the pop? Let's start with the pop. What is that? Sure. So the IPO pop, I'm putting quotation marks with my hands, refers to the. Or the sarcastic hand quotations by the way. Yes, because it's more of a media term. And in the industry, when you're a finance person, you don't necessarily like to say pop necessarily. Okay, we don't like that word then. It's the amount that the IPO appreciates after the price in the first day, generally.

And so we saw with Square, it closed 45% up from the initial IPO price, which is the price it gets the night before. It actually prices with that group of investors that are in the book. So there's a lot of discussion in the media about the price. pop because that's what people pay attention to to sort of give a first judge of whether or not an IPO was successful or not. Google started at $8 and close a day at $300, like that kind of thing. Exactly. Okay.

Now, the irony, of course, of it, as Nicole knows from having been a practitioner in this area, is, you know, too little a pop and people say, wow, that was a bad IPO too much. And everybody says, which, you know, I'm reading today in the paper is about Square, is, gee, they left all this money on the table, right? Meaning that if the investor demand was really at 1350 or wherever it closed yesterday, why didn't the underwriters, you know, price it at, you know, 1250 or something, and therefore, you know, Square would have had more proceeds from the sale of those same deal. So it's very much a, you know, I'm not sure you can win. I'm not sure you can ever win on this one, quite frankly, but, you know, for better or worse, momentum does matter in the market.

So, you know, all things being equal, you do want to leave some money on the table so that actually the initial trading out of the gate is positive as opposed to. Right. You know, we had a recent deal, not that long ago, pure storage, right? where that came out probably about a month ago now, where it priced and then immediately traded down on the first day, right? So it is, but it is often this dance between, you know, the underwriters trying to make sure there's enough room there and the company and the CFO in particular saying, gee, this is a capital raising event for me, obviously. So I want to kind of maximize the proceeds that I can bring in. Right. And isn't that very point of going public to kind of have, if there's a perfectly symmetrical formula where you could perfectly price it like the underwriters and then the market prices it a certain way, there's just. no opportunity to create that value. That's exactly right. You want to create, you're going into an open

market and you want to create a market. And for there to be a market, there have to be buyers and sellers. And when you go in and you price an IPO, you have very candid conversations with investors about what price will they buy in initially in the IPO. And in the aftermarket, what prices will they continue to buy in the market? And so you want to set up a situation where you still have people the next day who are going to want to buy and you know you have people who are going to want to sell. And that's what creates the appreciation. And to your earlier point about momentum, when it gets going and you see that people are actually buying, more people want to jump in and continue to buy. And that's why you have IPOs, the pop, go well above the conventional 25 to 30 percent that investors

like to see. Got it. Okay. So let's talk about the beaten race, which I heard about that term for the first time yesterday when Jamie was explaining it to me when I was like, tell me, help me get to the bottom of this. So this goes back to what we were talking about earlier with respect to how much you believe the forecast numbers. So you want to set up your numbers as a company when you're going public such that you will be able to beat them in the market. So every quarter when you come out and you announce your financials, the market is going to react to whether or not you exceeded expectations or if you came in below expectations. So that's the beat part of beat and raise. You want to be on the side where you're beating your forecast financials because that builds credibility in the

market. And then if you want to actually exceed expectations even further, it's great if you can then raise your forecast financials even further. So you're basically telling the market is a very bullish signal. You're telling the market that not only did we beat our expectations, but we think we're going to do even better than expected in the next quarter, there's a lot of acceleration and growth in the business. And that's what people like to say. Right. Just to take people back. So the process of going public, right, which Nicole is very familiar with is the company kind of spends a lot of time meeting with the research analysts and the banking teams from the various underwriters. And so you can almost think about it as it's kind of, they're almost best.

backward solving in some respects a financial model, right? So they're saying, look, we think this is, you know, realistically, we might be able to get here, you know, maybe it's 100% growth year over year, but in order to be able to do this consecutive exceeding expectations on a quarterly basis and then increasing our forward-looking guidance, you're kind of then, you know, ratcheting that number down. And that's a different kind of ratchet than we're going to talk about. Probably the wrong word to use in this case, but actually that's fair. You're reducing the numbers that you're going to kind of put out there as kind of the benchmark and with the expectation, hopefully, that the business performs as you would expect.

So this actually does brag a broader question, which I would really love to hear your insights on, which is the broader theme, putting aside what's happening with what's yesterday's news and even some of the other recent IPOs. What is, like, I also hate when people say, public is in your private and private isn't you public and they have these sort of religious debates about it. Let's actually get to the bottom of it. Like, first of all, like, how do we define public and private just to be really obvious? And secondly, why does it matter?

Like, why does a company need to do this if they have to do all this backwards? solving when in fact they could just get capital staying private. Yeah. Yeah. Public still is the new public, which means, you know, going public is actually this process that Square went through yesterday, which is becoming, you know, creating a liquid market for your stock, taking on, you know, all the obligations on that that entails. So things like Sarbanes-Oxley and Reg FD and all the various other reporting requirements, you know, filing quarterly and, you know, annual statements. So that still is the real public and there's no such thing in the private market, quite frankly, even if you take money from Fidelity or somebody else that equates to that.

I think the biggest thing, if you think about why companies go public, right, in the old days, right, before we used to have kind of a lot of this later stage private capital, you went public, number one, primarily to raise capital because you couldn't otherwise do so. It was often a branding event for companies, too, as well, to do this stuff. And then importantly, also, you were creating liquidity, a trading market for your stock, and often that meant for employees and potential investors. And then fourth, which I still think is very important for companies, is if you want to be able to make acquisitions, it's still much easier to make acquisitions as a public company. And the reason for that is because you at least get a report card every day about what the price of your company is worth, right?

And in the private markets, when we do acquisitions, we have to fight about two prices, right? Like, what's my price and what's your price? And we have to kind of figure out the relative valuations. We don't have that marker. So I think what's happened, the biggest thing that's changed, right, the new public thing that has changed is branding events really, you know, people can achieve through, either social media or other things like brand of these companies exist in the private markets, almost as well as they do in the public markets. The idea of capital raising, as we've talked about, right, you know, is a lesser-relivenous. There is capital available. So I still think the reason

to go public ultimately for these companies are largely to create a liquid trading market for employees and other people to be able to get some liquidity, and then for acquisitions. And then there's probably a side case, which is there are certain companies probably in the enterprise space who sell to large companies where there's an implied stability. that comes from being public, right? So the fact that if I buy from you as my vendor, I can go look at your financials every day or I can go look at your stock price,

there are still some industries where that matters and that kind of public almost stamp of approval does help from a sales perspective. That's obviously less true for these consumer-facing companies, but that's certainly still another area. I would just add that the discipline of being part of the public markets and the scrutiny from investors and people really getting on these quarterly calls and asking where the growth is going to come from,

maybe a driver for companies to maybe do things a little faster than they ordinarily would do in the private markets because of the scrutiny and the need to grow every single quarter. So but isn't part of the problem that that's very scrutiny can sometimes keep you very focus on the short termism that you can't really build an innovative new thing, particularly in categories where you're creating a new category. So how do we how do companies navigate that? Yeah. So I think that's right. I think there's two there's two things at least for us that counsel in favor of staying private longer. if you have availability to capital, right? So let's assume that you could, you know, all other things be equal to raise capital at the same rate that you could in the private markets. One is, and we've talked to this before, so we won't want to detail. But in the capital markets today, if you are a small cap company, so let's say you're a $500 million market cap, it's a very lonely place to be because you don't have a lot of research analysts, which are people who kind of cover the stock.

You don't have a lot of sales and trading people who kind of create markets for the stock. So in general, kind of our bias for our companies is, look, you want to get to a certain minimum. size, and typically that's probably a billion-dollar plus of market cap where you're going to have enough heft that the institutional community is actually going to pay attention to you in the first place. And then I think the second reason is exactly what you described, which is the scrutiny is greater, which means if you have things that are still highly unproven and you have investments you want to make that are significant or you have variability of your revenue or earnings that is

not quite at the level of predictability that you'd like, it's much better to do those things in the private markets where the quarter-over-quarter scrutiny that you're going to realize is just nowhere near equivalent to kind of the daily report card, of course, that you get in the form of stock price in the public markets. So, okay, so one question I have then is we do obviously talk about companies staying private longer. It's not just a longevity thing. It's actually about new players coming into the ecosystem, which is actually a very good thing. A lot of late-stage investors who previously would have found their returns in public companies who are now investing in private companies and have very different

frameworks for analyzing those companies. And this is why I think it's really fascinating, because when you map the arc out from a public to a private company, you have the very early stage investors who value it a certain way. Then you have this sort of mid-range who are taking a very different framework and valuing. Then you have the public valuations and you have this whole thing happening. I'd like to talk about that and also hear from you on what that means for the ecosystem and then also just in this case how that played out, particularly in the case of the ratchet. So a couple things. And I'm just going to say this in the most crass way I can, which is, you know, people, I really find it very hard to believe when, you know, other, when people talk about fidelity

and others as, you know, dumb money or not knowing what they're doing, right? These are some of the most incredibly sophisticated financial investors there are out there. So what happens is, right, if you think about Square, you know, a set of investors came into Square at the last private round. I forget exactly when that was, and they valued it at roughly $6 billion. They valued it based upon their view as to like what the forward model was at that time, how long it might take to get there, what the market conditions were in the financial markets at the time. And so there are a lot of things that, you know, at some point got them to that number. Now, when you get to where, you know, Square came out yesterday, lots of things

have changed, right? We know the overall financial markets have changed, right? So Nicole talked about kind of risk on versus risk off, which is really just a shorthand for kind of people's appetite for forward-looking risk as opposed to kind of, you know, you're really ticking and tying what's happening today. We know when we look at the public markets, multiples change all the time and stuff. So there's very rational reasons or there's also company-specific reasons. And I don't know this in the square case, but perhaps the timeline on which they told those investors they would get to some of those milestones was different for a variety of reasons. So there's all these things that, you know, cause this to happen. This happens all the time in the public markets. Prices go up and prices go down

in the public markets, and that's, you know, that happens. People get there. The whole idea behind the ratchet, right, was these guys said, look, we're not exactly sure if $6 billion is the right price. We think that's the right price based on what we know, but look, market conditions could change, other things could happen. So we want some form of protection. And the protection that they get is they say, okay, we're pricing it at $6 billion today. But if you do an IPO later that turns out to be at a lower a price, we effectively will get to reprice our stuff as if we had done the deal at that later IPO price. And so the idea is it's a way for them, in many cases, to hedge their downside and say,

look, we recognize there's variability uncertainty in this. This is our best guess as to what it is today. But given that there are macro issues and other things that could impact it, we want to make sure that we get the benefit of some downside protection. VCs, however, don't get that kind of, they don't get that protection. I mean, they tend to not, a lot of the Silicon Valley VCs tend not to introduce that sort of structure into a deal. Yeah. So VCs get a modified form of it. So, right? So there's always this concept of anti-dilution protection, even in the early stage venture capital rights.

And so there is a scenario where, gee, if we price a round at $100 million and then next time they raise it $50 million, we get some protection. The difference between what VCs typically get and what is known as a ratchet is almost a dollar-for-dollar protection, meaning literally, if you invested at $100 and the next price is 50, it's as if you had invested in $50 is how we're going treat your stuff. In the typical anti-dilusion clause that I measure capital guess, they will get some kind of protection there, but it's usually kind of, you know, a certain percentage is how the math tends to work out. So they don't kind of get all the way dollar for dollar production. Right. So to me, it's just like basically a framework for how do you basically, when you're coming in very

early, you take on a lot more risk, but you also get a lot more return as a result. And the flip side of this, you're coming a little bit later. You may not get that same return, but so you have to kind of find other ways of not controlling for that risk, but to sort of offset things. The way to think about it is there's kind of price and then there are these other elements of structure. And in some respects, you can solve for one or the other or some combination of the two, right? And what you see oftentimes, and, you know, as much as it's talked about, by the way, I think Fenwick and West came out with the report yesterday that it's only about 30% of the deals actually that have this ratchet in it. So it's not, we've all kind of convinced ourselves that,

you know, this is the new, new, but it's not really the case. It's not really than you knew. But, you know, arguably, you could, you know, it could be a situation where you say, gee, I'm going to raise money at a billion dollars with a ratchet. Or maybe if I go back to that investor and say, you know what, I don't like that ratchet, he'll come back and say, you know what, I'll price it at $700 million today on a clean deal with no ratchet. So there are always optimizations you can make. In this case, Square, you know, whether rightly or wrongly, that was kind of their decision.

They decided to go with the $6 billion with the structure. But there are also many companies where, you know, they may also rationally make the decision that we'd rather have a deal that doesn't have structure, albeit at a potentially lower price. That's great. Well, thank you, Cooper. I know you have to run to lunch. So given that this is in the spirit of the hallway conversations, we're bringing in now Steve McDermid, who's also on the corporate development team with Nicole. And Steve, what we've been talking about is this arc of how you have a private valuation that happens in the very early phase, and then you have later stage investors come in and you have, you know, at every round, there's a new

valuation. And then at the public, when a company goes public, there's a public valuation. And the thing that I'm trying to get to the bottom of in this podcast is if there's a formula or a way to analyze the difference between a private and a public valuation, like why do people say, for example, and I've seen a lot of really smart people share recently, especially in the context of yesterday's IPO, like, how come it doesn't match the private valuation and the public? And Nicole has already shared some of the broader factors as well as some of the specific factors that go into this. What I'm really interested in hearing from you is how do you actually value a private company? Like, why isn't there a single formula? It would make life a lot easier for what there was a single formula. Unfortunately, it's more art than science. And one of the things that is interesting here is that everyone's got different opinions.

And the vast majority of these investors in this market are all really sophisticated. They're making decisions and investing based on years of experience and their own views of the future. And those decisions are informed based on past pattern recognition and all sorts of other inputs. The unfortunate thing is there's just not. a formula. They draw in some of the same fundamental techniques that public investors do in terms of looking at future cash flows and revenue multiples and EBITDA multiples. But ultimately, it's informed by their view of where this specific company is going. And what it ultimately comes back to is, you know, this concept of art versus science. And it's really on the private side, more so than

the public side, is the art is a heavier component of that analysis. I agree with Steve's comments that it's a mix of art versus science, and definitely science weighs in a little bit more heavily on the public markets, but we shouldn't also discount the art. And part of that art, I would say a subcomponent, is momentum as well. And so investors will notice what other investors are doing, and once momentum is created in the stock, that actually drives valuation as well. And so you can't discount the art on the public side either. One of the things that makes valuations on the private side, particularly challenging, is the fact that some of these companies are growing at incredibly fast rates. When you look across the public landscape, you're growing at 50 plus percent

puts you in the very top tier of public companies. We see private companies that can be growing at 100, 200, 300, even 400 percent. And it's really hard to think about what that means for the future in terms of how long you can sustain that growth, which just makes it really challenging to think about the future for some of these companies because the growth is at such a steep curve. So, okay, so in that case, because I really still want a formula, God damn it. Can you guys at least tell me then what variables go into the decision making and how they might vary, no pun intended, with both the public and the private valuations? Yeah, so, I mean, the way most investors think about the, you know, the ingredients of the formula that you're referring to are growth rate, the overall market size that they're addressing, the unit level economics, you know, for the majority of these private companies. they're not profitable on a net income basis.

Some may be profitable on an EBITDA basis. But really, they're looking at the profitability on a unit level basis and what that means as you start to look out two, three, four years and look at profitability on an overall basis at that point. So really one of the very big differences that private investors think about is looking out over a much longer term time horizon to look at a normal steady state business versus public investors that may look out 12, 18, maybe 24 months in some of the most aggressive situations a little bit longer than that.

Whereas private investors generally have to look out a little bit further than that to try to see what a steady state looks like. But in terms of going back to the ingredients, you know, they're looking at a balance between growth, profitability, market size. And then you have to think about all the other more intangible elements like barriers to entry, defensibility of the model, competitive landscape. there's all sorts of other qualitative assessments that go in. And the reason, you know, there's differences of opinion is these aren't easy questions to answer. If these questions were easy to answer, you'd have a specific price and everyone would agree on it. And there would be no questions and there would be no debate. And there'd be no market. Yeah. That's right. So I would absolutely agree with the framework, Steve, that you laid out in terms of valuation. Actually, they are the

same elements that public investors look at largely. It's just a matter of a shorter term. Why is it shorter term because you can have a higher degree of confidence that those shorter term projections can actually be achieved. Do public investors have the same variance in how much they agree or disagree with those numbers? Because it seems like private investors, it could depend on what VC firm you're going to and what mindset they have. And of course, that's the whole point of having diverse VCs and different people coming in at different rounds. But like, is there like a standard deviation? Like, is there a way to make sense of that? There can be. I think it really, again, depends on the name. And I think that's why everyone is very fascinated by the Square IPO, because in this instance, there was a broad variation in viewpoints on what the business is going to look like in 12 months. What is the business going to look like in 18 months?

Again, tacking back to what we were talking about earlier around the debate of payments versus software and data. And so I do think that in this instance, there was a broad variation. And we will continue to see that quarter after quarter in the way that the company performs and also how it trades. Speaking of earlier, you actually mentioned three specific methods. You mentioned revenue multiples, EBITDA multiples, or DCF. And so if you could actually break those methods down for us, and also what is DCF? What does that stand for? So discounted. Oh, cash flow, of course.

Yes, discounted cash flow. Right, okay. So, okay, so revenue multiples and EBITDA multiples, I should sort of just set it up are actually shorthand ways of doing a DCF anyway. And so a lot of people will look at revenue multiples because, frankly, it's shorthand. It's a little bit easier. and they want to use those when a company actually does not have profitability or does not have EBITDA. And so in most cases, most technology IPOs these days are valued based on revenue multiples.

In this instance, most payment companies, though, are valued based on EBITDA multiples. And that's why there's a temptation and a need to do some analysis actually to check your revenue multiple valuation by looking at EBITDA multiples. But because there was no EBITDA in this case, folks had to take a view on what. what are the EBITDA multiples in a fully mature business for Square? So those are the multiples valuations. And then on the discounted cash flow, I mean, that's the fundamental way to value any company, right? What is the value of a company? It's a value of their forward cash flows.

But the problem with DCF is that you then, again, get a wide variation of viewpoints on what is the revenue growth going to be, what are the margins going to be over those years, what should the discount rate be? and all of those things in combination can give you a wide variation on the answer from a DCF valuation perspective. What's interesting there is you think about some of these hypergrowth companies that are investing in growth, there are no near-term cash flows. So when you start to sum up all those future cash flows, all the value is derived at some point far out in the future. You know, the most extreme example of that is Amazon, which has a tremendous amount of cash flow. And as we've seen from some of the analysis that Benedict's done in the past, it's often difficult to people.

back the onion to identify where those cash flows are actually hidden. We've been fortunate to see a little bit of that in the Amazon's expanded disclosure of AWS. But it's just a challenging situation to really think about these cash flows for these hypergrowth companies. So how does that play out then, Steve, in the private valuations and when you're thinking about this, because one of the big things we always talk about, is an internal debate, an external debate. It's about the tradeoff and the balancing act. It's almost a dance between growth and profitability. And so how do we sort of navigate that, especially when you're talking about a private company?

Yeah, I think it goes back to a little bit what we talked about before. I think you got to think about what the unit level economics are. And what I mean by that is, what are the profitability metrics on each marginal unit? And if you're investing in positive profitability on a unit level basis, that's one thing versus the other. And I think that starts to think about, you know, what is competitive positioning? Are you in a commoditized market? Do you have network effects? Network effects.

Which is protective. Exactly. So there's a lot of ingredients there that unfortunately there's just no specific answers for and you have to at some level make a leap of faith and you're making assumptions and behind what you believe or where you believe the world is going. How does this play out with specific categories? And I'd like to hear about the evolution of this because SaaS is relatively new for example, software's a service.

And part of the whole way the accounting rules are and the way SaaS models are valued, and we published a primer in this last year, they're not always in sync. And so I'm curious about how that plays out with categories of businesses like that. Steve, and also, Nicole, I'm curious to hear your thoughts on how the early days of SaaS were and how we stand now with how the market views SaaS companies. The way I would answer that is not all revenue is created equal in the sense that if you have contractual revenue that gives you a certain amount of visibility and predictability to that revenue, that's worth more than revenue that is not contracted, that, you know, can be based on some other

elements. So when you think about SaaS companies, one of the reasons they're more valuable, at least on a revenue basis, is that revenue is generally contracted and predictable and you've got recurring and get visibility behind it. So on a dollar for dollar of revenue, that, you know, is just a higher quality revenue. The markets understand the SaaS business model a lot more these days than they did earlier in 2004 when you had some of the very first SaaS IPOs coming to market, the success factors of the world,

who really had to pave the way. And for the first time, describe in their prospectus what their business model was, describe where the revenue streams were coming from and how it actually works. I think now people have muscle memory around SaaS companies, and frankly, people really like the recurring revenue aspect. and the growth in a recurring revenue model is very high quality and it's very predictable

and that's what everyone likes. They also understand the rest of the P&L a lot better. So when you're spending dollar for dollar, what you're spending on a sales and marketing perspective, people understand how that turns into revenue in the future and they can much more easily get comfortable with margin losses in a business early stage because they understand how that evolution happens over time. We're still talking about some, like, you know, we talked about the pop, which is like the day of and it opened on this number and ended on this number. But honestly, like, the whole point

of this, as we talked about, is to have this discipline to get this capital and all these other factors about company going public. How does this evolve over time in the long term? Like, how do we view what's going to happen next? I don't mean this in the specific case, but just more broadly when an IPO happens. My view of this, particularly in the context of square, is it's a financing event. You know, they've got growth opportunities in front of them that they want to invest in. And this was an opportunity for them to raise capital and use that cash to invest in. invest in growth. To evaluate the quality of an IPO based on whether it priced above or below the range, whether it had a pop on day one is largely meaningless. The float that was sold here is sub 10%.

So it's a very small percentage of shares. You can't really evaluate an IPO until you start to get clear of the lockup period, you know, when there's an opportunity to have all the insiders sell. And at that point, you'll have a couple of quarters under their belt to see their performance. And it's really at that point that you can start evaluating the quality of an IPO and you've really got some normalized performance. The key question is, do these companies, are they setting up, setting themselves up for success as they execute? So have they set the foundation among public investors at large about what the business is about and what the growth opportunities are? And have they set them up to actually understand the performance of the company on a quarter by quarter basis? Would they come back out to discuss?

Okay, here's how we did this quarter. or do people have the basis of understanding to really evaluate that and take a view on whether that was good or, you know, what that was relative to their original investment thesis? And so that's the seasoning that Steve is talking about in the first year of the company, quarter after quarter, as they execute on the information that they gave to the market. What about if market conditions change, though? I mean, this is not like a static thing we're talking about, like this company that's evolving in this very linear manner.

I mean, there's clearly a chicken egg thing here as well, isn't there? Helping investors really understand the first. fundamentals of the business is going to help you weather through those ups and downs in the market and help you continue the conversation in a helpful way. The only day that you know who your investors are are the evening that you price your IPO. The next day, after the first trade, you have new individuals coming into the stock and you already don't know those people as well. And the degree to which you've educated that group of public investors, you're going to reap awards for that as you continue to prosecute into the markets and discuss.

how the company's results on a quarterly basis. I don't want to focus only on Square. This is just recently in the news. So it was top of mind and really want to get to the bottom of this question and my desire for a formula, which I get it now. But can we talk about some of the other recent things, just kind of put it in broader context? Like how does this compare? And then also, actually, more broadly speaking, what is this sign of a successful IPO? Like, how does that, how do the mechanics of that work?

So this is one of the busier weeks for IPOs, actually, when Square came out. So the same evening that Square priced its IPO, we also had Match Group price their IPO. And then the following day, we had Mimecast pricing their IPO. And I'm speaking broadly to the tech space specifically. And I would say largely it was a successful week for IPO. So people get a little bit hung up on the fact that, you know, Square was $2 below, the indicated range on the cover, and where companies priced within that range. But I would call it a successful week for IPOs simply because of the trading activity.

It seems to indicate that the model is worth. investors are in the markets, buying, buying shares and selling shares and creating appreciation in the companies in the aftermarket. Yeah, I guess, you know, one of the things I think about is what this means for the future. You know, given the quality of performance this week, I think we're going to see more IPO activity. Atlasian is likely the next one to attempt an IPO. And I think you're likely to see more in 2016. So I think this is ultimately a good sign for,

for where the IPO markets are going. Okay. So then how do you guys define now the success or failure of an IPO? Like how do you make decisions about that? And can we talk about the specific example of Square? Just to kind of wrap up because that's top of mind. Yeah. So again, I think if you think about Square, the principal objective was to raise capital.

And they achieved that objective. And they put themselves in a position, in my opinion, for long-term success. if you look back at the investors in every single round of private, as well as in the IPO, they all made money. There's some great coverage in Bloomberg that articulated how all that worked. And ultimately, the test is going to become on their first earnings call. Have they outperformed what they've told investors or where they set expectations with investors? And that's going to continue on their second earnings call.

And I think at that point, you're going to be able to determine whether it was a success or failure. But is it fair to make that decision in the first earnings call? like can't we buy them a little bit of time? Yeah. So yeah, my view is it takes a couple earnings calls and you have to get on the other side of the lockup release. What's a lockup release? What is a lockup in general? So at the time of an IPO, the underwriters request that the investors in the company not trade their shares for a period of usually about 180 days from the time of the IPO. And the reasoning behind that is because that's a seasoning period for the company. So give them a couple quarters to release earnings and allow the stakeholders.

to season a little bit before you have an influx of additional float. And so it's to help reduce volatility in the trading of the stock and let the company continue to cede the market with results on the back of their IPO. How do we kind of make sense of this in the broader context of IPOs in general? I mean, there's a lot of headlines right now about the Square's IPO and what it means. And I just really want to hear your thoughts on how we make sense of it all to kind of close up. Absolutely. And, you know, I think that's one of the things people love to talk about is, you know, is the square IPO going to determine the success of all tech IPOs? It's really important to think about the IPO market at large and appetite for investing in IPOs,

but you can't really divorce that completely to the fundamentals of each business that decides to embark on an IPO. And investors are going to look at each individual business and come to a view based on the merits of those individual businesses relative to their risk tolerance and their belief in a particular industry sector. So I think we will continue to see in the future, and we should continue to see. When you get away from that, that's when you actually get true bubbles, when people aren't tacking back to the fundamentals of the business and doing the work and doing the analysis. So I think we will continue to see discerning markets where investors will take a viewpoint on various businesses and the success of those businesses over time. The way I think about it is just it's different markets to secure capital. And there's just a different subset of investors that happen to play in one versus the other.

some plan both. But really, all this is about is raising capital to continue to execute against your goals and objectives. And really, the idea is, you know, it's a belief we have here is good companies can get funded in pretty much any market. If they're good fundamentally sound businesses, they can get, they can raise capital in the private markets, they can raise capital in the public markets. You know, investors want to invest in good businesses. And that's the takeaway I have from all of this is as you start to look at the fundamentals as Nicole, was talking about, that's really the most important piece. I think that's actually really helpful, you guys, because I think the thing that I hate

when we get caught up in these, like, these debates about public is a new private and private is a new public and sometimes descending into that religious war misses a deeper underlying point, which is it's all about building a good, healthy business. And getting the capital is about doing that and having the metrics and the right unit economics is about driving towards a good, healthy business. That's like long lasting and sustainable and valuable. So I think It's great to hear your perspective on this, both in the context of the square IPO and more broadly, how to make sense of it all. Thank you, guys. Thank you.