I had lunch a few weeks ago with Eric McAlpine, a Managing Director and co-founder of Blackstone’s Technology Advisory Group based in Menlo Park, CA (we share the same building on Sand Hill Rd.). Eric is focused on advising public and private technology companies on M&A and capital raising, so he sees a ton of great companies.
We got to talking about what drives ultimate valuation – in the public markets and in M&A scenarios, and Eric showed me a presentation he often uses with clients with an analysis of technology IPOs from the beginning of 2010 through present. I particularly liked Eric’s explanation of what he calls “Rare Air,” and I like it for the same reason I like Bill Gurley’s post a few months ago titled “All Revenue is Not Created Equal” – it simply and succinctly explains why certain companies are valued more highly than others in an IPO and over the long run as public companies. I’ve got a screen shot of Eric’s “Rare Air” slide below, and you can view the whole presentation on SlideShare (click here).
JR: Love the presentation and the concept of “Rare Air” – can you explain it in layman’s terms?
EM: It’s pretty simple. Valuation in Tech is driven by growth. Approximately 80% of public sector valuation revenue multiples can be attributed to a company’s growth rate and there’s an over 90% correlation between earnings multiples and earnings growth. Beyond growth, important factors are things like sector leadership, long term margins at scale, and operating history. One of the reasons we are seeing companies in the Internet space come to market with “Rare Air” valuations – LinkedIn is the best example, while Pandora and FusionIO are “Knocking on the Door” and Zynga and Groupon are in the wings – is they have a very solid mix of these basic components – though both Zynga and Groupon have shorter operating histories than LinkedIn and Pandora. There’s also a great deal of scarcity value – there aren’t very many companies like this. As a result, there is strong demand and they trade at a premium to their peers. Combine this shortage with the fact that growth has slowed in the public markets for Tech to around 10% overall, while the median Tech IPO since 2010 is growing at a median of 26% year over year, and an average of 38% (sample size of 51).
JR: Talk about longevity. Both LinkedIn and Pandora have been around for a while – 10+ years.
EM: Longevity builds an impression in investors’ minds that “these companies aren’t going anywhere.” Both are companies that have been through both good markets and bad markets – and not only survived but thrived. An institutional holder of the stock may see ups and downs, but these kinds of companies are unlikely to go out of business in 12 months. Which sounds funny, but it did happen back in the 2000 bubble. Could it happen again? Longevity + track record lowers the risk profile.
JR: I guess a lot of people I speak with who can’t understand the valuations on these companies ask “But they’re not profitable?!?!?” How do you respond to that?
EM: Amazon wasn’t profitable when it went public either. And you’d loved to have bet the farm on that one 5 years ago (Amazon recently crossed $100B in market value). The key is finding companies that can scale – and achieve a high level of profitability over time. LinkedIn and Pandora are both doing more than $150M in annual revenue with growth rates of more than 100% annually. Investors get comfortable with the valuations by doing a forward projection of how profitable these companies may be at scale – think $500M or $1B in annual revenue – or more. Growing at 100% annually, it won’t take long to get there. What are perhaps harder to understand are the private market valuations for companies with less than $100M in revenue and not a lot of longevity. You can make the argument that the private market is way out in front of the public in terms of valuation and “rare air.” Will we see “IPO downrounds” (where the company goes public at a valuation lower than its last private round)? Could be interesting.
JR: What do companies you meet with do when they get your “Rare Air” chart?
EM: The first thing they do is plot themselves on the chart, of course. It’s humbling. There are a lot of great companies on that chart and it is not an easy feat to break out of “The Pack.” It puts some very basic context around IPO and M&A valuations.
JR: What’s happening on the M&A front?
EM: I’d point to a few trends. One, deals are taking a long time to get done. Boards are increasingly cautious. Two, larger cap players seem to be more interested in transformational deals versus programmatic expansion. They’re willing to play big stakes poker and bet on a larger deal than play lots of hands at the small stakes table. Look at the recent deals by Google for Motorola Mobility and Microsoft for Skype. We aren’t seeing a ton of companies getting acquired after filing an S-1 either – which has often been a way to bring buyers to the table. Third, in the Internet and Software sectors in particular, there just aren’t a lot of buyers. We don’t have a ton of companies with $5-10B+ market caps and cash war chests. That leaves a few large buyers, who don’t generally feel like they need to pay up for a rising star which will become a product line. The deals you do see getting done are the big stakes poker deals – HP/Autonomy, Google/Motorola, Microsoft/Skype, etc.
JR: We’re certainly believers that there is a ton of opportunity for great companies to disrupt massive sectors – cloud, mobile and social come to mind – and are making bets accordingly. You agree?
EM: Absolutely. I think what you’re seeing is the market is already rewarding companies that are hugely disruptive with scale and high growth. Facebook, Zynga, Twitter, Groupon, LivingSocial, Square, etc. These are all companies being valued very highly in the private markets.
Since I interviewed Eric, a few of these companies – notably Groupon – have seen investors question the long-term viability and sustainability of their business model. It will be interesting to see how they do over the next 3-5 years and whether they can sustain the “Rare Air” valuations given to them in the private markets.
Disclaimer: My firm, GGV Capital, is an investor in both Pandora and Square.
EDIT 10/19: Blog post picked up on Fortune/CNNMoney: Click here to read