Originally published by Forbes.com.
I found Daniel Lyons’s “Disrupted: My Misadventure in the Start-Up Bubble” irresistible. In case you have not been paying attention, it is the story of a fifty-something veteran journalist trying to adapt to a marketing position in a startup called HubSpot. According to its website HubSpot offers
With our powerful, easy to use, integrated set of applications, businesses can attract, engage, and delight customers by delivering inbound experiences that are relevant, helpful, and personalized. HubSpot is, after all, on a mission to make the world more inbound, one business transformation after another
As best I can tell it is selling a suite of software applications.
HubSpot’s all-in-one marketing software helps you optimize your website to get found by more prospects and convert more of them into leads and paying customers.
I mention that upfront, because even though Lyons alludes to it, it is not real clear as you are reading the book, exactly what it is that HubSpot is selling.
A Funny Book
The book is pretty hilarious. Like when he tells the kids he is working with “You know, you guys are the first generation that’s willing to work for free candy. My generation would never have fallen for that.” Or when he characterizes HubSpot and the concept of being HubSpotty:
A big part of establishing your HubSpottiness involves being relentlessly upbeat and positive. HubSpot is like a corporate version of Up with People, the inspirational singing group from the 1970s, but with a touch of Scientology.
I ended up not having a tremendous amount of sympathy for Lyons. I encountered many of the problems he did as I had a bad culture fit in the waning days of my career and annoyed mysterious powers that be with my on-line presence. I don’t think I whined about it nearly as much, but that’s not what I found really interesting about Disrupted. It was the accounting stuff in there that really grabbed me. Balance sheets and income statements, the stuff of life.
Should You Be Able To Go Public Without Profits?
The important issue that Lyons raises in his book is whether there is a new tech bubble being created with HubSpot being but one example. Bubbles, if not as old as humanity, are at least as old as capitalism. Charles Mackay in Extraordinary Popular Delusions and the Madness of Crowds documented the phenomenon in 1841 including three chapters on money madness. Whenever you hear about things going up in value at an incredible rate and you can’t discern what underlying value there is remember two words “tulip bulbs”.
Lyons had lived through the first tech bubble. Of course, when it was going on, it was not called the “tech bubble”. It was the New Economy. Things like profits and cash flow just weren’t that important anymore. Reflecting on those days Lyons wrote:
During the bubble I felt like a sane person who had been thrown into an asylum. The economics of these companies made no sense. Their valuations were completely irrational. …
Of course the dotcom bubble finally blew up, and I felt a little bit vindicated and even a bit relieved. Now everything would go back to normal. I figured the dotcom bubble had been a historical anomaly akin to the Dutch tulip mania of the seventeenth century, something we would never see again in our lifetime.
The New Bubble – According To Lyons
Lyons sees the new bubble being facilitated not only by a new bunch of very young entrepreneurs who don’t remember the first one, but also by all the cheap money that is floating around. Lyons continues:
Walking around San Francisco, it strikes me that this cannot end well, that the combination of magical thinking, easy money, greedy investors, and amoral founders represents a recipe for disaster.
As he observes the intense sales culture of HubSpot he notes:
By the strange rules of bubble economics, companies do not have to generate a profit before they can go public, but they do have to demonstrate revenue growth.
Particularly ironic is that the HubSpot software product is marketing software.
If our software really does what we claim, why are we working so hard to find new customers? Why do we need an army of sales reps and an army of marketers and an army of consultants?
As an accountant, what intrigues me about all this is that everything seems to boil down to one number on the financial statements. Revenue. If you get the revenue growing fast enough, before you run out of money, the company can go public. One of Lyons’s friends explains it to him this way:
The one thing people do not appreciate is that these companies are incredibly fragile. There is so much less to them than people believe. The difference between success and failure is so much smaller than people recognize. The whole thing is based on companies trying to achieve escape velocity before they run out of money.
Would Warren Buffett Have Bought HubSpot?
Since HubSpot did in fact go public, we are able to look at the numbers to see what Lyons is talking about. You can go to page 34 of the 10-K and see results for the five years 2011-2015. There is impressive revenue growth as (rounded to the nearest million), HubSpot goes from $29 million in 2011 to $182 million in 2015. Meanwhile losses grow starting at $24 million in 2011 and reaching $48 million in 2014. Maybe they turned the corner in 2015 as net loss was “only” $46 million.
This is not the case of the brothers who go out to the country and buy apples for a nickel and bring them to the city and sell them for four cents. HubSpot had a gross profit of $134 million on its $182 million of sales, which amply covers its research and development and general administration costs that total $68 million. The problem is the $112 million in sales and marketing. Year in year out they have spent over sixty cents to get each dollar of revenue, which brings me to Warren Buffett.
One of my favorite reads is Warren Buffett’s annual letter to Berkshire Hathaway shareholders. As a matter of full disclosure, I should tell you that a disproportionate amount of my unimpressive net worth is in BH stock. What I like about his analysis is that he looks at every element of the financial statement including book value and discusses why it needs to be tweaked one way or the other to arrive at “intrinsic value”– which is what he manages for.
Of course “intrinsic value” ends up being a prediction about the future. It is the present value of how much money you will ultimately be able to take out of the enterprise. HubSpot’s book value (assets minus liabilities) was $122 million at 12/31/2015. The latest number I have for market capitalization is $1.46 billion. The difference has to be in that ever growing revenue, which you can see in evaluation of HubSpot’s “intrinsic value”.
This analysis by X-Fin shows that HubSpot has an intrinsic value of $154.88 per share compared to a market price of $43.62 per share. It is based on revenue growth continuing over 50% and not going below 30% until 2023. Operating income does not go positive until 2022, but, according to the model it would be possible to borrow to make distributions.
The analysis of gurufocus, on the other hand, is that HubSpot has an “intrinsic value” of zero or maybe it is $-4.25 per share.
Valuing Based On Revenue
The problem with using one metric, such as revenue, to determine value is that if you are not hands on, the metric can be gamed. Accounting practices will change hands based to a significant extent on revenue, but frequently the payment is over time and only based on retained revenue. There are regulatory restraints that make it very hard for accounting firms to go public, but over the years I observed a perennial debate over whether to focus on top line or bottom line. I was never quite close enough to the inner circle to have much impact.
And of course, a company like HubSpot also has intellectual property that does not show up on its balance sheet, not to mention the supreme HubbySpottiness of its dedicated staff, that Lyons could never seem to fully appreciate.
HubSpot’s Reaction To The Book
Dharmesh Shah, one of the HubSpot founders, reacted to Disrupted with a Linkedin post – Undisrupted: HubSpot’s Reflections on “Disrupted”. Shah notes that even though Lyons was mainly focusing on HubSpot, the book was also a
…broad criticism of the tech industry including companies like Google, Apple Facebook,Twitter, Airbnb, Uber, Box, Salesforce.com, LinkedIn, Amazon and Netflix
As far as the profitability goes
But, Lyons would argue, “You’re not profitable!” He’s right. There’s usually a tradeoff between growth and profitability. We’ve been growing revenues over 50% year over year while simultaneously improving our margins by 12 percentage points in Q4 2015 (non-GAAP). We’ve also begun to generate positive operational cash flow. What we’ve shown, and what investors seem to value, is growth plus a path to profitability.
As a fairly simple minded accountant, I can get that. The thing is that if you are close to even while on the path to profitability, you can afford patience. But if you are posting losses. Well that is like there is something ominous chasing you on your path.
So Read The Book
At any rate, Disrupted is an easy read and very entertaining. So read it. The bubble warning is also worth pondering.