Henrik Torstensson's Weblog

The number of announced personell reductions at larger US tech firms continue, just in the last day or so with Coinbase cutting 20 % (after cutting 18 % in June 2022), Flexport also cutting 20 % and Carta cutting 10 %.

It is new proof points of the reset many companies are doing, and probably a combination of cutting personell to get better financial results (duh!) and not getting bad press (“as everyone is cutting”).

For high growth tech businesses that have had the focus on revenue growth, there is quite significant difference between a 10 % cut and a 20-30 % cut.

A 10 % cut is in reality mostly a slightly more conservative way of managing overall expenses, and not enough to drive significant improvement to profitability. Profit improvements need to come from relatively significant revenue and gross profit growth.

A 20-30 % cut of all personell has more significant profit impact and combined with other savings measures can take a company closer to profitability alone. Even if some gross profit growth is often needed to.

Adam Schaub and Marcus Jacobs have started Seider, a Stockhom-based games studio, and raised capital from A16Z Games. Video and mobile games is one of the sectors where Stockholm and the wider Nordic ecosystem have real depth from multiple large successes (King, Supercell, Unity and many others). “Standing of the shoulder of giants” is a strength of any ecosystem, and with the giants in the games space I expect many interesting gaming companies to be built in Stockholm going forward.

Games in an area where generative AI can be helpful, e.g. for things like outdoor world generation and creation of graphical assets. It might not be quite as good as AAA-work by specialists, but it can be quite close and probably take costs down 90 % over time for AA/AAA or improve the graphical quality of smaller productions. Which both are very interesting.

Storytel, the audiobook subscription company, has had a bumpy ride on the stock market the last 2 years, especially in 2022 after founder Jonas Tellander left his role as CEO in February 2022.

Founder leaving, somewhat of a reset in the growth/profitability trade-off and crashing tech valuations is an unpleasant combination. Still, the company managed to stay above two million subscribers in Q4 of 2022, of which a little more than half in the Nordic countries.

Two things worth noting:

1. Despite losing subscribers during 2022, Storytel has grown revenue as the average revenue per user has increased
2. Gross profit for non-Nordic countries was 47.3 % in Q3, compared to 41 % in the Nordic countries and the 25 % gross margin Spotify had in that period (across both Premium and ad-supported).

After a startup has grown larger (hopefully $100 million in revenue), a good way for founders and early investors to exit is via a listing on a stock exchange of the company. The overall leaders in this aspect is the Nasdaq and New York Stock Exchange, who really are the only western stock exchanges for very large companies ($10 billion+ in market capitalization) to list.

But for smaller companies there are many local/national stock exchanges to list at, and the Stockholm Stock Exchange and the affiliated First North are two good places for this.

One interesting aspect is when a company is not doing great and gets an acquisition offer to sell all shares and leave the stock exchange. One such example in Stockholm is Readly, a digital magazine service. The company listed in 2021 and have had a tough time growing (ca 30 % growth and significant losses planned for another 1-2 years). Local major publisher Bonnier offered to buy out Readly (as they would likely get economies of scope and a better licensing situation as they are a major magazine publisher), and now we’re seeing at last one major mutual fund (Robur) being against selling.

The main challenge with Readly for me is that founders have left and early investors seem to be willing to sell. That is not unlike TradeDoubler many years ago when they had an offer from AOL, and Swedish mutual funds declined to sell. It will be interesting to see if the result will be the same.

Fred Wilson (partner at USV and long-time blogger) had some good observations in his What will happen in 2023 blog post.

On the new fundraising environment (lower valuations and higher demands on startups to be funded) he writes:

“This new normal will lead to many flat rounds, down rounds, inside rounds, and rounds with a lot of structure on them. None of that is good, but the worst of those options is rounds with a lot of structure. I believe founders and CEOS and Boards should take the pain of a new valuation (flat, down, whatever) over structure.”

Structure (I interpret this as things like tougher terms in Shareholders agreement, additional approval rights, preferential options deals, additional board seats, aggressive preference rights etc) might feel better than a lower valuation initially for a founder, but I agree with Fred. If at all possible (enough money to execute the plan without excessive share dilution) it is better to go with a clean structure and a lower valuation than a complex structure and a slightly higher valuation.

Some very good comments on tech M&A by Rick Sherlund (vice chairman investment banking Bank of America, formerly top tech analyst at Goldman Sachs for 17 years).

The very high valuations in 2020 and 2021 make it hard to find willing sellers, as they see the current valuation (-80%) as too low. Rich points out that fast growing unicorns can get back to the same valuation in dollars as in 2020/2021 in an acquisition offer through high annual revenue growth (50%+), higher margins (after cost cutting), possibly lower US interest rates and bid premium (40%). All in all it sounds like end of 2023 or 2024 to see all that play out, and that if $100 million+ software companies can continue growing fast this year with a likely recession and cost cuts in their sales & marketing organizations.

In 2022 the focus of public market stock valuations went from revenue growth to profitability. This has impacted small and large technology companies, and layoffs started already last year (in Stockholm both Klara and Kry made cuts to their respective organizations). Now a second phase of layoffs are coming with Salesforce, Amazon and Vimeo announcing new layoffs in the last day.

An often used reason for layoffs have been something along the line of “we hired too many people due to the pandemic”. To some extent that is true (especially as the headcount growth from 2020 to 2022 has been 20 %+ at many companies), but the default mode for major tech companies for the last 10 years have been to hire additional staff if that can increase revenue growth.

As the trade off revenue growth/profit has changed, another part of the reason for the headcount cuts is that, for the time being, it is more important to increase profit margins than revenue growth to drive stock valuations. And stock valuations are important not only to shareholders, but to the companies themselves as they are paying staff in restricted stock units and/or options, and if that part of compensation gets cut 50-90 % it will likely impact retention of key employees.

If the founders of a startup manage to build an extraordinary software company that becomes very large (billions of dollars in revenue), at some point the company will be valued in-line with other mature, successful technology companies. Based on observation my rule of thumb that is a price/earnings ratio of circa 20.

The P/E ratio should be adjusted for growth rate, level of profitability, long-term prospects etc. This is not a small thing, especially considering that one of the most noteworthy things of the last 10-15 years is just how fast FAANG companies grew when they already had tens of billion of dollars in revenue.

And for smaller companies that haven’t reached ‘steady-state’ growth and profit margins, the P/E can reasonably be significantly higher both from lower than steady state profit margin and much higher growth.

In the earliest stages of a company’s lifetime, I don’t look at P/E or price/revenue but rather the likelihood (both operationally and funding-wise) of the startup becoming a large company and what characteristics it is likely to have at that point.

Bill Gurley interviewed by McKinsey Quarterly. ‘If you’re going to build something from scratch, this might be as good a time as in a decade’

Starting a startup now is probably better than in late 2021 or 2022.

Many tech companies used EBITDA (Earnings before interest, taxes, depreciation and amortization) or even Adjusted EBITDA as highlighted profitability measures. EBITDA excludes financings costs, taxes, depreciation and amortization and Adjusted EBITDAs exclude a bunch of other costs and generally are all over the place as Adjusted EBITDA is not an official GAAP (Generally Accepted Accounting Principle) measure. Safe to say, neither is a perfect way to measure profitability.

Following accounting principles and laws are one thing, but they alone are not the best tools to understand how valuable a company is or can be.

It is often said that the value of a company is the discounted value of its future cash flows. But neither EBITDA or net profit are actually measures of cash profit. And the often used free cash flow metric is not a GAAP measure, and thus different free cash flow formulas treat e.g. stock-based compensation differently. While stock-based compensation might be “non-cash”, it is an economic cost to current shareholders.

To get a better understanding of a company’s profitability one need to look at multiple measures. Unit economics (non-GAAP), gross margin, EBITDA, EBIT, Net profit, Free cash flow (non-GAAP) etc.

What weight an investor assign to each measure should differ depending on the type of investor. A small private investor in public stocks will view profitability in one way, a private equity fund buying a mature company in another, and a venture capital fund will think about it in a third way. To quote Charlie Munger “It is not supposed to be easy. Anyone who finds it easy is stupid.”