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Deconstructing an 85% Markdown
Sanity is finally coming to private market valuations.
Klarna, a star private fintech company, announced new financing at a 85% discount to its last round in March 2021. Affirm is a close public comp. AFRM stock is down about 83% since last January.
Klarna’s release about the raise stated, “Klarna closes major financing round during worst stock downturn in 50 years.”
Sequoia partner Michael Moritz was quoted in that release: “The shift in Klarna’s valuation is entirely due to investors suddenly voting in the opposite manner to the way they voted for the past few years. The irony is that Klarna’s business, its position in various markets and its popularity with consumers and merchants are all stronger than at any time since Sequoia first invested in 2010. Eventually, after investors emerge from their bunkers, the stocks of Klarna and other first-rate companies will receive the attention they deserve.”
C’mon. The shift in Klarna’s valuation is because the odds of good investment returns at a $46 billion valuation, nonetheless anything higher, were extremely unlikely. Investors aren’t voting in the opposite manner. They’re now voting in a responsible manner with rational assessment of odds vs an irresponsible manner over the past few years.
All due respect to the legendary Moritz and a very successful company, but these two statements suggest a detachment from the realities of valuation. Retrospective math tells us why.
We looked at an opportunity to acquire some Klarna stock on secondary markets last year. We couldn’t get comfortable with the valuation. Here’s the simple model we used at that time.
First, establish the target return, holding period, and what that implies for exit valuation.
Valuation at time of investment of $45.6 billion.
Four year holding period at a 20% target return. Investing from mid-2021 to mid-2024 liquidity event, which means the market would value the company on 2025 numbers.
3% annual dilution.
The 20% target return plus 3% annual dilution implies around a $100 billion exit valuation.
Next, given the necessary exit valuation, what does that demand from business performance?
Assuming a 50x earnings multiple, the company would have to be generating $2 billion in FCF in 2025. 50x earnings did not feel particularly comfortable then for a company growing ~40%. It feels even less comfortable now but go with it for the exercise.
Assume the company generates net margins of 25%. As Klarna’s CEO mentioned on Twitter, the company hit 14% EBT margins in 2017. They were around 8% net that year. They burned about $130 million in 2020 to drive growth. The 25% net number feels reasonable at a target for a fintech platform and compares roughly to Synchrony Bank’s net margins.
At 25% net margins and a $2 billion net target, the company would have to generate about $8 billion in revenue in 2025. The company had just generated $970 million in 2020. To get to $8 billion in 2025, the company would have to compound revenue growth at more than 50% per year. The company had just grown 40% in 2020 and around 31% in 2018 and 2019.
Given the business performance demands in our set of assumptions, what were the odds that Klarna could yield a good outcome at $45.6 billion?
Didn’t seem good.
Accelerating revenue growth to over 50% off a $1 billion base, then sustaining it for years happens rarely in my studies of great growth businesses. As in almost never. The odds of also hitting a 25% net margin in four years after coming off a heavy cash burn period also seemed unlikely.
A defender of the prior valuation may challenge some of the assumptions up or down — multiples, margins, etc. Any such challenges don’t change the reality that the odds were uncomfortable at $45.6 billion that Klarna would yield a good outcome.
Simple models, like the one above, are powerful because they frame in broad strokes how the business needs to perform, and the investor can assess probabilities of that performance demand. It doesn’t matter if any of the assumptions are off a little. When a simple model casts doubt on the potential for strong investment outcomes, a more complex model will often only bias the investor in the wrong direction. Harder work and more knowledge make us want to believe the work and knowledge are worthwhile.
Notes and Quotes
Geoff Lewis, a partner at venture capital firm Bedrock (vibe capital according to him), suggests we’re entering The Great Unwinding. We’ve just exited a period where every investor was blinded by a “brain fog.” That fog reflexively fostered the bubble of 2021. Per Lewis, we now need to rationalize many investments made during the fog that may never justify their valuations.
We should unwind those investments that we know won’t work now that we’ve come to our senses.
As I’ve been arguing related to cutting headcount, the rethinking of valuations and growth at all costs is a healthy return to sanity. The good companies that warrant continued funding, like Klarna, will suffer markdowns. They will reduce inefficient spending, and they will find ways to drive profitable growth. The bad companies will die.
Order will be restored to capital markets.
Great businesses are ones that generate consistent and growing profit over long periods of time. Period. Great investments usually involve buying great businesses at what turn out to be cheap prices. That is axiomatic. If you buy a great business at a cheap price, you’re going to be happy with your long-term outcome.
Most businesses aren’t great, although many can seem great for short periods, and rarely do great businesses trade at a cheap price.
The investor’s job is to check qualitative strengths against quantitative outcomes to determine the odds of acceptable return. When we lose sight of this in the brain fog of market euphoria, we need to come to our senses and make hard decisions about investments to keep or cut. That’s likely to be the continued narrative in tech for the rest of this year.
Talking Your Book
The Twitter saga is fun.
Elon says he isn’t buying it. Twitter says he is. Courts will decide. If the courts rule against Elon, we’ll all get to see if he even listens.
The cacophony of opinions about the deal was deafening over the past few days. The opinions weren’t very diverse. Either people believe with near certainty that Delaware Chancery Court will force Elon to pay the full $54.20 for Twitter, or certainty that he would walk away because Twitter is infested with bots.
As with so many things on Twitter, there was little room for nuance.
Matt Levine, former lawyer at Twitter’s chosen firm of Wachtell Lipton, had several great takes on the case. My favorite of his ideas:
“So there is some compromise where Twitter buys the stock directly from Musk at — I don’t know, $26? — and Musk and Twitter are both better off than he would be if he dumped the stock into the market.”
Elon still owns 73 million shares of Twitter. Doesn’t Elon turning over 73 million shares to Twitter and maybe $1 billion in cash seem like an out that makes everyone pretty happy?
Twitter reduces its share count by 9% to the benefit of its shareholders and gets some cash. Elon gets to walk for less than $4 billion in nominal consideration. While logical, I doubt market odds makers would but a very high probability of it.
The reason is a good lesson from processing the binary Twitter opinions over the weekend: Everyone is always talking their book.
Many of the opinions about Elon having to buy Twitter seem to come from arbs playing the spread or Elon haters. Opinions about Elon walking come mostly from TSLA holders who theoretically benefit from a reduction of financial overhang on the stock (it being collateral for Elon’s Twitter loan), plus more focus from Elon on Tesla.
None of these opinions are purely rational, and none of them have any bearing on the outcome of the Chancery case.
If there’s one thing I do know, it’s that all things related to Elon are wholly unpredictable.
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As usual, I like your use of clear models, reasonable assumptions, and accessible math, w.r.t. Klarna. And as usual, I'd like to add a comment. Does the company have a moat, as in IP but also the talent to increase the moat? With a moat, one can assign some probability to achieving such high growth and margin rates. Without a moat, its fantasy, borderline fraud. Harsh? Not really. 25% FCF means the company has something that people must have and cannot get elsewhere. That kind of margin power requires IP or decades worth of brand equity.