Tech Forgot How to Make Money
The New World Order of True Free Cash Flow
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The past decade of easy money made us all forget how to make money.
It’s actually pretty simple: Operating cash flow - capital expenses = free cash flow.
But investors and entrepreneurs played a reflexive game where magnitude, velocity, and potential of sales mattered more than generating true cash flow. More sales meant higher multiples which meant more valuable stock which was used as currency to hire, drive more sales, make acquisitions, raise more money, and so on we went.
When money is easy, there’s always more available to drive asset prices higher, which inflates a bubble that gives the appearance of economic value creation. In the insanity, investors forgot that free cash flows are the original and guaranteed way to earn a return on investment, not higher multiples. Entrepreneurs forgot that generating cash is the way to creating real economic value as a business, not a higher valuation.
With the bubble burst, we’re left to relearn how to make money in the form of true cash flows, both investors and entrepreneurs alike.
My hypothesis is that growth investors and CEOs who can figure this out — or keep living it if they already manage this way — will be the winners of the next cycle.
There are several important things that should happen if this hypothesis is right, roughly in this order:
- No more easy money
- Embrace of true free cash flow
- Right sizing tech headcount and compensation
- Increasing prices to economic realities
No More Easy Money
It seems obvious that easy money should be dead, but is it?
There are two opposing realities here.
First, after a bubble bursts, markets are usually hesitant to pile back into the thing that most recently burst. Tech was out of favor for years after the dotcom boom. Real estate was avoided for years after the GFC.
When we burn our hands, we learn the lesson and smarten up. At least for a while.
The opposite side of the lesson learned is that private markets are still sloshing with cash.
Venture capital dry powder grew almost 10% y/y in Q1 to $479 billion (Preqin). Further, institutional LP interest in deploying to venture is growing, with 14% of allocators expecting to commit $600 million or more in the next 12 months vs 10% last year.
Some of this dry powder is shifting to earlier stage venture and away from late stage. This makes sense on the surface-level reality that relatively lower valuations on early-stage investments give more long-term upside potential vs late stage where depressed public market comps dominate exit multiples. Challenged public markets will apply persistent pressure to realized venture exits.
Public easy money is dead. SPACs are dead. IPOs of poor-quality companies are dead. Companies with no viable path to true cash flow generation are dead. We shouldn’t expect these things to return any time soon.
Early and late-stage valuations will tighten in the near term to compensate for less friendly public markets, and if those lower valuations still fail to generate acceptable returns, LPs could eventually reduce allocations to venture. That could provide a further leg of tightening for venture markets.
The best, most promising companies have always been able to raise and will always be able to raise, even if they have to take a lower price than they enjoyed a year ago. Most marginal companies can’t raise right now at any price. That probably won’t change in the next few years.
True Free Cash Flow (tFCF)
True free cash generation is the definitive separator between great companies and marginal to poor ones. If easy money is dead, investors will push companies to generate true free cash flow to prove greatness.
I’ve been using the term true free cash flow here, which I define as operating free cash flow less CAPEX and less SBC. In other words, true free cash flow does not give companies credit for “cash flow” generated by paying employees in stock. Investors often get away from this more conservative calculation of FCF in frothy times, but it’s how we calculate cash flow at Loup. I suspect many investors will come to do the same.
tFCF is important because if a company only generates “cash flow” because of stock comp, it’s not generating any real cash for investors. In essence, you’re just paying yourself with equity raised via employees, not real profit generated from the business.
Many “profitable” companies fail to show meaningful or any profit on this adjustment.
Of course, selling consistently selling equity for a structurally unprofitable business relies on easy money. And easy money is supposed to be dead.
What does this mean?
The stock prices for these companies will be fractions of what they were. For employees to enjoy the same total comp they had before, the company will either need to step up cash comp — a real cash cost — or give even more equity, diluting shareholders more.
Something’s gotta give. Great companies have to show they’re great by generating consistent and growing tFCF, but that’s hard to do when you’re paying employees the same as when stock was 3x higher.
Either tech employees need to get paid less, or they need to charge customers more. Maybe both.
Time to Cut Headcount
Most tech companies have way too much headcount. Smart tech companies will use the economy as a reason to right size, then be slow to rebuild.
We’re already seeing many such companies reduce their labor force:
Most tech businesses are IP businesses. Their biggest input cost is labor to write code bases and build customer bases. In some ways, the overpayment of tech talent is like a more traditional, capital-intensive businesses building too many factories. That’s why we have capital market cycles. Under investment in capacity, build phase, over investment in capacity, reduction phase.
Tech shouldn’t be any different. It’s just that we’ve lived in build/over investment phase for so long that it seems different. The reality is this: If we persistently invest in talent beyond reasonable incremental productivity for a business, then the business is never going to show meaningful tFCF to investors.
Extreme case in point: FTX is the third largest crypto trading platform in the world by volume, and they have less than 30 engineers. Coinbase is significantly smaller and probably has 30-40x more engineers if not more.
At a Sohn interview with Patrick Collison, FTX founder Sam Bankman-Fried said that he thought most tech companies were structurally inefficient with hiring. He even thought Facebook could be on the order of 5-300x smaller in headcount (that’s not a typo).
Whether his math is right or not, companies and investors all seem to be coming to the uncomfortable realization that tech is wildly overstaffed. While it will be messy and take time for companies to reduce headcount, such a trend is great for investors.
I hate to have to note this, but I will because sometimes people intuit dumb things on the internet. I’m not celebrating job loss. I’m recognizing a structural reality that needs to change for healthy market function. The marginal software engineer or product manager is not worth $400-500k in total comp or more because he isn’t adding that amount of incremental value for investors. Companies aren’t charities despite the emergence of stakeholder capitalism.
Time to Raise Prices
A vast swath of consumer tech was built on the idea of transforming old world services with the internet and using scale to deliver those services at lower costs to consumers. Many companies succeeded in modernizing necessary services on the internet, but often the lower prices were subsidized by easy money rather than benefits of structural scale.
Uber is a great service. I use it. It deserves to exist, but it’s been around for 13 years and never generated any true free cash flow. The dying traditional cab business has probably made more tFCF than Uber has over the past 13 years.
If you never profit from scale because you’re beholden to highly elastic general consumer demand, then it might be worth rethinking scale in favor of sustainable profit.
Imagine Uber were entirely private, bought out 100% by one individual. Now imagine there was no liquid market for the stock. Can’t sell it. How would that individual try to earn a return on his investment?
He’d probably lay off more than half of the company, raise prices to serve a smaller group of customers better, and try to pocket hundreds of millions in free cash flow per year into perpetuity.
Considering price increases bring us back to the beginning of our adventure that started with venture funding.
Many of these persistently unprofitable, underpriced companies have easy money built into their very founding. The founders knew that if they could drive massive user growth and topline revenue, venture money would keep rolling in. The easiest way to maximize chances of that outcome is to structurally underprice the thing you’re selling. Consumers are smart. They know a good deal when they see it.
The problem is a whole class of consumers is trained on low prices that still don’t generate decent profit despite much larger scale.
In the tight money, tFCF-focused world, such structural underpricing is a sin that will be punished. So is excess staffing and compensation. Companies built on these byproducts of easy money that can adapt will survive and maybe thrive. Those that can’t are destined long-term losers, and so will be the investors that stick with them.
Notes and Quotes
Only one this week, and it’s relevant to the discussion above. From Bryne Hobart at The Diff regarding feedback about a piece he wrote on valuation:
“Discounted cash flow analyses, while theoretically correct, also involve lots of guesswork.”
I’ve always chafed at the objection that DCFs involve a lot of guesswork. Any valuation perspective involves guesswork. You can either make your guesses explicit using something like a DCF, or you can mask them in something like a multiple.
A company trades at 10x revenue. Great. What should we expect the long-term tFCF margin to be and how long do we think the company can sustainably grow so I know the company is cheap at 10x when another company trades at 15x and another at 7x?
Valuation is better viewed as a two part mosaic of the future rather than theoretically correct guesswork.
The first part is to quantify how much tFCF the company would have to generate and over what period to generate an acceptable return. The second part is to figure out qualitatively what you believe has to happen for the first part to come true. Then set odds on that outcome happening and constantly reassess it for as long as you own the stock.
It’s always worth making your assumptions explicit vs implicit.
Thanks for reading, and see you again soon.
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I’m reminded of an old saying "I lose a little on each deal, but I make up for it in volume."
Irony: Your great piece has "The New World Order" in the title. And I just read Ming-Chi Kuo's rumor-based piece Apple xR headset which referred the "Metaverse Standards Forum".
Of course, the Metaversians, think they're creating the New World Order, precisely at a time when people care much more about old world things like tFCF and the US dollar, oil, minerals, and food. Sadly, we have add weapons to the above list.
More specifically, your point about employees and IP underpins one the best reasons to stay long on Apple (and similar companies) with superb tFCF to hire the talent to grow the IP to widen the moat to raise the ARPU to keep on increasing tFCF. Dayenu. I recommend adding Glassdoor metrics to your screening.