Foreword
Let me introduce you to the latest, and greatest new investment opportunity! It is a disruptor in the space of retail and ecommerce, growing its business at the unprecedented rate of 50% per month! Sales grow entirely linearly with investment into the business — this is basically an infinitely scaling sales machine!
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Sales metrics
Before I tell you more about this incredible business, let me first throw out some numbers:
| Age of company | 2 years |
| TTM annualized revenue | $1 billion |
| MoM sales growth | 50% |
| YoY sales growth | 110x (that’s 11,000%!) |
| Total investment raised | $500 million |
| Valuation assuming 2x FTM P/S | $220 billion |
| Unrealized gain for existing investors | 440x (that’s 44,000%!) |
Sounds wonderful doesn’t it! 440x returns! In 2 years!
Imagine if we scale the business for 2-3 more years, before tamping down on customer acquisition spend to ramp up profits!
Would you invest in our business?
Problematic numbers
If you looked at the numbers, and immediately noted that:
- The valuation is based on FTM P/S (forward twelve months price/sales ratio),
- The valuation assumes that the business will grow at the same incredible rate of 110x in the next year,
- That rate seems unsustainable,
then give yourself a pat no the back! Yes, those numbers do seem incredible, and in a regular business, would almost definitely be unsustainable — any $1B business that grows at 110x a year would be doing more business than the world’s combined GDP in the span of about 3 years, and clearly that has not happened.
But what if I told you that I can guarantee the business will grow by 110x or more, as long as we continue investing in it? Would you buy into the business now?
Doing business
Hopefully you said no — because up till now, you still have no idea what the business actually does!
To be honest, the business is a very simple direct to consumer sales, with some very large B2B customers. We sell $1 US dollar notes, for 50c. That’s it. We’re, literally, a half-off dollar company.
Now that I’ve revealed the secret, can you see why I say the business metrics are real? And that we can definitely grow 110x or more per year, as long as we keep investing in the business?
But would you invest in this business?
Terrible business
There are no lack of businesses nowadays whose sole focus is to grow revenue at all costs. Many of them sustain massive losses while they “scale the business”, with the hope that at some point, they’ll be able to reduce the cash burn somehow, and thereby turning profitable.
To be fair to these companies, there are some truths to the basic idea. When a company is first starting up, it will not have a lot of economies of scale, so it tends to need to spend more to manufacture its products. At the same time, the company needs to spend on advertising and have other customer acquisition costs (such as retention, etc.). These costs tend to level out once a company has reached sufficient scale,.
However, some companies take the basic idea and push it to extremes which no longer make sense. For example, our half-off dollar company has basically no hope of ever turning profitable — any attempt to sell that dollar for more than $1 will immediately lead to complete customer base loss.
In other cases, the scale required by the business to be profitable would require the business to have more customers than there are people on Earth. Perhaps they have some insights into alien civilizations that I am not privy to, but this business model also seems suspect.
And in yet other cases, the business is in a commodity space (here “commodity” meaning “easily copyable” as opposed to actually trading physical commodities), and the moment the business stops spending on customer acquisition and retention, their customers will quickly be stolen by any competitors that are still spending on customer acquisition. Businesses like these are basically just racing each other to the bottom. Yes, maybe one of them will eventually crowd out the competition and win the race, but by then, the business would likely have burned so much cash that it may never return a sufficient return to investors. Even more condemning, the eventual winner may not be the one you actually bet on!
Before making an investment in a (currently) money losing business, it is imperative to figure out if there is actually a plan to profitability, and to then vet that plan for feasibility. Otherwise, you aren’t investing, you are making charitable donations for the benefits of the company’s employees.
Numbers game
When vetting such companies, you need to be careful, and think critically of the numbers presented. At a minimum, the gross profit (revenue – costs of goods sold) should be positive, or at least becoming less negative over time. This would indicate that the business is not simply selling products for below costs to attract customers — businesses selling products at below costs, like our half-off dollar company, often find that when they try to raise prices to become profitable, customers tend to leave.
Next, you need to verify that both operating and non-operating expenses are not growing faster than revenue. These are supposed to be “fixed” costs, and if they are moving linearly (or worse, super-linearly) to revenue, then something is very wrong indeed! Either maliciously or not, there is a chance that the business is classifying some costs of goods sold as operating/non-operating expenses. You need to figure out what’s going on here, before investing, and as before, understand the plan, and the feasibility of that plan, for reducing expenses in the future.
Finally, you need to then figure out if the company’s projections for when it’ll be profitable is reasonable. If the business needs to have 10billion active customers to be profitable, then run away as fast as you can! Or somehow figure out how to create 2billion humans out of thin air(1).
Total addressable market
One sneaky trick that needs special mention, which many companies like to pull, is to talk about TAM, or total addressable market. This is the amount of total potential sales that the company estimates is in its industry, and is often thrown around, conflated with “potential future sales of the company”.
The 2 main issues with TAM are:
- It is an estimate. There are no guarantees that it’s anything near to reality. Especially for new (disruptive!) industries, the number is often just a random pie-in-the-sky figure the company’s management dreamt up.
- It is imperative that TAM claims are thoroughly researched by the investor to make sure they actually make sense. Or just ignore them completely.
- TAM is the total potential sales of the industry. What makes management think they’ll be the sole company in the industry? Or that they’ll even be in the top few by sales?
- The TAM of the global cooked food industry is huge, and my random estimate puts it in the $1 trillion range per year. But that number is for the entire industry worldwide, and since different regions of the world have different preferences for food, it is unlikely that any single company will ever gather more than a small fraction of that TAM.
- So, if a brand new fast food startup comes to you, and starts throwing the TAM of global cooked food industry around, trying to implicitly hint that they’ll grow to that size, your only reaction should be to laugh, politely excuse yourself, and find something else to occupy your afternoon.
In short, any company that brings TAM into the conversation should also provide:
- Verifiable research into how they come up with that number.
- How much of that TAM they actually believe they can address (in general any number more than 50% is highly suspect).
- What plans they have for achieving that portion of the TAM.
Footnotes
- Current population of Earth is about 8billion.
Janky Thoughts 