Assets > Wages

Aside from a short period of turmoil during COVID and the inflation that followed the economic stimulus, the US economy has been pretty strong over the last ~15 years. The stock market is at all-time highs. Unemployment is near all-time lows. Inflation is now mostly back in check. The dollar is strong.

But there is a somewhat troubling trend that people — particularly people early in their careers — should be aware of. And that is the expanding gap between the high growth in asset values versus the relatively low growth in wages. 

Since the Great Financial Crisis in 2008, stock prices have increased 540%, home prices have grown 114%, inflation has increased 50%, while wages have only grown 43%. Unfortunately, this trend contributes greatly to the wealth gap in the US. Generally, lower-income people are less likely to own assets and make most or all of their income from their jobs. People with higher incomes own most of the assets. The rich get richer. Literally.

It wasn't always this way. From 1945 to 1973, wages grew nearly twice as fast as home prices. But this new trend of assets growing faster than wages has accelerated significantly, driven by a variety of factors that are unlikely to change:

1/ Home price inflation. Over the last several decades, zoning and other types of laws have made it almost impossible to build large numbers of new homes in areas where people want to live. While there's plenty of land to build on in the US, bureaucracy gets in the way. Meanwhile, to fuel growth, we need more people to come into the country (through immigration or births). That means more and more demand for homes, which means higher prices. 

2/ Stock prices continue to rise rapidly. The US stock market has really stood out lately compared to virtually any other country. Given our democratic system, the rule of law, and our embrace of innovation, we're really outpacing the rest of the world. And while things might be a bit overvalued due to AI and low interest rates, it seems like there's no end to the scale of the large tech companies that are leading the market. When I was a kid, the largest US companies were companies like General Electric and General Motors. Companies that were selling high marginal cost hard goods, mostly in the United States. Now, we have these tech companies with very low marginal costs selling their product to nearly everyone on Earth. These companies are huge. Facebook has something like 6 billion users. And it costs a lot for General Motors to build a car; it costs Facebook next to nothing to display an ad. 

3/ Wage stagnation. While wages will continue to increase, they won't grow nearly as fast as assets. Offshoring and technological innovation (particularly AI) will put downward pressure on wage increases. Again, as I've mentioned in the past, there will be plenty of jobs, and wages will increase, but people who only generate wealth through their time and effort will continue to fall behind. 

Owners of assets have benefited disproportionality over the last couple of decades. And outside of some earth-shattering change, there's little reason to believe that will stop. 

It’s important to understand these trends and act accordingly. The message to younger people is to start getting their money into assets as much as possible sooner rather than later. Trying to get rich on your time and effort is an uphill battle. Be frugal, start saving and investing as early as possible.

Breaking Down $4.5 Trillion

Healthcare is a $4.5 trillion dollar industry.

I can’t tell you how many startup pitch decks start by stating this fact. Unfortunately, without more details, this number is somewhat meaningless with regard to the vast majority of healthcare companies. Better to break the $4.5t down into parts and talk about the share that your company will seek to impact or how it may shift dollars across categories. Here’s how the $4.5t breaks down at a high level:

• Hospitals and Healthcare Facilities – 31% (~$1.4 trillion)

• Physician and Clinical Services – 20% (~$900 billion)

• Prescription Drugs and Pharmaceuticals – 10% (~$450 billion)

• Health Insurance and Payers – 29% (~$1.3 trillion)

• Medical Equipment and Devices – 6% (~$270 billion)

• Healthcare IT and Digital Health – 4% (~$180 billion)

• Home Healthcare and Long-Term Care Services – 5% (~$225 billion)

Even these categories are way too broad to tell a good story around (as an example, the EHR industry is about $35 billion out of the $180 billion healthcare IT industry; cancer drugs are about $200 billion out of the $450 billion pharma industry).

I love a company story that starts at a high level that everyone can understand and then zooms in deeper and deeper, educating the listener along the way. So it’s a great idea to start with the $4.5t, but that’s just the start of a much more interesting drill down into what you plan to do and how you plan to do it.

Fundraising & Incentive Alignment

There was a really interesting discussion on the “state of venture capital” on the BG2 podcast this week. It's definitely worth listening to the entire episode, but here are three key insights for founders that I thought were worth highlighting, along with some brief commentary:

1/ $100M+ exits are incredibly rare but can be life-changing for founders. Taking 15% of a $100M exit is $15M—not bad at all. But if you've raised $100M in venture capital, a $100M exit is off the table due to the preference stack where VCs get paid first. If you've raised $500M, a $500M exit is off the table. $1bn, etc. Raising more money than you need makes great exits harder and harder to achieve. This is also true of valuations: a high valuation sets a new benchmark for success. There's an important trade-off between driving up valuation (so investors take a smaller portion of your company per dollar invested) and setting expectations so high that even a strong exit may not satisfy investors. I wrote a post a while back about how employees should think about this topic when joining a startup.

2/ Raising too much can lead to a loss of focus, spreading talent too thinly across initiatives. Companies often say they won’t use all the capital they raise, but that’s tough to avoid in practice. If you’re an entrepreneur with a bank full of funds and a head full of ideas, you’re likely going to pursue those ideas. The discipline to keep the money in the bank is inconsistent with the mindset of a creative, ambitious, high-growth leader. And early on, focus is everything, and it’s one of the major advantages a startup has. You only have a small team of top performers that can create outsized value, so spreading them too thin can significantly reduce their impact.

3/ The incentive structure in venture capital has shifted a bit, impacting the alignment between VCs and founders. The venture model, traditionally known as "2 and 20," means firms typically charge a 2% management fee and take a 20% carry (their share of profits when a portfolio company exits). In the past, venture capital was sort of a boutique asset class, with a few players managing smaller funds and relying heavily on that 20% carry to make a profit. Today, due to companies going public later and seeing more value creation in the private markets and the fact that starting a company has become much easier, venture capital has become a far larger asset class with more capital, more investments, and lower margins. As a result, that 2% management fee can become a substantial source of income — 2% of a $1 billion fund is $20 million per year. This structure incentivizes VCs to deploy capital more quickly as they don’t earn that management fee until the money is deployed. It's not a huge deal, but this can lead to some incentive misalignment between a VC and founder, so it’s worth being aware of.

A Finance Deep Dive

A couple of weeks ago, I completed a Finance for Senior Executives course at Harvard Business School. I took the course because, while I feel like I have a pretty good grasp of finance from business school and work experience, I wanted to refresh my brain on the fundamentals and go a bit deeper than I've been able to over the last several years. The course was excellent, and I highly recommend it for operating executives who find themselves in a similar spot. The content was designed for senior executives who don't work directly in the finance function. The course had a virtual portion followed by four days of in-person living and studying on the HBS campus. The class was grounded in the case study method, with 13 real-life case studies (including a great one where we had to try to rationalize Peloton's stock price in the Summer of 2019...). The class was filled with an incredible group of intelligent, thoughtful, energetic, and self-motivated students who were really fun and inspiring to get to know — 89 students from 21 countries. Just a great group. The syllabus covered six primary topics:

• Measuring Performance and Financial Ratios

• Discounted Cash Flow 

• Valuation

• Capital Structure and Leverage

• Mergers, Distress, and Recapitalizations

• Capital Allocation and Pursuing Margin and Growth

As we went through the coursework, I made a note of some of the more insightful reminders, ideas, concepts, and topics that stuck with me. I thought I'd share some of them here:

1/ The primary job of finance is to ensure that the company doesn't run out of cash and makes good financial investments. Watching working capital (current assets - current liabilities) closely is crucial — lots of very profitable companies run out of cash. I’ve seen this quickly become an issue for tech companies that don’t hold inventory and have taken their eye off working capital, as well as tech enabled healthcare service companies that have a revenue cycle lag.

2/ Terminal value of a company (its value in perpetuity) should be used carefully, as there's never really a company that runs forever. That said, over the long term, the discount rate will balance this and make the calculation more reasonable. The terminal value of a company should be calculated after growth and margin have stabilized.

3/ Net present value measures the dollar value an investment adds or subtracts by comparing the present value of cash inflows and outflows. Internal rate of return calculates the percentage rate of return that makes net present value zero.

4/ There's really no such thing as a "good" growth rate or margin or financial ratio. It all depends on the context and the particular situation. It's sort of like a size 10 shoe. Does it fit? Well, it depends. 

5/ You should care a lot more about the market value of a company than the book value of a company as that’s the value that investors will pay assign to the firm, though the latter is a lot easier to calculate and make sense of.

6/ Bad economics in an industry almost always beats great management over the long term. 

7/ Don't discount the fact that your debtholders are important stakeholders and investors. While interest payments cap their upside, they are the first investors to get paid in a liquidation, and returning their capital and providing them with interest payments drives substantial value. Too often, we only consider equity holders when we think about enterprise value creation.

8/ A good formula to memorize is valuing a company using its free cash flow projections. As I've written here many times, the value of a company is the present value of the discounted free cash flow you can take out of it. Free cash flow can be calculated using the balance sheet and income statement with the following calculation: EBIAT (earnings before interest after taxes) + depreciation - cap expenditures - change in working capital. It's not about memorizing the formula; it's about understanding how the balance sheet and income statement interact and how to use them to calculate the cash flows a company will generate.

9/ Debt is a government-subsidized form of capital. The tax deduction on interest is the major value in financing an investment with debt over equity. This is really meaningful. Obviously, it is less relevant for startups that still need to produce profits. 

10/ The "irrelevance hypothesis" says that in an ideal world with no market imperfections, the dividend policy of a company is irrelevant to its overall valuation because shareholders can create their own homemade dividends by selling their shares. Of course, real-life market imperfections always need to be logically applied when creating a dividend policy. 

11/ Operating leverage is an important metric to watch over the long term. High operating leverage means that small changes in sales lead to disproportionate increases in operating profit because fixed costs remain constant while revenue increases. 

12/ Businesses can be placed on a spectrum from "high tech," which are high growth/low profit, to "cigar butt" businesses which are low to no growth/high profit (companies that only have a few puffs left). There’s nothing thing wrong with a company that isn’t growing but is throwing off cash and not all companies need to stay in business forever. It's important to understand where a company is on this spectrum to guide where to place capital — invest in growth, return to shareholders, or pay down debt. 

13/ Dividend payments are effectively the same as a corresponding investment in growth when the dollars generated and value creation are the same (the only relevant difference is that in one scenario, the money is in the investor's pocket versus the company's pocket). But the value is the same. This is a good reframing, similar to the importance of returning capital to debtholders. Capital is capital regardless of whether the investor holds it in your company or puts it in an index fund.

14/ Generally, markets value growth increases over margin increases because growth compounds on itself. The exception is low-margin businesses. You'll get more upside there from growth. All should be calculated through discounted cash flow analysis.

15/ High discount rates favor high-margin businesses, and low discount rates favor high-growth businesses. 

16/ Detailed discounted cash flow rates often aren’t used on a practical basis inside of companies. The reason, generally, is that there are often more ideas that exceed the discount rate hurdle than can be executed. That said, it’s crucial that all leaders understand discounted cash flow, NPV, and IRR.

I'm really glad I took the class. I'll look into other courses like this to deepen my knowledge in areas where I haven’t gone as deep as I’d like in recent years.

Growth Endurance, Benchmarks, & Horizontal SaaS vs. Vertical SaaS

Investors will often refer to SaaS benchmarks to gauge how well their portfolio companies are performing. They'll look at things like growth rate, CAC/LTV, gross margin, EBITDA margin, net revenue retention, etc. They'll often cite the most successful companies like Monday.com, Zoom, Hubspot, ServiceNow, and Zendesk. These are all top-tier SaaS companies, and investors like to have their companies aspire to have similar metrics. 

These companies, and nearly all of the top-tier SaaS companies, have two important things in common:

1/ They can sell into virtually any company in any industry (horizontal SaaS). 

2/ They can sell into virtually any country. 

As an example, in theory, Zoom could sell a license to everyone over the age of 18 with an internet connection — let's call that about 3.5 billion people. So their overall total addressable market (TAM) is 3.5 billion multiplied by, say, $100 per year. So Zoom's TAM is something like $350 billion.

Now consider a healthcare technology company that operates within the complex, highly regulated US healthcare system (vertical SaaS). They have a much smaller TAM than Zoom. There are about 21 million US healthcare workers, so, in theory, if a health tech company could get its product into every healthcare worker’s hands at $100 per year, their TAM would be $2.1 billion, about 0.6% of Zoom's TAM. Obviously, I'm using ridiculously simplistic numbers.

This becomes relevant when we start thinking about benchmarks, particularly with regard to growth and growth endurance (the ability of a SaaS company to sustain consistent growth over time).

Consider Everett Roger's Technology Adoption Curve, which illustrates how different groups adopt new technologies over time. 

You start by acquiring the innovators, then the early adopters, etc. As you move through the curve and gain more and more customers, each sale typically gets more and more difficult. The first two parts of the curve (innovators and early adopters) generally represent about 16% of the addressable market for the technology.

So, using the examples above, when the health tech company gets to 16% of the market, its revenue is $336 million. When Zoom gets to $336 million in revenue, it hasn't even made a dent in the innovators and early adopters. It has another $349,664,000,000 in innovator/early adopter revenue to go get. 

If an investor benchmarked the health tech company against a horizontal SaaS company like Zoom on things like growth, growth endurance, or the cost of acquiring a marginal customer, they'd be very, very disappointed. To say the least!

Now, obviously, it’s on the health tech company to figure out how to innovate, sell its product to a wider audience, and go international, but the point here is that we're not talking about apples to apples. Benchmarks that don't take into account the uniqueness of a business or a particular industry are, at best, a waste of time and, at worst, create really bad incentives for founders and management teams. 

Who Should A Company Serve?

A reader responded to my Hospitals & Financial Engineering post, where I made the case that hospitals should be protected from various financial engineering tactics that allow for short-term profits for investors that result in major challenges for the company in the long term. From my post:

”I'm a big fan of capitalism, and I generally support the work of private equity firms in delivering returns to their shareholders, many of which are large pension funds, endowments, and foundations. But Steward's collapse is an important signal that our most important and prized institutions shouldn’t be operated as attractive targets for short-term, financially engineered profits.

Hospitals are different. They're a special thing. And regulators should ensure they're treated that way.”

The reader asked: Shouldn't these regulations apply to every company? Why just hospitals? Should private equity investors be allowed to hurt any company in the interest of taking their own short-term profits?

It was with this question in mind that I came across this piece in the WSJ, titled Private-Equity Firms Desperate for Cash Turn to a Familiar Trick. The piece points out that private equity deal volume is way, way down since the increase in interest rates. There just aren't that many deals happening in this environment which is making the investors that invest in private equity firms rather anxious. They'd like to start to see some returns and get some liquidity. Because private equity is illiquid and doesn't trade in the public markets, these firms can't get their investors liquidity until they sell the companies they invested in. But this isn't a great time to sell; it's hard to do because of the low volume, and you might not get a great price. 

So, to give their investors liquidity, private equity firms are doing what's called a dividend recapitalization. That is, some firms are having their companies take on a large amount of debt and then taking the cash and giving it to their investors in the form of a dividend. From the piece:

”Among the largest dividend recaps so far this year is a $2.7 billion recapitalization by auto-body repair center Caliber Collision, according to data from PitchBook LCD. The company is backed by investors including the private-equity firm Hellman & Friedman. A report from S&P Global Ratings said the money was used to pay existing debt and distribute a $1 billion dividend to its equity holders.

In March, rail and transportation services company Genesee & Wyoming completed a roughly $2.7 billion recapitalization. The company, backed by investors including Brookfield Infrastructure Partners, used the transaction to pay a $761 million dividend, according to S&P.”

So investors get some short term return and liquidity without the PE firm having to sell the company. This leaves the company with a new, potentially very large debt obligation without a corresponding asset to show for it. So you're potentially hurting the company in the long term in the interests of short-term profits for investors.

Similar to the point I raised in the hospitals post, are these transactions that benefit investors in the short term at the cost of the company's health in the long term ethical?

Rather than answering that question directly, I think it's worth first asking who a company is meant to serve. A company isn't a living thing, so it technically can't be hurt by or benefit from such decisions. What a company actually is is a set of stakeholders who have an interest in it: leadership, employees, investors, vendors, customers, and the community. 

That's a lot of stakeholders with different incentives and different desires and timelines for the company. Who should the company serve first?

The technical, business school answer is that a company's purpose is to maximize returns for shareholders. Not employees. Not management. Not future investors. So if you believe that, and the company's board believes that taking some cash out of the business — by putting a lot of debt on the balance sheet that might harm employees in the long term and might result in less return for future investors — is good for current investors, then that's what they should do. 

Again, without taking a side in these debates, the point I'm trying to get to is that as an investor or operator, it's important to zoom out and remember who the company is trying to serve. The answer can be different depending on a variety of factors such as its industry, stage, and the way it’s financed. And seeing these very public financial engineering tactics brings this issue front and center. Getting alignment and transparency around this point is crucial in aligning all stakeholders and managing difficult tradeoffs so management and boards can make good, consistent, clear-minded decisions in the short and long term.

Growth, Innovation, And Knowing Who You Are

On a podcast the other day, Ben Thompson made the point that Meta (Facebook) has taken a lot of heat in that they haven't innovated and built a great new product in a long time. Sure, they have Instagram and WhatsApp, but those were acquisitions, they didn't build those products themselves. 

He made the point that the mistake wasn't that Meta didn't create great new products; it's that they even tried.

Thompson noted that creating big, new products that scale is not only extremely difficult but also almost never works. Of all the ideas that new founders have and that existing companies try, very, very, very few make it. A better strategy for a mature and cash-flush company like Meta is to let its innovative employees leave, raise venture capital, build great products, and acquire the ones that work.

This last point is so important and can’t be overstated. Startups have such an advantage when it comes to innovation.

1/ They have full focus from their best people. When companies get big they have so many competing priorities that have nothing to do with innovation. I imagine a top 3 priority for Meta right now is dealing with international regulators. What an incredible distraction that no startup has to deal with.
2/ Failure isn’t an option. If a product leader inside a large company fails they move on to the next thing. If a startup fails, the company dies.
3/ They have unlimited freedom. They’re not constrained by customer commitments or burdens and processes and systems that were setup in the past. They have full freedom to be flexible and innovate.

All of this is to make a larger point. You have to know who you are. I see this challenge a lot with companies that succeeded through the low interest rate period and are looking to get back to high growth. They look at Rule of 40 and say, let's get to 30% growth and 10% operating margin because investors still favor growth companies over profit-focused companies. Related, see this great chart from Logan Bartlett at Redpoint. It shows the multiple of the importance of growth vs. profitability. In February of this year, the market valued a point of growth 2.9x more than a point of free cash flow. Obviously, it's nothing like it was in 2021, but you can see that investors are still very growth-focused. 

Boards and leadership teams know this and are setting their companies up to plug into higher valuations. But, many of those companies have saturated the market for their core products and don't have a great second act. It's time for many of these companies to flip the switch to a focus on EBITDA and free cash flows. 

Obviously, every company is different. And if you have a great idea and a great team that can execute on innovative growth and the management capacity to go all in and the risk appetite for it, then, by all means, go for it. But remember that we all have egos, and it’s easy to get caught up in what’s exciting versus what we’re capable of and what’s best for the company. We all want to be on the growth side of Rule of 40. Operational efficiency isn't as exciting as launching a giant new product. That's a lot more fun, and you'll get a lot more credit. But it might not be right for you right now. 

You have to know who you are.

SaaS vs. SaaS Margins

The concept of SaaS was launched in the 1960s, though it didn't really gain traction until Salesforce was founded in 1999. It didn't get widespread adoption until the 2010s. Today, it's a standard for how businesses use and buy software. 

SaaS was distinct from traditional, on-prem software in 4 main ways:

1/ Deployment location. The software was hosted on the vendor's cloud servers rather than the customer's servers. 

2/ Subscription pricing. SaaS typically uses a subscription model where users pay a recurring fee that includes maintenance, updates, and support, as opposed to on-prem where there's a large one-time fee, and then additional charges for updates. 

3/ Accessibility. SaaS products can be accessed from any internet connection, whereas on-prem typically can only be accessed inside a company's network.

4/ Customization. SaaS customers rely on the vendor for new features and configurations, whereas on-prem offers far more flexibility to meet specific customer needs. 

As a result of these and other distinctions, SaaS has become extremely attractive from an investor perspective. These companies generate recurring, high margin revenue that grows consistently as the company's customers grow. That equates to higher cash flows than traditional software products, which result in revenue multiples of around 10x for high-growth (30%+) SaaS companies.

Regarding these attractive margins, the most relevant feature is the fourth point: customization. Internet-based companies can become enormously profitable because the marginal cost of adding an additional customer is near zero. It costs Google almost nothing to add an additional user or search advertiser. SaaS is similar. Adding a new customer to Zoom costs Zoom next to nothing. Compare that to an office supply company. In order to add a new printer, the customer has to source parts, manufacture, sell, and ship a printer to the customer. That's a lot more work than adding a new user to Zoom. 

In order to maintain SaaS-like margins, SaaS companies have to limit and constrain their customers' ability to customize the product, ideally down to zero. The moment a SaaS product starts to build custom features for its big, important, strategic customers is the moment the company starts to lose the high-margin, near-zero marginal cost benefits of the SaaS model. Even if it charges very high prices for these customizations, the margins can get lost over time because the customizations have to be serviced in perpetuity and aren't amortized across thousands of customers.

Inevitably, every SaaS company will feel pressure from customers to customize. The high-margin, successful SaaS companies have resisted this pressure by creating roadmaps and features that satisfy most customers and/or have built configurable products where the customer can make their own customizations. Ideally, the customer actually likes the lack of customization because they pay less, but that won’t always be the case.

You could break software up into three distinct categories based on the amount of customization allowed for and the corresponding margins. 

SaaS software - High Margin (Hubspot, Zoom, Docusign)
Enterprise software - Medium Margin (SAP, Cisco, Oracle)
Custom software - Low Margin (Accenture, Infosys, Tata)

All of this is to say that there's nothing wrong with lower-margin software as there's an enormous market for it, and the growth inside of those markets could easily offset the lower margins in terms of cash flows. But it's really important to know which market you want to serve and to make a deliberate decision and stick to it. I've seen lots of companies that think of themselves as SaaS because their software runs on the cloud and their revenue is recurring have a roadmap full of customer customizations. I suppose you can call that SaaS, but it won’t have traditional SaaS margins. And that’s ok. But the decision to do so needs to be made deliberately with eyes wide open to manage the difficult tradeoffs associated with growth and profit.

Capital Markets & The Technological Surge Cycle

As the stock market continues to reach record levels despite a number of economic headwinds, I can’t help but think back to a framework offered by Carlota Perez known as the Perez Technological Surge, first introduced to me by Fred Wilson. Perez studied all of the technological revolutions of the past and found that there are two phases in every major technological revolution: the installation phase and the deployment phase. The installation phase is when the technology comes to market and is often coupled with a big boom as investments pour into the hot new thing, followed by the deployment phase, where all kinds of applications are built on top of the underlying technology that actually delivers on its promise. But between the two phases, there’s a turning point that leads to a substantial crash in capital markets associated with the technology as the hype and capital inevitably get ahead of the practical use of the technology.

I started my career almost right in the middle of the turning point of the internet’s deployment and installation. Everyone knew what the internet was, and the world was enormously excited about it. The cables had been laid in the ground, broadband was widely available, and the NASDAQ was at its all-time high as capital poured into unprofitable and pre-revenue internet companies. I had recently graduated from college and was living in San Francisco when the turning point hit: markets crashed, we felt lots of pain, and then we moved to the deployment phase where all kinds of applications that we never could’ve imagined and, in many ways, changed our lives were built on top of the rails of the internet (Uber, Airbnb, Netflix, Zoom, etc.).

The most interesting thing about the deployment phase is how many applications and businesses you never would’ve imagined or associated with the technology get built on top of the technology. Perhaps the best example of this is the automobile. With the deployment of the automobile came the typical hype and over-investment and then a long and fruitful installation phase where an enormous number of applications were built thanks to human creativity and ingenuity. Consider Walmart, which at one time was the largest US company. Walmart was an output of the deployment phase of the automobile. Without the automobile highways couldn’t have existed and without highways suburbs couldn’t have existed and without suburbs Walmart and large shopping centers couldn’t have existed. Surely, Henry Ford wouldn’t take credit for inventing Walmart, but perhaps he should have.

Coming back to present day, the stock market continues to thrive through all kinds of headwinds and setbacks and I can’t help but think much of this is still the exhaust of the technological deployment of the internet that may be more impactful than any other technological revolution in world history, especially given its size, speed and global nature.

And, of course, now the internet has led to things like crypto and artificial intelligence, which are going through their own Technological Surge.

So when we look at unemployment and inflation and productivity metrics to try to figure out what’s going in capital markets, it’s important to consider the backdrop and the larger context and the size and scale of the technological revolution and the deployment of the internet that we’re still experiencing. It’s hard to know whether we’re still in the deployment phase of the internet or if we’re in the installation stages of another revolution with artificial intelligence. Or both. When investing in technology markets, it’s crucial to have a sense of the cycles we’re living through and what phase we’re in. The Technological Surge Cycle is a very helpful framework to help do just that.

Bookings As A Lagging Indicator

Bookings (the value of contracts signed within a specific period) is a crucial metric for companies to watch. Investors watch this number very, very closely. Boards will put enormous emphasis on it. When a deal is booked, the product then gets delivered to the customer, which turns the booking into revenue generated in a specific period, which equates to the top-line growth of the company. Bookings are the tip of the spear. It’s a leading indicator for revenue.

Investors will also look closely at qualified pipeline (the pool of potential sales opportunities that are deemed highly likely to convert into bookings) as that is a leading indicator of bookings.

Bookings and qualified pipeline are watched closely and are heavily scrutinized.

The problem with placing too much focus on these numbers is that a sales and marketing team is limited in how much they can move these numbers one way or another in a specific period. If a company crushes their bookings in a period, it generally means that there was a bluebird deal or that goals weren’t set accurately or that there was an external macro event that caused a large swing. Rarely are sales and marketing teams able to swing these numbers up and beyond expectations in a major way. The reason is that bookings are capped by the TAM (total addressable market) or, more specifically, SAM (serviceable addressable market) available to them. I wrote about TAM, SAM, and SOM a few years ago, find that post here. So, the reality is that while sales and marketing teams can do great things, they are limited by the stuff they have in their proverbial bag that they can sell. To really move these numbers and continue to grow, companies need to create new SAM at a high rate. So, while pipeline is a leading indicator for bookings, SAM creation is a leading metric for pipeline.

To make this point more concise, bookings growth is dependent on product investment decisions that were made 1, 2, 3, or even 5 years ago.

So, while it’s obvious that companies should be focused on in-period bookings and retention and profitability metrics, arguably it’s more important for companies to be focused on in-period SAM creation such that the cap on bookings growth in future periods gets higher and higher. The reason this is arguably more important is that product investments made now can drive far larger swings in growth in future periods than a sales and marketing team can in the current period. If two years ago a company made large investments in new products and new SAM creation, bookings will be high in the future. If two years ago they made no investments in new products and new SAM creation then bookings will be low in the future.

So, while obviously investors should be asking companies how bookings are going in a specific period, they’re really looking at a lagging indicator for good or bad investment decisions that were made in the past. They should place equal emphasis (arguably more) on how much new SAM is being created in that same period, as that’s the number that’s going to drive material and sustainable growth.

Valuation Fundamentals

The 10+ year period of near-zero interest rates caused a lot of investors and leaders to deemphasize the fundamentals of valuing companies. As I’ve written many times, we know that a company’s value is equal to the present value of the amount of cash you can take out of it over time. That is, the amount of cash you can take out of the company over time discounted to present-day dollars. When you’re in a zero-interest environment, there is no discount rate. When there’s no discount rate (or no risk-free way to make money), investors take more risk to find a return, thus the overflow of money into venture capital and other high-risk investment vehicles during that period. When there’s no risk-free bar to clear to find a return, an investor is more open to non-traditional investments. When interest rates are high and low-risk treasury bills are paying out 6%, in order to invest in something risky, the investor has to be comfortable that any investment will exceed 6%, causing money to flow out of venture capital and other high-risk investments.

When the risk-free rate is very low, investing gets hard because there are no guarantees, so you start to use proxies and benchmarks for future returns. This was particularly true in SaaS which really emerged in a big way during the 10+ year period. Things like Rule of 40 and 35% EBITDA margins and 70% gross margins became solidified as proxies for investable software companies. We needed those proxies because they provided guidance for what to invest in in a world where almost anything “could” be a good investment.

Now that investors have raised the bar on what they’ll invest in and there are real questions about the future of SaaS margins due to the emergence of new pricing models and pricing pressure from AI duplicating SaaS products at a far lower cost, it’s time to return to the fundamentals of valuation. Remember:

Growth is just a proxy for future cash flows.
Gross margins are just a proxy for future cash flows.
Operating margins are just a proxy for future cash flows.
Net income is just a proxy for future cash flows.

None of them alone can tell an investor the amount of cash they can take out of the company over time.

Now that we’re back to desirable risk-free rates, and CIO budgets have tightened, and high interest rates have squeezed company margins, it’s time to be more flexible and get back to the fundamentals of valuation. There are numerous ways to get there that might not fit with the traditional SaaS benchmarks we’ve used as a reliable guide over the last decade.

Incentives, incentives, Incentives

"Show me the incentive and I will show you the outcome" - Charlie Munger

I’ve found that when you think understanding incentives is really, really important, you still don’t understand how important it is. When you find yourself in a difficult conversation or challenging situation with an employee, a customer, a partner, or a vendor, pause and make sure you understand the incentives of all the stakeholders. It almost always gives you instant clarity and gets you unstuck.