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Show me the money: What's wrong with the startups picture?
Not so long ago, investors would have frowned on a company headed for the stock market with no profitability – and no clear sight of future profits – to show. Yet in recent months, ride-hailing companies Lyft and Uber Technologies both rode into Nasdaq IPOs, egged on by eye-popping valuations but apparently running on fumes – neither had made any profit despite having been in the business for close to a decade. (And Uber had in its offer prospectus said it would not be profitable in the foreseeable future.)
They tanked, not surprisingly. Lyft started trading at US$72, giving it a valuation of US$24 billion, and rallied momentarily before moving south, last closing on Thursday at around US$63. The much larger Uber, whose US$82.4 billion valuation made it one of the biggest IPOs in American trading history, never traded above its US$45 IPO price in May.
Uber subsequently reported losses of US$1 billion for its latest quarter, in its first public earnings statement post IPO. The company now trades at around US$44, buoyed by a recent rally in IPO stocks.
Loss-making of course is not peculiar to Uber and Lyft, which have been in the business for 10 years and seven years respectively. Internet poster boy Amazon was 14 years in the red after its 1997 IPO, before finally turning a profit.
Singapore's homegrown grocery delivery startup honestbee, facing a cash crunch, stopped operating some services in Hong Kong, Indonesia and Thailand last month.
Honestbee, established in 2015, which raised at least US$15 million in initial funding, is said to have burned through US$6.5 million cash in December alone, with profitability still elusive.
Ride-hailing player turned "super-app" Grab, now officially a unicorn with a valuation in the billions, fights shy of revealing bottomline details and will only say it is "on the path to profitablity".
While startups, by definition, are young, new businesses, and new businesses are rarely immediately profitable, it seems to be the new normal that startups will not be profitable - for a long time.
Yet, losses used to be a dirty word. In the "old economy", a business that was not generating profit couldn't last long, and it would not make economic sense to continue bleeding even if the owner had the capital. Now, cash-burning is routine.
What has changed? Where is profitability in the picture? How are startups valued, given that most have no profits to speak of but profit is a key input for most valuation methods? How patient are investors with seeing red ink before they start seeing red?
It's all about the liquidity
Investors, hunting for outsized returns in an ultra-low yield environment, are plying startups with funds and biding their time through the cash-burn phase, in the hope that they've bet on a winner.
Walter Theseira, economics professor at the Singapore University of Social Sciences, thinks that it's a combination of growth of private equity (PE) and venture capital (VC) and the high scalability inherent in many "new economy" startup business models that has led to the new "profitless" normal.
He says: "First, sophisticated capital increasingly prefers to be deployed as private equity or venture capital, because of the belief that returns in public capital markets are inferior for a variety of reasons... So there is a lot of money available."
Investors believe - not without good reason - that the greatest returns are in investing in a business model with great potential to scale. So they are willing to stay invested in anticipation of outsized returns.
Indeed, Helen Wong, a partner at Qiming Venture Partners, says that investors who understand the network effects model are willing to wait for profits. The VC veteran notes: "There is a lot of capital hungry for technology startups these days, which drives greater tolerance for losses."
And the depressed cost of capital has swayed priorities. Professor of management and innovation at the IMD Business School Howard Yu points out that it is cheaper to borrow capital in the current very low interest rate environment compared to the past. "That in part explains why investors or the financial market historically valued profitability much higher in the past than today," he says.
The startup phenomenon is itself a revival of the expectations reminiscent of the dotcom boom in the late 1990s, says Kenneth Goh, assistant professor of strategic management at Singapore Management University.
He says: "Investors are betting that today's startups will become the Amazons and Googles of tomorrow. It took Amazon 14 years to make a profit."
"The bucket of gold at the end of the road"
When a startup is in the fast growth phase, profits should not be the focus, says Qiming's Ms Wong. "I recall that (Alibaba founder) Jack Ma said if you are focused on picking up the gold nuggets on the road, you might miss out the bucket of gold at the end of the road, as others get there first. "
Still, the path to profitability is important, she adds. When Qiming invests, it has to be persuaded that a startup can make profits at some point in the future and build a sustainable business.
The problem, as Prof Theseira says, is that it is not easy for investors and business entrepreneurs alike to tell if the business model can ultimately pay for itself.
"In short, it's much easier to scale - because all that takes is money - and it's much harder to build a self-sustaining business model. Money will be provided as long as there is some belief the business model is still viable," he adds.
As long as there is some belief that the business can scale to become dominant in some industry, the economist thinks there will be willingness to invest. History has shown that companies who dominate the markets they operate in - such as Google, Microsoft, Amazon, Facebook - generate outsized returns that pay back initial investors many times over.
Nevertheless, the bottomline is important. Gryphus Capital Group managing director Steve Ting says: "I'm from the old-school of thought, I believe in three things: revenue is vanity, profit is sanity and cash flow is reality."
Food-tech startup Grain's chief executive and co-founder Yong Yi Sung gives a resounding yes when asked if profitability matters.
"Not only does it mean the company is default alive (not being profitable is like getting closer and closer to your grave each day because you're bleeding/haemorrhaging money), it's also a good proxy that the company is well run and every department is functioning efficiently," Mr Yong says.
Grain, which sells freshly cooked everyday meals via its online restaurant and catering arm, was in the red for 2-3 years until it turned profitable last year. It achieved that by keeping tight reins on big cost buckets such as food and delivery - keeping food costs to under 30 per cent of total sales and delivery costs to under 20 per cent. It is also discerning in the types of customers it spends to acquire, "as opposed to throwing money to just buy customers". Running a lean product and engineering team also helps.
Mr Yong adds: "A big part of the strategy was also refusing the temptation to expand to a new city before we were ready too."
Super-app builder Grab, which sidestepped a request from The Business Times to confirm it had raised US$8.88 billion so far in 25 rounds, says that it has raised US$4.5 billion in the current round of fund-raising. It tells BT that both profitability and scalability are important.
"Our business is fundamentally strong and, with the diversity of services we offer, we are on a path to profitability and are already profitable in some of our more mature markets," a Grab spokesman says.
It aims to make at least six investments or acquisitions by the end of the year. Many of the company's new business lines (GrabFood, Grab Financial Group and GrabExpress) are under two years old, and " growing rapidly". GrabFood, for instance, kicked off in May 2018. While declining to reveal figures, Grab says GrabFood revenue "grew 45 times" between March and December 2018. Grab touched US$1 billion in revenues last year and has targeted US$2 billion in revenues this year.
I expect, therefore I value; but not all startups are created equal
Without profitability, which in conventional models is a key to value, how are startups valued?
IMD's Prof Yu points out that many of the startups are consumer-facing B2C businesses, which are in the business of gathering and generating a lot of data.
"Since data is the raw input for any artificial intelligence or machine learning, which holds the promise of reinventing any new business models, we saw a different type of valuation today."
Conventional financial analysis, while not entirely thrown out the window, is preceded by proof of growth potential. Still, the potential of startups depends on what the funds are spent on.
Prof Yu cites Uber as an example. Unlike Amazon, transport giant Uber's huge expenses have never been about infrastructure building for its core business.
Amazon built not only websites, but warehouses and logistics and information technology systems; Uber does not. It uses the services of cloud computing providers; it spent tens of million to use Google Maps.
Prof Yu says: "(Uber) therefore finds its market position hard to sustain as being extremely asset-light means being extremely vulnerable to newcomers. We may just be witnessing how an investment thesis is falling apart."
To SMU Assistant Prof Goh, startup valuations are more of an art than a science, as conventional approaches of valuation are not appropriate and thus driven largely by investors' expectations.
While investors are definitely more comfortable with short-term losses, the key issue is what startups are burning the cash on, he says.
Simply spending on short-term incentives for customer acquisition will not be sustainable if it is not supported with spending on infrastructure to build a strategic moat that also locks in customers.
For example, cloud storage services like Google and Apple make it very easy for users to upload information to the cloud, but transferring data to another cloud service is considerably more troublesome.
So the issue about whether losses are sustainable depends on how locked-in customers and suppliers are and the degree of difficulty for new competitors to enter the fray, he notes.
This would explain why the IPO of vegan meat-alternative maker Beyond Meat shot through the roof while Uber and Lyft sank, even though Beyond Meat in its prospectus declared that "we have a history of losses, and we may be unable to achieve or sustain profitability".
As The Motley Fool Singapore CEO David Kuo points out: "I think the barriers to entry for ride sharing and ride hailing are too low. I could probably start a ride hailing operation tomorrow without too much trouble. All I need is a backer who has more money than sense.
"The barrier to entry for Beyond Meat and Impossible Meats is considerably higher. There is some real technology behind the product. Additionally, with food, quality and trust are vital."
Qiming's Ms Wong hints that venture capital has a decidedly more unequivocal view: she says the main factor determining a startup's valuation is often market forces - supply and demand. It is the most efficient way.
"But of course, we also have reality checks with existing comparable company valuations, both in the private markets and the public markets. We will do our own financial modelling to ensure that we can predict our return profile."
She encourages startups to look at the value that they are creating for their spending - the return on investment. If they are burning money unnecessarily, it is a danger sign for investors and it is also bad for the founders as they suffer more dilution.
However, if each dollar that they spend is bringing a high-value, high-repeat customer, they should be more aggressive.
"The best entrepreneur will also keep an eye on the cash balance and ensure that fundraising keeps pace with the cash burn. Often startups fail because the funding environment changes and they run out of money. It is imperative for CEOs to balance growth with the resources they have, and this is often an area we coach our CEOs."
Don't say we didn't warn you
INDUSTRY players and pundits warn that should the tide of easy liquidity recede when recession hits - possibly in 12-24 months' time - startups that are not well capitalised will go bust.
Lurking in the background is systemic risk, says Walter Theseira, economics professor at the Singapore University of Social Sciences. Risk arises from the market distortions caused by willingness of startups to lose money. He says: "The market distortion is that these firms tend to pay above-average wages for labour and above-average prices for inputs. This encourages the market to serve the loss-making firms, for example, people to quit their jobs to become Uber drivers, or take out loans to buy cars for Uber use.
"The systemic risk is that if the business model doesn't cover the real input costs, then once the venture capital money runs out, those resources are wasted - people have left good jobs where they could have gained actual skills for a bad job with artificially high pay."
Fortunately, no startups have become integral to a market structure to the extent they are "too big to fail".
"But imagine the consequences if we have no taxi service because taxis can't compete with subsidised private hire car services, and (later) the money runs out of the private hire industry. We would have to rebuild up the taxi industry from scratch."
Gryphus Capital Group managing director Steve Ting says that when the economy enters a downturn, valuation of startups - along with profitable businesses - start crashing, and investors would go back to the basics and look at fundamentals.
Assistant professor of strategic management at Singapore Management University Kenneth Goh points out that venture capitalists and sophisticated investors have the expertise and means to evaluate and hedge their risks that retail investors do not. He reminds these retail investors of the Netscapes, Webvans, and Pets.com of the dotcom era.These names did not see their glory days outlast the dotcom boom, which ended in 2000. Webvan and Pets.com filed for bankruptcy not too long after raising millions from the stock markets.
The Chartered Financial Analyst (CFA) Society in April flagged the risks of listed unicorns should they be added to major large-capitalisation indexes and find their way into portfolios across the income spectrum, including funds with retirement savings. It said: "While such unicorns (startups with valuation of US$1 billion when they are private) have strong growth prospects, they often have uncertain paths to profitability. They may be at the forefront of innovation, but many of them are also early-stage enterprises with a high chance of failure."
While the potential returns from startups are alluring, the risk of losing capital is very real. And when that occurs, it might not be just the investors at the losing end - the economy and stakeholders such as suppliers of other inputs will also pay for it.