Dear startups, focus on the steak, not the sizzle

Everything was so much simpler before the Internet.

Back then, the VC world was neatly divided into IT and Health Care, and the whole rest of the U.S. economy could go about its merry business without worrying too much about Silicon Valley and the threat of “disruption.”

Then everything became connected to everything else, and then, with mobile, everyone became connected to everything, and voila … no industry is safe.

In the late 1990s, the media and retail industries drew the attention of entrepreneurs and VCs first, leading to Amazon, eBay, Google, Yahoo, AOL, etc.

After a sojourn in the trough of disillusionment, entrepreneurs have gone on to target the rest of the economy, including transportation, hospitality, food, education, agriculture, manufacturing, logistics, as well as the four horsemen of fintech (payments, lending, investing and insurance).

This phenomenon, may it live long and prosper, undergirds the current re-expansion of venture capital from its post-2000 hibernation.

The logic goes that while IT and healthcare are finite industries, which may in fact be maturing and slowing down, VCs can now fund entrepreneurs attacking multiple hundred-billion-dollar opportunities across the economy, thus uncapping the rewards available to our asset class.

I believe this development to be real and durable with a level of fervency only a deeply self-interested party can muster.

That said, it poses a new challenge for entrepreneurs, VCs and, ultimately, the acquirers and IPO buyers who provide us liquidity: How do we value these new types of companies that bring a new set of toys to an old set of sandboxes?

We are once again learning the old lesson that if it walks like a duck and quacks like a duck, it probably shouldn’t get a SaaS multiple.

Many of the current high-fliers have advanced the notion that while they participate in traditional industries, they should still be viewed and valued as technology companies.

This is a dangerous idea that is currently being dispelled one unicorn at a time, with painful and bloody results.

We are once again learning the old lesson that if it walks like a duck and quacks like a duck, it probably shouldn’t get a SaaS multiple.

In fintech, the newly popular neighborhood where I live, we have had at least two recent examples of companies being hoisted on this petard.

The first was Zenefits, a commercial insurance broker with a compelling and novel business model.

They figured out that, in light of the fact that a broker makes money from insurance carrier commissions, they could afford to build and give away high-quality HR software as a way to acquire clients. The software itself helped in the process of benefits administration, which knit the model together in an elegant way, i.e. it wasn’t simply a bribe or a spiff to induce clients to use the brokerage services.

I won’t go into the particulars of their comeuppance, which has been told in lurid detail elsewhere, but ultimately it turned out that the company took too many shortcuts in a highly regulated industry, displeasing regulators and disappointing customers.

More recently we’ve seen LendingClub lose most of its market cap due to sloppy compliance and governance procedures.

What these companies had in common was that they lived in a willful state of denial about who and what they were.

What these companies had in common was that they lived in a willful state of denial about who and what they were. From podiums at conferences and in investor materials, they proclaimed that they were “technology companies,” “Internet companies,” “marketplaces” and “platforms.”

They did this in the cynical hope of getting a higher valuation at every turn. What we’ve learned is that the consequences of this are far worse than the inevitable collapse of valuation metrics back to traditional frameworks. The downfall is compounded by two additional factors:

  • People lose trust in the company and its leadership. Regardless of the regulatory issues that have hobbled Zenefits and LendingClub, there was a growing resentment of the hype-driven categorization both companies made into a fetish. I would frequently hear people say that they liked LendingClub’s growth and financial profile, but wished they would admit that they were a specialty lender with a unique funding model versus a marketplace. After a while, it makes you question the CEO’s motivations, judgement or both.
  • The company itself fails to take on the necessary compliance culture. If you ignore or reject the fact that you are a broker/dealer/lender/merchant acquirer or whatever you actually are, you will inevitably slight the regulatory obligation that comes with that identity.You will also miss the opportunity to benefit from the lessons of the past; almost all of these hard lessons have been learned before, by other companies.

What exactly are these companies running from?

In general, the valuation frameworks that exist for a set of comparables are there for historical reasons, based on economic attractiveness. To the extent that your company defies those traditional norms based on its innovation, it will get a better valuation than its peer group. That’s how capitalism works. It may take some time and will certainly require some proof, but it is inevitable.

Financial Engines, a tech-enabled RIA, trades at a 51X PE ratio, over 2X that of Charles Schwab. PayPal, a mobile and Internet-focused payments company, trades at a 36X PE ratio, nearly 3X that of Amex. MarketAxess, a trading platform for fixed income securities, trades at a 49X PE ratio, 2.5X that of Nasdaq. I could go on.

It turns out that it’s not a terrible thing to have the best house in a stodgy neighborhood.

Entrepreneurs have to weave a story every day, often a story that differs slightly or meaningfully from reality at that moment. They have to convince employees, customers, partners and investors that the future will be different than the present in unlikely ways, and find methods to demonstrate that some of this promise has already come true. They need to do this in a manner that never calls their integrity into question, even as they create their own version of reality.

When you add to this challenge the burden of having to disclaim their true identity so as to don a more highly valued mantle, the strain is impossible. A former associate of mine named Polonius probably said it best:

This above all: to thine own self be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.

[I am indebted to Isaac Oates and Andy Stewart for their help with this essay, though of course any errors are my own.]