The Download: A tip for start-ups: Don’t go public without profits
There are two kinds of rants that just about every public company chief executive loves to deliver. The first is about the company’s stock price: It’s never high enough! The second is about Wall Street investors’ obsession with quarterly earnings reports: They don’t appreciate our long-term vision!
For that reason, last week’s widely shared comments from outgoing Twitter CEO Dick Costolo in the Guardian rang hollow to me. Costolo said the “90-day cadence” of reporting quarterly earnings leads to “short-term thinking.” Twitter was under so much pressure from investors that its achievements were obscured, he added. Twitter co-founder and board member Evan Williams made a similar comment to me in December, noting that Wall Street doesn’t have “a sophisticated understanding of what creates value” at technology companies.
It’s hard to disagree. Trading long-term strategy for short-term gains tends to kill innovation. It can lead to an obsession with arbitrary metrics, or worse, “juking the stats” a la the corrupt cops and teachers in “The Wire.” In Twitter’s case, the company hasn’t even been public for two years. For each of the last two years it has doubled revenue, which is impressive, but its investors and analysts have been fixated on quarterly profit and user growth, not revenue growth. That doesn’t seem fair. I wrote exactly that when Costolo announced his resignation.
The lesson of Costolo’s Twitter tenure is clear: Do not go public unless you are wildly profitable and growing like gangbusters, or are willing to suffer constant criticism.
Still, short-term thinking has its merits, too. Though some blame it for some of the shortcomings of U.S.-style capitalism, it imposes a discipline that companies don’t always have — especially when sketchy metrics used to estimate private company values can camouflage fundamental business model problems.
The simplest argument in favor of short-term thinking is that it’s the only way to achieve long-term success. (In other words, you execute the big-picture strategy by making day-to-day progress.) Beyond that, large corporations tend to move slowly. Forcing them to think about each quarter adds some urgency to the way they operate. “Without quarterly pressure, I really think they’d be even worse,” Andy Swan, founder of social media data startup LikeFolio, noted on Twitter.
But the strongest argument in favor of going public is that it forces a company to get real. Sure, private companies provide quarterly performance updates to their boards of directors, but that’s nothing like providing quarterly updates to the world, thus, to use Costolo’s metaphor for a company’s stock price, letting the world vote on your performance.
Staying private gives a young, fast-growing company room to make occasional mistakes and to work through various “growing pains” without hurting its valuation. But eventually the companies must be valued by traditional standards, not user growth, revenue run rate, customer growth or any of the metrics start-ups love to tout. (Take Uber, which is in no hurry to go public. The company is seeking a $50-billion valuation, but generates $470 million in operating losses with $415 million in revenue, according to Bloomberg.)
Alan Patricof, founder of venture capital firm Greycroft, who has been investing for four decades, put it best:
“People are buying traffic growth and revenue growth, but it’s the ‘emperor has no clothes’ theory,” he told me in an interview this year. “At some point all of these companies will be valued on a multiple of Ebitda” — which stands for earnings before interest, taxes, depreciation and amortization.
Twitter is not profitable, by any standard accounting measure. Its losses even increased leading up to its IPO. Regarding Ebitda, Twitter only reports “adjusted Ebitda,” a metric that has been criticized for excluding big expenses like stock-based compensation. (Companies are required to include this cost when calculating their earnings.)
No CEOs want short-term investors holding their companies’ stock. Luckily for CEOs, it happens to be their job to convince investors of their long-term vision. If investors aren’t biting on the long-term plan, there’s one thing that speaks louder than any visionary gobbledygook or PR, and that’s profits.
Amazon, the famously unprofitable exception to this reality, is exactly that — an exception. Somehow, without profits and while dedicating only six hours per year to investor relations, CEO Jeff Bezos has convinced Wall Street to believe in Amazon’s long-term vision. He’s been rewarded with a rising, albeit occasionally volatile, stock price.
This year, start-up CEOs are increasingly confident that they, too, can pull a Bezos. In the first quarter, only 10 of the 37 companies that went public were profitable, a 43% decrease from just two years ago. Some of them quickly learned that Amazon is indeed an exception. Etsy, On Deck Capital and Castlight Health were popular with investors when they went public but experienced big sell-offs after failing to deliver profits.
Those companies aren’t as valuable or high profile as Twitter, but I imagine their CEOs are studying Costolo’s tenure very closely. They might sympathize, seeing Twitter as a victim of unkind short-term public market mercenaries. But in reality, Twitter is struggling to get real. I’ll amend my prior warning to highly valued start-ups: Growth is nice. But do not go public unless you are wildly profitable — end of story.
Erin Griffith is a writer at Fortune.
Twitter: @eringriffith
