Public market investing lens to private companies

Hi,

“We take a private equity approach to public markets” is a line we all have heard once, but that got me thinking - can the reverse work? After all, aren’t they all businesses?

Thus, the journey started, after spending more than a year evaluating 300+ Pre-Seed to Series A startups for investment, here’s my take on how by adjusting and employing the lens we use to evaluate public market companies we can perhaps make VC investing better.

Let’s Begin

Laying the Foundation

The basic philosophy in any business is the return on capital; at the end of the day, whether you’re disrupting an industry with a product or building yet another factory to boost production, is about “can you make money?”

Now let’s add an aspect of public markets I love - Factor Investing.

If one sees public markets from a factor lens - 3 factors are quite well-known

1. Momentum - Powered by herd mentality and over-reaction to events
2. Quality - Measured by return ratios and leverage
3. Value - The price you’re paying vs. what you’re getting

Lastly, a common theme in successful fundamental investors is looking at companies with good return ratios (ROCE / ROE) and entering at what they deem to be a good price for the growth they are getting.

After, the only two things as an investor you’ve in control are:

a) picking a good business

b) ensuring you enter when you’re paying the right price

To add to the above, stocks with good return ratios but low growth don’t do as well as companies with good growth with temporary hit on the return ratios

In fact, companies with low ROE/ ROCE that eventually move higher tend to do better, given that this change also impacts the market perception of the stock.

To sum it up:

• Businesses are about return on capital
• Herd mentality exists and does make money even in public markets
• In the longer run, the quality of the business and the price of the investor seem to be the common theme in ensuring a good return.

The challenges in private markets

Now, while public markets are extremely challenging, compared to private markets, it’s relatively easy to be contrarian in public markets in India due to a relatively limited set of industries, companies and mean reversion being applicable

Further, you can exit quicker, the feedback loop is faster and it’s an “acceptable” strategy as an institution.

And the biggest advantage - you can enter the company again anytime you wish to.

Coming to private markets, things change in a few ways

1) Difficult to gauge what is a fad vs. what is the next big thing - since usually there’s no history, and since you can’t enter it later in most cases (a deal once gone, rarely would come back except in a few cases), hence you don’t have the luxury of being wrong in the short term and fix it 2 months down the line when there’s more clairity.

2) No tangible financials to judge (atleast before Series A)

Blending the two philophies

Now that the context is established, here’s the perspective on blending the two.

Ideally, as a private investor, one should be looking from the lens that company eventually needs to IPO - A buy-and-hold strategy in my head

And for a company to go do a successful IPO and eventually be considered a good public market investment, it’d need to eventually:

• Deliver a solid ROCE / ROE
• Has to show growth
• Be in a sector that has enough tailwinds to come into momentum - in private markets, a better term would be, can this sector drive FOMO?

Keeping this in mind, building a VC investing strategy on the lines of “value investing” or the contrarian approach of buying out of favour, or in this case, sectors with tailwinds but still nascent/undiscovered, would make more sense and would work better than “momentum” or herd mentality (i.e. FOMO).

Or again, as VC likes to call it and as cringe as it sounds, being a “Thought Leader”

And here’s why: unlike in public markets, where momentum has evidence of existing and enough tools to exit as momentum dries up, private investing is tougher, and you’ve fewer cues.

Moreover, unlike in private markets, where going out of favour as a sector just usually means a lower PE being assigned and good underlying business surviving to a certain extent, in private markets, it can mean capital running out, and the sector going “dead” in most VC fund’s thesis, leading to deadpooled companies.

The above is also the precise mistake that many angels and early-stage VCs end up making: investing in fads due to FOMO, copying bigger investors at times, but entering it much later in the cycle (much like retail investors). This sometimes does give a good return for 12-18M when the company raises their next round and gets early traction, becomes a “winner” but then eventually fails to raise beyond this round or grow at the same pace.

Adjusting the Public Market Lens for early stage investing

We started this long post with two things - Return on Capital (the holy grail) and growth.

Now Return on Equity (ROE) = Net Profit Margin (NPM) Asset Turnover Ratio (ATR) Leverage - according to DuPont anyway

Let’s go each component-wise and try making a scorecard that makes sense before coming back to growth

The Margin Game

Net profit margin is extreamly tough to gauge for Startups - Why?

Cause they don’t exist in most cases.

In fact, even unit economic-level margins like gross margins are rarely higher than those of established companies in stages before Series B.

So the better way to see it is “How will it look like 10 years down the line” and for that we need to take a look at three things:

1. Gross margin potential (and as an extension Unit-Economics Potential)
2. Operating leverage

1. Gross margin potential

Gross margin, is basically how much value a company adds to the raw material to deliver the final product

iPhones have a High Gross Margin because the value of it is much higher than the raw material goods combined - whether this is tangible or a market perception is up for debate, but frankly, either way, is it sustainable is what one needs to focus on.

A solid product evaluation can actually help determine if there’s gross margin potential—how? Well, if the product is tangibly better, eventually, it’s going to be something people would pay more for, if not at least the same as the market.

Also, while it’s very common for a startup to not have a high gross margin starting out because of lower volume for raw materials, outsourced manufacturing, etc. (this is why tech / SaaS companies are in favour), knowing what is causing the low gross margin is important.

For example, is it something that’d be fixed with scale, or is it structural—say, packaging that always costs more than the top brand and adds little to the final cost/value-add to the customer?

Think of a company that says, "I spend an extra 10% on my packaging to make it look premium," but is unable to add a proportionate / significant increase to the gross margin due to not being able to command a selling price close to premium brands. This could mean it’s not adding as much value as one thinks.

Another thing to do is to see if the costs pushing down the gross margin today will turn around. Today's gross margins can be lower on account of discounts, returns due to lower quality control, etc., but the question to ask is, can it turn around with scale? If yes, why?

Unit economics potential

I came across this insight on one of the podcasts that featured Manu Chandra of Sauce VC discussing evaluating an omnichannel business. He mentioned that CM2 is a great metric since it reflects most marketing efforts + repeats to see the business's efficacy.

Similarly, once we figure out the gross margin potential, the next step is to see how the contribution margin would eventually look since that’s the key to a sustainable business.

Considerations such as entry barriers, pricing pressure, who controls the supplier and pricing even in mature companies are a good way to figure this out.

2. Operating leverage

The reason why investing in startups chasing growth makes sense in my eyes is because they’ve deep potential for operating leverage

In the book; Value investing and Behavioural Finance, Parag Parikh makes an important point about commodity investing and operating leverage.

The commodity companies that do the best in a bull run are not the ones that are the most efficient (low debt, decent return ratios) but the ones that have the most to gain due to operating leverage (low NPM to high NPM and a rise in EPS due to rise in commodity prices).

Now, this doesn’t fit the traditional “value investing”, but my correlation with VC investing is as follows.

A 2-year-old SaaS company targeting mid-market companies with a 10-member team is developing a product with a 90% gross margin. Each developer has a salary of INR 2L p.m., or effectively INR 2.4cr. The salaries are probably 60-70% of their expenses at this stage, company is of course in a loss right now.

Seems expensive, but if they are able to make a 90% gross & have high switching cost (like most B2B SaaS), and are able to maintain customers, the high burn is less of an issue as long as they’ve decent growth.

At an Average Contract Value (ACV) of INR 2.4L p.a (i.e a product that is sold to companies for INR 20K), it’d take them ~100 customers to break even, but then, every customer they add would add a straight 2.16L to the bottom line, another 100 customers and that’s a 40-50% bottom line, even if they were to add sales folks for a 10% commission, 20-30% Net profit Margin.

Given it’s an asset-light company, so the asset turnover>1 and would have a ROE of 20-30% on NPM alone at 200 customers > for a gross margin 90% and an ACV of INR 2.4L (any product that replaces a Low-cost labour today, easy sell)

This is, infact, perhaps an aspect which is the most important for a VC investor to take note of how operating leverage would kick in

An example of where volume/operating leverage kicks in fast;

Swiggy started a platform fee of INR 3-4 > for a million people who order thrice a week. That’s a straight INR ~50M / 5 Cr added per month or INR 60 Cr per annum (~$10M)

Another example in developed companies; there was an airline once that removed one olive (a singular olive) from its meals leading to a huge cut in losses.

Summarizing: Net profit margin in startups is hard to gauge, but gross margin potential, unit economics potential and operating leverage are figurable.

If I were to rearrange NPM in the earlier DuPont, it’d be gross margin potential (which further determines the unit economics potential) and the level at which operating leverage unlocks.

Gross margin potential = Current gross margin + improvement as the startup scales (what components cost would reduce) +- unique gross margin

Further, this can be ranked vs. other startups and players to see where would it stand

Level of where Operating leverage potential is unlocked: This is more from a perspective of how many customers/orders it’d need at gross margin potential level to hit a comparable EBITDA margin to a similar mature player at the costs that time (assuming similar cost % structure as an industry for operational expenses like salaries etc, if not more)

Moving from net profit margin to Asset turnover now.

Asset turnover Ratio

The idea behind asset turnover is how efficient the operations are (in a way if NPM is a way to gauge how much people pay for the product - a demand thing, asset turnover is how efficiently you can meet the demand - a supply thing)

For most Startups, these are “asset light”, so what is the asset? People + Idea

Well, let’s look at IT companies > a key metric they use is revenue / per employee (as with any people business)

A startup that is able to have better ACV / employee or a Revenue / total employee cost that is higher than peers and/or developed companies is a company that’s more efficient in its use cases.

The only issue here is - that companies have lower ACV / revenue per employee initially - the trick here again is the ACV potential/employee costs today (given if anything, you pay more as a startup for the same employee)

But even more than ACV, what matters is loyalty > i.e Customer Net Promoter Score (that’s the true leverage)

If the aspect of ACV potential combined with today’s net retention and Net promoter score adjusted for employee costs / operational costs of the startup in an asset light set-up - that’d be a good proxy asset turnover ratio for a startup to measure efficiency.

This works since it showcases how much sustainable revenue it’d make for every rupee invested, like asset turnover ratio, which is more robust as a metric for MOAT vs NPM (which is sensitive to temp factors like raw material), here too, the retention and NPS are longer-term metrics unlike gross margin which may be impacted by returns/discounts

Leverage

Startups don’t usually have financial leverage. The idea behind measuring leverage however is that it multiplies the gains (and, parallelly, reduces the cost of capital).

Leverage actually impacts all three levers.

1. It increases the asset base (which can either reduce or increase ATR)
2. Reduces NPM (in most cases)
3. Increases leverage

So unless the debt actually has a net positive affect, it may not be the best thing in the world.

Now the other way to look at leverage is - how much capital does / can a company have access to and if taking that capital and putting in that business at a cost (capital as an input); would it help the business or not.

A commonly accepted fact is - if someone has money, they will spend it > companies flush with cash do M&As that add low value, are not reinvested back in the company at same ROCE leading to lesser investor returns, invested in mutual funds, etc. - which infact drives share price down at times under the reasoning of “improper capital allocation”

In a startup, larger rounds are essentially doing the same thing; you’ve more money to play around doing stuff that you could’ve done for cheaper; capital efficiency is a key aspect here - however, capital efficiency here isn’t just total revenue / total capital invested but also outcome / capital invested vs. other players

For example:

Let’s say a startup is operating in 50 locations and achieving a sale of 1L per store at 1cr capital; so INR 50L revenue on a INR 1 Cr capital base, so capital efficiency is 0.5x

Another startup is operating at 20 locations and achieving a sale of 2L per store at an 80 capital base; so INR 40L revenue on a INR 80L capital base, so capital efficiency is, again, 0.5x

Capital efficiency here is the same.

However, if we do outcome/capital;

50 locations/INR 100L vs. 20 locations/INR 80L is a good starting point; the former looks like it needs lower capex, but what about other aspects?

Given we add up the other aspects we talked about till now, a holistic score would successfully be able to help us decide here on the potential ROE

The Key: Growth

Lastly, comes growth - at the end of the day, the above is contingent on growth, you’d not be able to unlock operating leverage or be able to get higher gross margin potential or make larger ACVs when you don’t scale

Growth, however, has to be sustainable. Growth without retention is stupid,

Retained + sustainable growth (growth * a retention metric that’s suitable) - is a better way to look at growth

A 20% growth with a Day 7 retention of 30% is 0.6%

A 30% growth with a Day 7 retention of 15% is 0.45%

Assuming one makes money back in 7 days, in this case, the former growth, although slower, is likely to lead more to our outcome.

The d1/d7/d28 can be swapped out for the net retention basis industry.

Conclusion

This was probably the longest post I’ve written so far, so thank you if you’ve made it this far.

At the end of the day, startup investing is about the problem and the founders, a quest to make a better world by funding ambitious ideas and taking risks no other investors can (at least that’s the idea).

The above is just a way to rationalise to ensure we can better develop a framework from the “investing side” perspective to view and evaluate businesses with long-term potential.

Hopefully, the above allowed you to draw parallels between public market investing and venture capital investing and perhaps added to your perspective on early-stage companies.

Until next time, keep Manifesting Wealth.

This post was originally written for subscribers on my substack newsletter Manifest Wealth

Disclaimer 1: All above views are purely for educational purposes and are not to be taken as investment advice. Investments or trades taken of any kind based on this are solely the person’s risk, and I bear no liability. Please consult a financial advisor before making any investments. All investments are subject to market risks.

Disclaimer 2: The views presented above are mine and not of any organization(s) I work with / am employed at