Monday, February 6, 2017

Market Caps & The 2% Rule

One way to assess whether a startup idea is in a good market is to ask what are the market capitalizations of the biggest companies in that sector. For example in consumer internet, Google ($560 billion) and Facebook ($370 billion), and in enterprise software Microsoft ($460 billion), and Oracle, ($167 billion) are all large, high margin businesses.

Market caps in a pre-existing industry[1] tend to be proxies for the potential of the idea you are working on. There are three reasons for this:
1. The market capitalization of a set of companies reflects revenue in the market, growth rate of revenue and earnings, and the margins of the companies.
These core metrics used by wall street to value a stock are all metrics that help you understand whether a market is overall large, growing and profitable - all signs of a good market to enter.

2. Often, potential competitors are also potential acquirers. 
Having a large number of high valuation potential buyers in a market creates strong exit opportunities for a startup. For example, for Google to pay $1 billion for a company, it is only 0.2% of its overall stock or market cap. In other words, Google can afford a lot of acquisitions in the $100 million to $1 billion range.

In contrast, the US car rental business is a tougher one. There are 4-5 major players. The largest by far is Enterprise, with $20 billion in global revenue and a $20 billion market cap. The remaining players are much smaller ranging between $1 to $5 billion in market cap. The key characteristic of these companies is that they trade at a low multiple of revenue (e.g. Enterprise trades at 1X revenue) suggesting low growth and a competitive, low margin, market.  Starting a traditional car rental company therefore may be a tough endeavor. Starting a software company that only sells its product to car rental companies also seems like a bad idea - you only have a few potential customers who will each have lot of bargaining power.

3. Strategic investors.
Large, high market cap, cash rich companies tend to be great strategic investors at the later stages for a company. This valuation-insensitive capital can help accelerate a company by giving it a large war chest to act on. For example, GRAIL, an early cancer detection company is raising over $1 billion for its series B. I would not be surprised to see a number of pharmaceutical companies, payors, and health networks participating in this investment round and investing e.g. $100M+ each.

Early Markets Can Be Misleading
The hard part about this approach is defining the real market you are in and the companies that make it up. You can also be fooled by smaller, nascent markets that grow really fast. These are the best types of markets to be in. For example, the consumer cloud storage market when Dropbox started was itself not a large market yet, but clear potential buyers like Google (who had a cloud storage product internally for many years that never quite could launch for some reason), Microsoft and Apple were clearly relevant and in the same general market area. Dropbox recently claimed $1 billion in revenue.

At founding, was Uber a black car company? A taxi company? Or a replacement for transportation and buying a car? If you thought Uber was just a black car company (which in some sense it was at founding) the overall market size seemed middling. Even as a rental car replacement the market size is small and the potential buyers for it like Avis, Dollar, and Hertz range in market cap from $1.5 to $5 billion. This means, with the exception of Enterprise, it would have been tough for any of these other companies to pay $1 billion for Uber. In contrast, thinking of Uber as a replacement for cars (GM alone has a market cap of $50 billion and car makers in general are worth hundreds of billions in aggregate) means Uber has enormous potential especially given its lower fixed costs and higher margins. If reframed as a technology company, Google et al. become potential acquirers and potential market value is even higher. It is therefore no surprise Cruise was bought by GM for around $1 billion - this is 2% of GM market cap and therefore worth the dilution by GM relative to the potential upside (and cataclysmic downside if self-driving cars happen and GM is not a player).

New, high growth markets are also hard to assess. For example, when Google was founded the internet was a much smaller place. So looking at the market capitalizations of search engine companies would be a bad proxy overall. However, if you viewed Google as an ads business, or as a technology business, it became more attractive due to the market caps of companies back in 1998 such as Microsoft, IBM, Time Warner, and others.

M&A: The 2% And $1 Billion Rule
In general, you want to be in markets where multiple companies could afford to buy you for $1 billion, or where 2% of their market cap is at least in the hundreds of millions of dollars.

For example, Walmart's acquisition of Jet.com for $3.3 billion was around 1.5% of its market cap, Cruise's $1 billion acquisition was 2% of GMs, and Unilever's acquisition of Dollar Shave Club was slightly under 1% of market cap. Above a few % of market cap, the nature of an acquisition and its approval by the company's board becomes a dramatically different conversation.

Thanks to Ali Rowghani for comments on a draft of this post.

NOTES
[1] Versus a new industry, which is addressed above.

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