Jul 19, 2011

Why Consumer Companies Are Worth Billions

I recently met with an investor who bemoaned the fact that consumer tech companies get higher valuations than business tech companies. Many business tech companies have fantastic revenue growth, experienced management teams, and excellent execution, yet the market values consumer companies more. Here’s why.

Main St

M3

Mass Market x Monetization x Main Street

1.     Mass market.
From a business model perspective, mass market means mass reach and consumption. Everyone can be a user. The potential scale is as large as the number of people on the planet.

2.     Monetization.
All those users can consume ads, pay directly, or do both.

That results in a very simple to understand (and in theory, simple to execute) revenue model:
Many users x Small amounts money = Lots of money.

3.     Main Street.
From a market and investment perspective:

Many people have experienced or know of the company and are therefore more likely to buy the stock and drive up the price (many people prefer to buy the things they know).

People want to say they’re in it. I invested in “It’s really profitable but you’ve never heard of it corporation” versus “I invested in Google/Facebook/etc.” In later stage investing, investors can make a lot of money investing in less well known or undervalued/mis-priced assets, but many want to be in the “hot” companies.

There’s good reason for that: hotness by association. Plus, being hot begets more hotness. What is the value of being hot? Though it might seem irrational to some, the market certainly does its best to quantify it with multi-billion dollar valuations.

In addition to the three M’s, there are a few other important aspects that drive consumer company valuations:

4. Network, winner take all, and platform effects.

Consumer companies benefit from low user adoption costs and the network becomes more valuable the more people join. Social proof is obvious. In contrast, the enterprise equivalent is much less visible; social proof must be heavily and expensively marketed. Think ad campaigns like Oracle’s “10 of the top 10 IT service firms use Oracle.”

Users customize the product rather than the product developer. Users do this through preferences or their own content rather than customized “pro serve” content and development for individual customers.

This results in perceived (and sometimes real) lower operating costs. That is, the perception that a consumer company doesn’t have to hire lots of sales and service people, because the money comes from all those users. No long RFPs and sales cycles.

Winners tend to take the whole category; or there’s #1 and #2 followed by a long and not very valuable tail.

Consumer winners frequently become platforms because they leverage their consumer base, infrastructure, or both, to drive the development of third party applications on their platform. Developers are drawn to these platforms because of their broad adoption and the promise of accelerated adoption for their own applications (in exchange for paying a tax on anything they monetize, of course).

5. Scarcity.

Mass consumer successes are very rare. By definition, that makes them valuable.

Few products appeal to the mass market. When they do, it’s such a rare event that it’s inherently valuable. A mass consumer success is a Black Swan event.

Many business offerings turn out to be niche offerings or a large number of niches bundled together to create a “large” market. Successful consumer companies create one product. It may come in different forms (Apple) or skins (Zynga) but it follows one theme that appeals to all.

What about business companies?
All of this begs the question, is there upside in building business companies, when the market values consumer companies more? As just one data point, if the rumored $5B valuation for the impending Dropbox round has merit to it, then absolutely, yes – when it comes to building companies at the intersection of consumers and business, that is, Consumer IT. These companies benefit from network effects and the resulting customer adoption leverage (that is, lower costs of adoption), in much the same way that consumer companies do, and the market values that.

For companies that have very limited adoption leverage (and correspondingly higher costs of adoption), however, the potential market valuations are lower. Valuations hinge in large part on adoption, adoption leverage, and associated costs, and these companies don’t have a way to access that. Their exits are most likely to existing players that have the distribution channels (e.g. adoption leverage) tied up.

From a professional investor perspective, these companies are often mis-priced since they lack the Main Street appeal and valuation drivers of Consumer and Consumer IT companies. That, however, presents an opportunity to generate return multiples in this area with lower risk. Eventually the gorillas buy these companies; and while they may not pay Main Street prices, they do pay. Such exits require patience, consistent revenue growth, and proven operating margins – that is, strong  business fundamentals.

Conclusion
Mass consumer successes are Black Swan events. Together, the 3 M’s, network effects, and scarcity cause the market to give them 10, 11, and, yes, 12 digit valuations. Building a Consumer IT company? Focus on adoption leverage and reap the resulting valuation benefits.

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