[Updated 10/4/2016 to include credit to Ryan Caldbeck’s May 4, 2016 story in Forbes.]
Quick quiz: Who’s more profitable, LinkedIn or Lululemon? Google or Applebee’s? Facebook or Dunkin’ Donuts? The answers might surprise you. In fact, there’s a massive gap between companies thought to be the most profitable in the world and companies that actually are the most profitable.
So, who is really profitable? Based on earnings before interest and taxes, it isn’t LinkedIn, or Google, or Facebook.
According to a fascinating report by Saar Gur, general partner at VC firm Charles River Ventures, it’s a myth that tech companies — particularly the most famous and highly valued — are the most profitable. Though some tech firms have high gross margins of 70 to 80 percent (for LinkedIn and Facebook, 87 and 83 percent, respectively), the selling, general and administrative expenses in many of the largest tech companies are so high, their actual cash flow is whittled down to nothing. By comparison, the biggest and fastest-growing consumer brands are so profitable and capital-efficient, they argue that consumer deserves more investment than ever. An insightful analysis of Gur’s data published in Forbes earlier this year by CircleUp founder Ryan Caldbeck makes this point very clear.
For enlightenment, just look at Uber, which tallied more than $1.2 billion in losses for the first half of 2016. Recent reports say the privately-held tech darling saw first-quarter losses of roughly $520 million, and second-quarter losses of more than $750 million. Yet Uber is currently valued at $69 billion, backed with $16 billion-plus from investors like Goldman Sachs.
The most successful VC firms have poured money into technology for decades, CircleUp founder Ryan Caldbeck writes, riding high on the Silicon Valley wave. Most of those investments have failed, however, saddling investors with a pressing need to back only billion-dollar companies promising “high internal rates of return and big dollar returns.” Consumer businesses just don’t meet that need.
The hard data provides a reality check and an education in where LPs and funds might get the most bang for their investment buck, Gur contends, particularly in light of macro trends in health and wellness innovation. First, consumer companies tend to be incredibly capital-efficient compared to earlier-stage tech companies. Gur cites CircleUp data showing that 10,000 consumer companies surveyed lost nearly $4 billion, and most needed just $2 million in investment capital. By comparison, as Caldbeck points out, total Series A through C funding averaged $49 million for tech companies that had yet to reach $10 million in revenue, according to Crunchbase data Charles River compiled between 2010 and 2014.
Second, the dramatic and growing shift from large brands and companies to emerging brands and products offers opportunity within the consumer space. Driven by the preferences of Millennial consumers, the top 25 food and beverage companies have lost roughly $18 billion in market share since 2009, while major packaged food companies lost nearly $4 billion last year, Caldbeck notes. And the growing consumer demand for “transparency,” exemplified by organic, sustainable products from independent businesses, is helping emerging CPG companies pull more venture financing into the consumer market.
Surprisingly, many consumer companies have grown at least as fast as tech companies. Gur cites run rates approaching or into hundreds of millions at Krave Jerky, Dry Bar, and Shake Shack by the time they exited, yet none of them raised even $100 million in capital before being acquired. By comparison, well-known tech companies that are still private (Uber being the extreme) are raising billions to simply sustain their growth. Regarding speed to growth, Old Navy reached a $1 billion revenue run rate in just four years, one year sooner than Google and Amazon. JetBlue reached $1 billion just as quickly as Facebook, while Chobani reached $1 billion in the same timespan as Apple and Twitter.
Considering the market share recently lost by big consumer brands, along with the capital efficiency and growth rates of several emerging and innovative consumer companies, the exit opportunities look compelling. Gur cites a Kauffman Foundation finding that the average angel investment in a certain set of consumer products companies yielded a 3.6 times multiple on investment over an average of 4.4 years; in contrast, typical venture funds benchmark average time to exit at five years, and more often than not plan for exits of 10 years or longer. And with $235 billion in deals, the 2015 consumer mergers and acquisitions market dwarfed the tech M&A market by roughly 60 percent, according to PWC research in the report.
Year-to-date profits in the technology sector have proven “lackluster,” tech and finance reporter John Shinal writes, based on a Zacks earning preview. Sales were up by a mere two percent and profits down almost one percent at tech companies representing almost 85 percent of the S&P market cap, he says. But even those “meager numbers” represent revenue growth “well above” an estimated 1.2 percent growth for the national economy in the second quarter — good enough to keep pulling capital into tech.
None of this necessarily means every consumer deal will outpace every tech deal, particularly at the small-growth equity level. Certainly, the next Uber or Twitter or LinkedIn will emerge and grab headlines for creating fantastic riches. Still, investors seeking greater odds of success might want to aim for smaller but more consistent returns in equally fast-growing markets. The latest consumer product and brand innovations Gur describes show that trends are now in place to capitalize on this model across the board.
As Caldbeck underscores, capital efficiency simply works better in the consumer space: Growth rates are equally strong if not stronger; innovative businesses and products (particularly those offering consumers “personalized” health, wellness, and sustainability) are stealing market share from the large consumer brands that will ultimately acquire them; potential exit opportunities are happening in shorter time frames.
Though success is never guaranteed, exposing the myth of high-flying tech companies as the only game in town, and recognizing that authentic opportunities, particularly in emerging consumer, can be just as profitable and successful, is satisfying indeed.
Peter D. Henig is founder and Managing Partner, Greenhouse Capital Partners. He also currently sits on the board of directors of Lifefactory, Revive Brands, Neura, and Linkage BioSciences, and serves as a board observer with InsideView. As an adjunct professor at Dominican University, he teaches courses on product development and business innovation. Prior to founding Greenhouse, he helped lead a number of companies from the pre-business plan and formative technology development phase through to successful liquidity events. He was a founding board member and angel investor at ProcessClaims and an angel investor at Greenplum, Aravo, Solaicx, InsideView, and MobiTV. Earlier in his career he was a business journalist, serving as a senior editor and editorial board member at Red Herring, and publishing his work in The Economist, The Wall Street Journal, and Venture Capital Journal.