The first equity deal I ever worked on involved raising $140 million for the old Chrysler Corporation. It was November 1991, and the company was hemorrhaging cash during the recession/oil shock caused by Iraq’s 1990 invasion of Kuwait. They needed the money to finish tooling up for the Grand Cherokee, a smart-looking new SUV to be built in an equally smart-looking new facility in Detroit.
To get the transaction across the finish line, we had a +500 person roadshow lunch in New York featuring Lee Iacocca, Chrysler’s rock star CEO. His promise that day: the Grand Cherokee would make huge profits, and with a better economy the company could eventually earn its current share price ($5) in earnings per share. It worked – the deal sold, the SUV was a success, the stock went from $5 to $30 in a few years, and Chrysler did eventually earn $5/share.
That experience taught me three things about investing in money-losing companies that still hold true today:
- Equity in unprofitable companies looks a lot more like a call option than a traditional stock. They can expire worthless, or they can pay off handsomely; it’s usually one or the other.
- Management vision trumps earnings models. Even though it was Iacocca’s profligacy during the good times in the 1980s that had put the company in danger in 1991, investors still loved his charisma and vision.
- These two features only really work out for investors when marginal capital flows to a disruptive new product. The Grand Cherokee was at the right place at the right time, and Chrysler made +$5,000/unit on sales of +150,000 units/year; that $140 million equity deal allowed the company to generate $750 million in incremental pretax profit/year.
Fast forward a few decades, and this framework is a dominant capital markets narrative rather than just one dusted off for cyclical stocks at a trough. Four reasons for this transformation:
- Tremendous opportunities for disruptive technologies to reach worldwide audiences through mobile devices and global high speed Internet.
- Old-line companies suffer from the “Innovator’s Dilemma”, where they feel they cannot change their current business model to one that leverages mobile/Internet without killing their existing franchise.
- Low barriers to entry for disruptive companies to build a “Minimally Viable Product” and test their business model before requiring large capital outlays.
- The ability to monetize unprofitable companies not just through an IPO, but also in a strategic sale to another business in need of the audience/technology developed by the money-losing enterprise.
Since little of that list revolves around “How much money can the company make?” market valuations have shifted to an options-based approach rather than just a traditional discounted cash flow model. Take your premium (investment), your expected volatility (chance of success), a potential payoff, time and cost of money and you have a reasonable approach for valuing a disruptive startup. And, of course, you’ve also outlined the Black Scholes options pricing model.
As for proof that capital markets now embrace this approach, consider the following:
#1. As of the end of last year, 34% of the companies in the Russell 2000 were unprofitable. That hasn’t stopped it from rallying 3% this year, or 13% over the last 12 months. Nor has a large slug of unprofitable companies made the Russell more volatile in 2018; 30-day historical vol is actually slightly lower than the S&P 500.
#2. Many of the outsized winners in the S&P 500 both YTD and over the last 12 months have little in the way of earnings but tremendous “optionality”.Amazon, Tesla, Netflix… You know the list. Not much in the way of profits, but all are essentially a call option on their disruptive business models. And, no surprise, all feature highly visible CEOs that would give Lee Iacocca a run for his money.
#3. Crypto currencies like bitcoin are all straight-up call options on the remaking of “money” in some new decentralized and digital form. Or, if you prefer, a put option on government backed currency. Either way, without cash flows to value crypto currencies they will never meet the traditional definition of an investment. And that’s a feature, not a bug.
#4. Tech-focused venture capital sets the marginal price for disruptive companies with an options-based valuation framework, even if this approach makes equity investors scratch their heads. By our count there are +30 VC funded companies with last-round valuations over $5 billion, and most are unprofitable. US based venture capital firms are in the middle of raising fresh capital to compete with SoftBank’s $100 billion Vision Fund. All this money will flow into capital markets with optionality, rather than pure profitability, in mind.
For public equity investors, the shift to an option-based valuation approach can be difficult. It makes some parts of the market look extremely expensive and seems to misallocate societal capital as well. Even worse, traditional companies with above-average profit margins look more like targets for disruption than attractive investments. In a market neck-deep in options-based valuation frameworks, a money-losing business with a novel technology could well have a higher valuation than the profitable venture for exactly that reason.
Our simple advice: embrace optionality, just as Chrysler’s investors did in 1991. It is the way markets attempt to value disruption, since there are no near term cash flows to assess. This approach will fall out of fashion only once tech-enabled disruption slows down. And that may not be for a long, long time…