Why do we hate very good companies?


Evernote is apparently looking for a CEO. It’s not clear to those of us on the outside whether this is the result of struggles to grow or organization issues, but it’s been a notable story over the past weeks.

Dick Costolo is no longer CEO at Twitter, as investors grow increasingly concerned about Twitter’s slowing growth and apparent inability to scale its business to a level that appears more like Facebook’s or Google’s.

Box went public, but has become the heading for a new category of financing, the “down round IPO”, whereby the public markets judge a company to be less valuable than it’s ultimate round of private financing. Many of the most heavily-financed companies in the private markets have IPO ratchets that will make a down round IPO extremely painful for common shareholders and early investors.

More generally, industry players and observers are commenting actively about the high number of at-risk “unicorns”, and questioning whether the many companies whose future promise has generated a current valuation in the billions will ultimately achieve the financial characteristics that, in the long run, will justify these valuations. Square, Dropbox, Pinterest, Evernote, Box and others all sit at valuations that potentially look challenging when considering ultimate terminal value.

I am a paying Evernote customer and I like the product a lot. It solves a problem for me — allowing me to write notes to myself and have them propagate to all of my devices and environments. I believe I pay $25 per year and am happy with the features I get for that price. If Evernote were a brand new company today, one might start by asking — how many people want to pay $25 per year for synchronized note taking? The company and potential investors would do research and come up with a number. Let’s say we think about 10% of American adults care enough to potentially pay for this (abstracting away, for purposes of this exercise, competition and the rest of the world) — about 20 million people. So you’d look at the opportunity addressed by Evernote and you’d quickly calculate a Total Addressable Market of $500M. Then one would make some broad assumptions about penetration in other geographies and so on and maybe you’d say TAM was $1–2B.

The problem is, that number is “too low”. Too low for what? Too low to create a company with a $5B+ enterprise value. If your addressable market is $1B and you are a category leader, you are still going to (likely) bonk at a few hundred million of revenue, and once growth slowed a company won’t get the high multiple required to generate a multi-billion dollar enterprise value. And that causes investors to shy away, value the company lower, increases friction for recruiting and all kinds of other negative consequences for the company.

But … what if there is a great opportunity to be the category leader in synchronized note taking that effectively maxes out at $250M of sales. It’s somewhat absurd on its face to say that a company that has built a valuable product, achieved category leadership and has scaled to a quarter billion in sales is a failure. But that is effectively where we are today — the overlearning of the (very correct) Power Law observation made by many but most eloquently expressed in Peter Thiel’s book, has caused even very good companies whose steady-state value is organically less than a Google or a Facebook to make unnatural and ultimately ROI-negative decisions in an attempt to sit at the far left portion of the power law curve. These companies are encouraged (maybe required) to raise more capital than can be productively deployed, engage in NPV-negative marketing activities and twist their product and roadmap in ways that damage the value that’s already been created in service of a bigger future that was never really part of the company’s opportunity set in the first place.

In general I find that when markets are shaped by investor business models (e.g. investors wanting more junk bonds in the 80s, tech stocks in the 90s and mortgage-backed securities in the mid 2000s) companies are distorted and make bad decisions. It’s inexorable that venture investors want their best companies to be as large as possible, but it may be that each company has a natural upper bound or range above which it can’t productively expand. Some companies have business models that deliver high value to virtually every one (everyone needs web search, almost everyone chooses to participate in social media, huge numbers of people are willing to pay for on-demand transportation, etc…) but for those whose market opportunities are more constrained (even to an objectively attractive number), the need to aspire to stratospheric valuation is ultimately value-destructive.