Spreads
Finally — and relatedly — you have to capture much of the value you create in order to be great. A scientist or mathematician may create a lot of lasting value with an important discovery. But capturing a meaningful piece of that value is another matter entirely. Sir Isaac Newton, for example, failed to capture much of the immense value that he created through his work. The airline industry is a less abstract example. The airlines certainly create value in that the public is much better off because they exist. And they employ tons of people. But the airlines themselves have never really made any money. Certainly some are better than others. But probably none can be considered a truly great company.
-Peter Thiel during his Spring 2012 lecture “Value Systems” as quoted by Blake Masters
I spend a lot of time thinking about the reasons why I gravitate towards certain startups as opposed to others. All of the entrepreneurs I meet and speak with are incredibly talented and bright, so what are they seeing that I don’t see? More importantly, what is it that I’m looking for?
If I had to form my own investment thesis, one principle would be to invest in companies leveraging large “spreads”. This idea first dawned on me during an early morning coffee with the founder of Clover Health, Vivek Garipalli. Vivek’s company, Clover Health is leveraging technology in order to dramatically reduce risk scores for Medicare patients. The entire Medicare insurance market is predicated on the fact that insurance companies can underwrite risk that leaves them enough of a spread to make a profit on the government assigned risk score (after subtracting their hefty advertising spend). Clover is dramatically reducing the risk of these high-risk patients leveraging technology, which in turn increases that spread.
Startups that are disrupting traditional industry are often leveraging technology in order to reduce a spread that once existed because of a lack of transparency, accessibility, or efficiency. Marc Andreessen often quotes Jim Barksdale’s now famous line about how to make money in software. During the roadshow before the Netscape IPO, Jim Barksdale told investors that “you can make money in software in two ways: bundling and unbundling”. Companies that do this are often successful because in bundling and unbundling they uncover large spreads (and as a result profits) that weren’t available before the Internet and other new devices/technologies.
Take Metamorphic portfolio company UpCounsel for instance. UpCounsel is a marketplace for businesses to hire and manage trusted attorneys. By unbundling law firms, creating tools for attorneys and matching them with clients, UpCounsel can dramatically increase the spread earned by attorneys (and as a result the company) because they can service more clients and make more money servicing these clients without having to join a large firm or spend time and money bringing in new cases.
ClassPass is a good example of a company bundling together disparate services to create a spread. By offering a membership program for fitness enthusiasts to use at their leisure for $125 per month, the company is predicting that the spread between what they pay gyms per month and the average number of times users will take classes will be significant enough to net a profit.
Many of the peer-to-peer loan companies have found large spreads to exploit as well. P2P loan companies leverage technology and an abundance of data to provide efficient and unique underwriting that wasn’t previously accessible to the crowd or in many cases available at all. By doing so, these companies open up a much larger market of potential lenders that couldn’t previously access this type of investment vehicle. This creates a spread for these companies previously only available to banks (and without risk of actually providing the loans).
One of the reasons I’m so bullish on Square long term is because they have unique distribution at the POS level with so many SMB’s. As a result, Square Capital has proprietary origination and can easily offer merchant cash advances, creating a massive spread that didn’t previously exist because of the amount of money banks spend on acquiring customers and the interest accrued on the loans they give out to SMB’s.
Insurance companies have profited on these spreads long before the Internet. Underwriters issue policies in an attempt to access the potential risk of a customer in order to capitalize on the spread between the amount of money paid out in claims and the cost of the policies. This is an incredibly exciting sector right now because entrepreneurs are figuring out ways to leverage technology, big data, and analytics to provide better underwriting models and therefore increasing the spread which they can pass on to their customers in the form of a discount.
Examples of other companies with spreads:
Metromile is an auto insurance company that provides its customers with a device that tracks mileage driven and charges customers based on this metrics and not their demographic. The company can accurately track gas mileage, vehicle speed, and trip length frequency in order to provide better underwriting and decrease loss prevention, providing a large spread of profit.
By leveraging technology in order to make investment decisions, these companies provide wealth management to a much larger segment of the population that previously didn’t have access to a top-performing investment manager. By leveraging technology and artificial intelligence instead of huge teams of wealth managers and financial analysts, the profit spread is much larger than that of incumbents.
Compass is a technology-enabled real estate platform that leverages technology to create more leads for their brokers and drive more traffic to their listings, resulting in homes being rented and sold faster and more efficiently than competing brokerages. This speed and efficiency creates a large spread for the company (and their brokers) as they can service more listings and customers and extract the highest price possible in a shorter amount of time than if they were independent brokers at one of the legacy firms.
Munchery is a food delivery startup in which customers can order meals delivered to their home prepared by top local chefs. By cooking these meals outside of the big cities and in large quantities, Munchery increases the profit spread by cutting out costs weighing down restaurants, most notably their prime real estate locations.
Zenefits and EaseCentral
Zenefits is an online HR software company that provides payroll services, benefits, HR, and compliance all in one dashboard for free to their customers. Zenefits makes money by serving as the health insurance broker of record for its customers. The free software provided by Zenefits is a gateway providing a large profit spread when compared to independent insurance brokers. At Metamorphic Ventures we invested in EaseCentral, a company that provides cloud tools and software for brokers to leverage the same dynamics achieved by Zenefits. EaseCentral is similar to Compass in that the company allows brokers to manage a larger number of clients more efficiently and with a better experience. This in turn creates a larger profit spread when compared to their earnings before EaseCentral’s platform.
You could substitute the word spreads for net profits, however net profits can be attained selling a product or service for more than the cost to acquire a customer + cost of goods sold. This doesn’t provide insight into the disruption and value proposition of a technology company in the earliest days as all companies predict at scale that CPA + COGs <revenue. A spread is created by leveraging technology in order to increase profit margins or market size, oftentimes in disrupting traditional industry.
In some cases, the spread can be as simple as the cost to acquire a customer vs their lifetime value. The larger the spread, the more valuable the company is. This is a commonly used metric used to evaluate startups, although for reasons outlined by Bill Gurley, it’s difficult to depend on early on in a company’s lifecycle. This is why the size of the spread is so important. The larger the spread, the higher potential lifetime value of the customer. Therefore the risk of customer acquisition costs negating the profit is reduced. Does the spread increase with scale (network effects) or will it erode and become a race to the bottom when incumbents or new technologies catch up? The long-term success of the companies mentioned above will be determined by just how formidable these spreads really are.
Note: I didn’t explicitly discuss SaaS companies in this post because all of the best ones have big spreads and the truly great ones have big, defensible spreads. A very large spread exists in selling software to replace a function done less efficiently, especially when customer acquisition costs are paid back quickly. This is why you’ll oftentimes hear investors and entrepreneurs talk about 75+% gross margin for SaaS companies.
Disclosure: UpCounsel and EaseCentral are Metamorphic Ventures portfolio companies.
