by Tom Taulli
Of these, energy has been tough to control. This is why Facebook has situated data centers near electric power plants or in cold climates, because it is expensive to cool down servers
Gross Profit
This is revenues minus the cost of revenue. Investors analyze this number using the gross profit margin:
Gross Profit / Revenues
You want to see this above 50% because that means your company has much more room to be profitable. Facebook’s gross margin was 73.4% by the first quarter of 2012, which was standout.
It’s important for gross margins to increase over time, which indicates leverage in the business model. Again, it’s a key source of profitability—which can drive massive valuations. This has been the case with companies like Microsoft and Google. And this is why VCs often talk about gross margins.
Marketing and Sales
There has never been a Facebook Super Bowl commercial—or any Facebook television commercial, for that matter. Because of its mega-brand and global reach, the company has had little need to engage in large-scale marketing efforts, except for sponsoring conferences and events. This has been a huge advantage that has helped the company post strong profits.
On the sales side, Facebook has built a self-service ad platform, which has also been a cost saver. But the company has had to ramp up the hiring of top sales and business-development people as well as customer representatives. Top-notch brands aren’t satisfied with automated ad systems; they instead want the counsel of smart people who can create compelling campaigns. For this reason, Facebook has 30 sales offices around the globe.
Research and Development
This item consists mostly of salaries, benefits, and share-based compensation for engineers and computer scientists. Facebook has been aggressively hiring not just product-development people but also those with experience in areas like data mining and personalization technologies, content delivery, media storage and serving, power distribution, and advertising technologies.
These people are not cheap. In some cases, a top engineer commands a multi-million-dollar pay package.
As a result, R&D expenditures have increased substantially for Facebook. From 2009 to 2011, the costs went from $87 million to $388 million.
General and Administrative
These are known as overhead costs. That is, they tend to remain the same regardless of overall sales, at least in the short run. G&A costs include functions like finance, legal, and HR.
Net Income
This is a company’s bottom line (yes, because it’s at the bottom of the income statement). A positive number is a profit, and a negative number is a loss. A company calculates its earnings per share (EPS):
Net Income / Outstanding Shares
The outstanding shares can be those that are already owned. Or it can be on a diluted basis, which assumes that all options and warrants are exercised. Because fast-growing tech companies usually see high levels of exercises, it’s better to focus on the diluted figure.
Once you have the EPS, you can find the price-to-earnings (PE) ratio:
Stock Price / EPS
This is a rough guide to a company’s valuation. As a general rule, a hot tech company has a high PE ratio—say over 30 or 40—because investors pay a premium for growth. But it can also mean the stock is volatile. Even a small drop in the growth rate can hurt a stock. This has happened with public companies such as Zynga, Groupon, Yelp, and Pandora.
There are many flaws with the PE ratio, though. Perhaps the biggest is that it’s backward-looking: it’s based on the past 12 months of earnings. So, investors may instead use a forward PE ratio:
Price / Earnings Forecast for the Next 12 Months
And if a company has losses—which is common for tech companies—then these metrics are meaningless. What to do? Investors instead often look at the price-to-sales ratio:
Market Capitalization / Sales
The market capitalization (or market cap) is the stock price times the number of shares outstanding. It’s essentially the total value of the company.
The price-to-sale ratio is a good way to compare the value of one company to another. For example, if Groupon has a ratio of 5 and LivingSocial’s is 3, then Groupon is commanding a premium valuation.
Of course, Wall Street looks at other metrics as well. But for the most part, they focus on earnings and revenue growth. Because of this, a publicly traded tech company often announces its earnings and revenue forecasts for the next quarter and the full year. This helps to reduce volatility in the stock price because investors have a better sense of the company’s momentum. Wall Street hates surprises.
But some companies like Facebook and Google don’t provide any guidance. Their belief is that they should be focused on long-term growth, not quarter-by-quarter results. This approach is fairly rare on Wall Street; only marquee companies can do it.
The Balance Sheet
The balance sheet includes a company’s assets, liabilities, and equity. It should always balance according to this equation:
Assets = Liabilities + Equity
This makes intuitive sense because to buy assets, a company needs to raise capital by obtaining loans or selling stock. The equity also includes retained earnings, which are profits. It’s another key source for buying assets.
Tech companies like Facebook tend to be asset-light. Most of the value comes from supersmart engineers and the code they create—but they can’t be listed as assets on a balance sheet. Although Facebook has total assets of $7.1 billion, the company’s market value is over $50 billion.
Think of a balance sheet as a snapshot of a company at a certain point in time. It usually tallies everything at the end of the quarter, as you can see with Facebook’s balance sheet in Table 8-2.
Let’s take a look at the key items of the balance sheet.
Assets
An asset is anything a company owns, such as cash, inventory, or real estate. On a balance sheet, assets are listed in terms of liquidity, which is how quickly they can be converted into cash. The current assets can be turned into cash within a year or so.
Cash and Cash Equivalents, and Marketable Securities
A large company like Facebook keeps a relatively small amount of its cash in deposits. Instead, it holds marketable securities, such as Treasuries. These are near-cash but pay somewhat higher yields. The yield can be a big deal for a company like Facebook, which has high cash balances.
Accounts Receivable
An account receivable means a company has sold a product or service but the customer has yet to pay. This is actually an asset.
It’s possible for a company to factor or sell accounts receivable, which can be a source of cash. Doing so is common for early-stage companies, but it can be expensive because the fees tend to be steep.
Also keep in mind that a few customers simply fail to pay. It’s part of doing business (and it’s never fun to deal with). Because of this, a company estimates a total for these losses, which is called the allowance for doubtful accounts.
Prepaid Assets
Prepaid assets are those items for which a company makes advance purchases. To understand this, let’s take an example. Suppose Facebook prepays for five months of rent. It can recognize only one-fifth of this amount for the current month as an expense on the income statement. The rest is considered a prepaid asset.
Property and Equipment
According to GAAP, a company must depreciate property and equipment (but not land). This means it needs to reduce the value of the assets due to wear and tear and obsolescence.
A common approach is straight-line depreciation. This involves deducting an equal percentage periodically over the useful life of the asset. How long? It depends on the type of asset. This is what Facebook has:
Network equipment: 3 to 4 years
Computer software and office equipment: 2 to 5 years
Buildings: 15 to 20 years
Let’s say Facebook buys network equipment f
or $100,000. If it uses a four-year term, then the depreciation is $25,000 per year.
A company may also use other depreciation methods that accelerate the process. These may take 25% or more of the value of the property in the first or second year. For the most part, these approaches are based on various tax incentives.
Goodwill
Goodwill is the value from an acquisition: the purchase price minus the net asset value of the target company. Goodwill is fairly common in the tech world.
Suppose Facebook decides to pay $10 million for a mobile app company that has $1 million in net assets. The $9 million is accounted for as goodwill and considered an asset on the balance sheet.
To be in accordance with GAAP, goodwill must be tested at least once per year for impairments (this is the duty of an outside auditor). This is a fancy way of saying that an asset has lost value, such as from lower revenues or obsolescence. When there is an impairment, a company will need to take a loss.
Liabilities and Stockholders’ Equity
A startup probably doesn’t have much debt. Banks generally avoid early-stage ventures because there is no collateral to lend against.
But there are still some liabilities. One form is accounts payable, which is money owed to vendors. As a company grows, so do these liabilities. It’s a key reason a startup needs to keep raising capital—and Facebook was no exception.
Statement of Cash Flows
Cash is king. It definitely makes a founder’s life easier because it tends to mean much higher valuations and less pressure to raise outside capital.
EBITDA is often used as a proxy for a company’s cash flows, but it’s a crude approximation. A better approach is to use the statement of cash flows.
Table 8-3 shows the statement for Facebook.
The statement includes adjustments for a variety of items on the income statement and balance sheet. Notice that there are three main sections, outlined next.
Cash Flows from Operating Activities
This shows Facebook’s cash flows from its operating business. The section begins with net income, which is then adjusted for a variety of items. This involves adding back non-cash amounts—such as depreciation, amortization, and share-based compensation—to the net income. Then other items must be subtracted. A key item is accounts receivable, because Facebook has yet to receive any cash.
Cash Flows from Investing Activities
It’s common to confuse the Investing section with the Financing section. But they have clear differences.
The Investing section includes major purchases, usually capital expenditures for assets that should last longer than a year. But these purchases reduce cash flows. At the same time, any sales of assets increase cash flows.
Over the years, Facebook has substantially increased its investment in capital assets to allow for its strong growth.
Cash Flows from Financing Activities
This is where a company includes inflows from issuing stock and debt. Of course, any buybacks or dividends are subtracted.
For tech companies, the Financing section is a huge source of cash. But over time, the company needs to show that it can generate positive operating cash flows. If not, it’s a sign that the business model is flawed.
Summary
This chapter covered lots of ground and provided enough information for most entrepreneurs. Knowing the language and main concepts of accounting is a big help, not just for building credibility with VCs but also for running a successful business.
The next chapter continues the finance theme by looking at a company’s business model. There are many options to consider.
The Business Model
There seems to be some perverse human characteristic that likes to make easy things difficult.
—Warren Buffett
In Mark Zuckerberg’s letter to shareholders in February 2012, he made a brazen statement: “Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them.”
This is something you never hear from a public company’s CEO. They would be fired! Even Google—which considers itself to be unconventional—doesn’t have the same approach as Facebook.
According to Zuckerberg, “Simply put: we don’t build services to make money; we make money to build better services.”
Now that is unconventional. And it has worked extremely well. As you saw in the last chapter, Facebook has posted standout financials over the years.
For Zuckerberg, building social apps means avoiding the typical money-making aggressiveness that is prevalent in corporate America. Keep in mind that he could have easily plastered ads across Facebook, generating huge revenues. But Zuckerberg realized that this is the worst thing to do when creating an enduring company.
Just look at MySpace. From its origins, the company focused on monetizing—which became even more intense when News Corp. purchased the business. But it ultimately damaged the user experience and killed the company.
This chapter looks at strategies for pursuing a business model. You will first see how Facebook has done this and then examine other approaches that have proven to be successful as well.
Facebook’s Business Model
The business model is how a company generates its revenues. When Facebook launched in 2004, the original vision was that it would focus on local ads. This made a lot of sense because the company was only in campus markets. As should be no surprise, there was a lot of demand for ads for local pizza joints and other cool hangouts. Classified ads were also popular because students moved frequently.
But as Facebook became ubiquitous, the business model evolved. As of now, it consists of two main sources of revenues: advertising and transaction fees from the Payments business.
Let’s first look at the advertising business, which is the main source of revenue (about 80% in 2011). Facebook has two main approaches. One is to use a direct sales force to sell to major companies and ad agencies. These engagements can take time to close and often require developing sophisticated campaigns.
Facebook also has a self-service ad platform, which allows any advertiser to use an online system to manage their own campaign. This is mostly for smaller companies that don’t have the budgets to hire advertising agencies.
Over the years, Facebook has invested heavily in developing systems for advertisers to get value from their advertising. The goal has been to demonstrate that there is a tangible return on investment (ROI).
Despite this effort, there have been concerns that social advertising is less effective than other approaches, such as Google-style search-engine marketing, television, and even radio. This was the conclusion of GM, which pulled all its Facebook advertising in May 2012. The belief was that the ROI was not compelling.
Perhaps one of the problems is that Facebook is a communications platform, which may not be optimal for serving ads because users are there to make comments, post status updates, and check out photos. Ads are often a distraction. It’s true that Facebook has put them in unobtrusive areas—but this makes the ads even less effective because they are easy to ignore.
Another problem is privacy. It seems inevitable that there will be more restrictions on the handling of user information, which is used for targeting for advertising. The big question is how far governments will go.
But Facebook has continued to improve its advertising system. Some of these efforts include the following:
Targeting: An advertiser can base ads on a group’s demographics. Factors include age, location, gender, relationship status, educational history, workplace, and interests.
Social context: Advertisers can engage a user’s friends based on activities such as Liking the advertiser’s Facebook page. The idea is that people probably value a friend’s recommendations versus a straight ad.
Sponsored stories: An advertiser can broadcast messages to more of its fans.
Analytics: These track the performance o
f a campaign in real-time.
Although much of Facebook’s advertising revenue has come from the web site, this started to change rapidly in 2012. There was a major shift to mobile traffic, which caught Facebook off guard. It didn’t have the right infrastructure to monetize things, which resulted in a slowing of revenue growth. Traffic up, revenue down!
This was not the kind of message investors wanted to hear during the IPO in May and was a key reason for the lackluster reception. The good news is that Zuckerberg has declared mobile to be the company’s number-one priority.
But solving the problem will take time. Mobile advertising is still in the nascent stages, and advertisers are experimenting with approaches, trying to see which get the most ROI.
This is why entrepreneurs need to be temperate about a business model based on mobile traffic. It could take a few years to generate any meaningful revenue.
The other important takeaway is that any type of advertising business model requires lots of effort. You need to hire top people, including those who can create campaigns as well as salespeople who can land clients. You also need to build an infrastructure that effectively delivers and measures ad impressions. Such things are not cheap and should be a big part of any venture funding.