A few days ago, a founder contacted me after reading my article about my approach to marketing investment opportunities.
He wanted to know if I could market his advertising agency as a tech company regarding its tech-powered processes. I've been asked this question a lot over the last two years.
Since the famous Software is Eating the World, if your company has been fortunate to be classified as a Tech company, you would enjoy a valuation multiple well above non-Tech companies.
We have reached a peak these last two years. Take Root Inc. (ROOT), for instance. ROOT is a technology-powered auto insurance company valued at $6.7 billion at the IPO in November 2020.
Just have a look at ROOT's S1 pitch intro:
Root is a technology company revolutionizing personal insurance with a pricing model based upon fairness and a modern customer experience. — Extract from Root Insurance Company’s S1
An investor reading this intro knows what he will get!
In November 2020, ROOT's price was $468 per share. In October 2022, the share price was less than $8, a 92% equity value loss in two years…
Because investors believed ROOT was a tech company, they bought it at $468. ROOT has been marketed as a tech company in a pretty good way.
If your company has been fortunate enough to be classified as a Tech company, you would enjoy a valuation multiple well above non-Tech companies.
However, the definition of a tech company is even more controversial than a start-up. In the last two years, I've met a commercial real estate company, an IoT engineering consulting company, and a mobile casual gaming company. All of them wanted to be considered as a tech company.
To leverage this trend, I’ve put together a framework called the Ultimate Software Company framework.
An Ultimate Software Company possesses an advantageous and differentiated enough business model to justify a premium tech valuation multiple.
This framework could help you market your company as a tech company. However, to deserve using its framework, you must promise me to:
Be generous about what investors want
Understand why investors pay premiums on tech companies.
What an investor wants
The essential principle for long-term investments is buying assets below their estimated ability to generate future cash flows or intrinsic value.
Indeed, what makes a business valuable is its ability to generate future cash flows — ideally a lot of it, with a high degree of certainty and for a long time. It's an axiom of business.
After estimating the intrinsic value of a business, an investor wants to buy this business at a price below that estimation. The more the discount, the happier an investor is.
Why an investor pays premiums on tech companies
The most reliable way to estimate intrinsic value is the Discounted Cash Flowmethod (DCF).
DCF is a methodology of future cash flow actualization, transforming future cash flows into their equivalent value today.
In a DCF-context:
the more a business has a business model tending toward the Ultimate Software Company
the more the estimated intrinsic value will be high
the more an investor will be eager to pay a premium for this business compared to their peers.
An Ultimate Software Company possesses a business model with operating characteristics leading to a high level of growing, predictable and durable cash flows.
Companies presenting most of the Ultimate Software Company's operating characteristics are known to be recipes for massive profits and help justify tech's premium multiple relative to the broader market.
An Ultimate Software Company has
High Operating Leverage
Negative Working Capital
Built-in Network Effects
Tying these operating characteristics with your business's aptitude to generate long-term solid cash flow dynamics makes this framework powerful.
To illustrate this, I've unpacked ROOT's S1 to show you how the management team (and their bankers) did an excellent job marketing ROOT as a tech company.
Disclaimer: you will dive into the Ultimate Software Company Framework. You will have a concise explanation of these four operating characteristics, and you will also have a look at how ROOT has leveraged this framework.
Or the ability of your business to retain customers
Compounding is a finance term referring to the exponential growth of an investment.
If you invest $1,000 at a 7% annual interest rate, you will earn $70. Instead of buying drinks for your friends with this $70, you reinvest them. Next year, you will make $74,20 because you will have compounded your $1,070.
Repeat the process for 20 years, and you'll turn your $1,000 investment into $3,870 — almost quadrupling your money. Einstein once called compounding the most powerful force in the universe.
The principle of compounding extends to other areas of life. In business, compounding captures the relationship between the cost of acquiring a client and the revenues this client generates over its lifetime.
It's easy to evaluate the compounding nature of a business, especially in subscription models. You acquire a customer, charge them for a service you're providing, and as long as your customer is happy, he will keep paying.
Businesses that can retain customers for long periods provide a high level of predictability and consistency in the future.
The more confident an investor is regarding your future cash flows, the higher valuation multiple you will get for your business.
Let's see how ROOT has framed the compounding growth effect of its business model.
ROOT is a technology-powered insurance underwriting provider that wants to be set apart from other insurance companies because of technology.
Our model is different from that of a traditional insurance company. We are high growth with a tangible distribution and cost-to-serve advantage. — Extract from Root Insurance Company’s S1
However, like any auto insurance provider, ROOT sells subscriptions. Premium is the technical term. But ROOT sells premiums to a specific niche: the low-risk Millennial drivers.
Relating to the customer segments we target, we lead our competition in what we believe are the two most important factors in selecting an insurance provider — price and experience. — Extract from Root Insurance Company’s S1
At the IPO, ROOT reported impressive growth. In 2018 and 2019, ROOT had a portfolio of 111,336 and 281,310 policies, respectively. From January to June 2020, ROOT had a portfolio of 334,327 policies.
Compared to the benchmark, ROOT had an immature portfolio, with only 47% of policies being renewal premiums, compared to an industry standard of around 80%.
At the IPO, customer retention after one year and two years was 84% and 75%, respectively, thanks to a digital-native customer experience.
Recurring customer premiums have no associated customer acquisition costs and minimal underwriting costs, driving profitability. — Extract from Root Insurance Company’s S1
In summary, ROOT has described itself as a fast-growing company with a subscription business model endowed with an immature portfolio that will ultimately turn into a mature one with time.
Long-term investors familiar with compounding know that most of the benefits come at the end.
From a cash flow perspective, it's the opportunity to buy future, predictable, growing cash flows at a discount, thanks to the compounding effect.
High Operating Leverage
Or the ability of your business to increase profit margin while growing.
Operating leverage is a cost-accounting formula to assess how a business can increase its profit percentage while growing revenues. This measure captures the relationship between a company's fixed and variable costs.
For example, a business with a high gross margin and low variable costs has an high operating leverage.
Furthermore, an high operating leverage company can scale beautifully. And investors love companies scaling graciously, especially when higher revenue means higher profit margin.
With software, investors have found their soulmate.
A software company sells access to lines of code with low variable costs. Indeed, there is no cost associated with producing new access to the code or distributing the product as it is delivered via the Internet.
When the company has sold enough copies to cover its fixed costs, every additional dollar of sales revenues turns into 100% profit. High operating leverage is supercharging profit growth.
High operating leverage companies can carry high valuation multiples because the future means having much higher earnings.
Let's see now how Root Inc. has leveraged this feature.
Like any traditional insurance company, ROOT's gross margin is based on a Loss Ratio: the percentage between the premiums paid by a client and the money paid to this client regarding a claim.
Again, ROOT has painted a portrait of a tech company.
Effectively harnessed, telematics-based pricing models are far more accurate than models built on traditional, demographic-based underwriting variables, enabling us to segment risk and deliver lower loss ratios which we can share with our customers in the form of better prices. — Extract from Root Insurance Company’s S1
ROOT's proprietary technology can generate insights about the probability of a driver submitting a claim based on recent driving behavior.
Fueled by proprietary insights, ROOT is implementing a targeted growth strategy. ROOT offers cost-competitive policies to the most profitable customer segment to increase conversion within that segment.
At the IPO, ROOT's Loss Ratio aligned with their peers. However, thanks to this targeted growth strategy, ROOT declared it would deliver a lower Loss Ratio over time.
Furthermore, ROOT claimed to have a better distribution cost to incumbents thanks to a direct-to-consumer approach.
Through our hyper-targeted, data-driven and ever-improving performance marketing capabilities, we have been able to acquire customers far below the average cost of doing so through each of the direct and agent-based channels. — Extract from Root Insurance Company’s S1
ROOT has just depicted a high-growth tech company with a predictable and scalable growth engine following a growth-at-all-cost strategy.
Finally, Root claimed a cost-to-serve advantage, giving economy of scale regarding claim management. Thanks to technology, claim management aims to become less labor intensive.
We are realizing operating efficiencies as we scale against our fixed expense base. — Extract from Root Insurance Company’s S1
In summary, ROOT has marketed itself as having higher operating leverage than incumbents, thanks to its tech-powered operations.
Tech investors are familiar with scalable companies having a data-driven growth engine.
From a cash flow perspective, it's the opportunity to buy a fast-growing profit engineat a discount regarding the first-mover position of Root in a high total addressable market.
Negative Working Capital
Or the ability of your business to produce economic profits
Profit is arguably one of the most critical business metrics. However, few of us distinguish accounting profit from economic profit.
For example, a firm can generate positive net income profit without posting any economic gains.
Indeed, Accounting profit is the gross income of a company, which is revenue minus operating expenses. On the other hand, Economic profit is gross income minus reinvestment expenses and the investor's opportunity cost.
To maintain its operations, a company needs to invest. The lower a company needs to invest for operations maintenance, the higher the amount of cash is available to fund growth or to reward equity investors in the form of dividends or share buy-backs.
Again, software companies provide an ideal scenario.
Due to high operating leverage and most of them receiving money from customers faster than paying salaries, software companies have negative working capital.
The cash upfront from customers reduces the business's cash needs, leaving more cash for growth and shareholders.
Let's see how ROOT has narrated its ability to reward better equity shareholders than incumbents.
There is no mention of ROOT's ability to charge its customers upfront. We cannot assume that customers are financing growth, reducing the cash needs for the business.
However, they emphasize an approach to maximize shareholder capital.
We operate a “capital-light” business model and utilize a variety of reinsurance structures to maximize returns on shareholder capital. — Extract from Root Insurance Company’s S1
Underwriting insurance providers must have sufficient cash in banks to comply with the 3:1 premium-capital-ratio requirement.
Every dollar of an insurance company's premiums must be associated with 0,3 cents locked in the bank to meet the premium-to-capital ratio.
This ratio undermines the ability to scale of an insurance company as the more it grows, the more it has to secure capital, generating no return.
In that context, ROOT has created an ecosystem of reinsurance partners to manage the premiums in their portfolio in a capital efficiency way. In other words, they cede around 70% of their premiums to other insurance companies.
For example, they have a subsidiary in the Cayman Islands where the premium-to-capital ratio is not 8:1, not 3:1.
Every dollar of net premiums we cede to Root Re requires less than half as much capital as it would have required in Root Insurance Company. — Extract from Root Insurance Company’s S1
In summary, they affirmed to be a better investment opportunity than other insurance companies for investors from a return on equity perspective.
Long-term investors know that high return on equity companies largely cover their opportunity costs.
From a cash flow perspective, it's the opportunity to buy fast-growing economic profits at a discount thanks to the ability of ROOT to control and leverage customer relationships.
Built-in Network Effects
Or the ability of your business to create long-term, defensible economic profits.
Whenever a company develops a profitable product or service, it isn't long before other firms try to get a piece of the pie.
Profits, especially economic profits, attract competitors, resulting in a war of attrition. The first-mover will experience a growth slowdown and/or a margin reduction as the best way to acquire a customer is to cut down the prices.
However, competitive advantages enable some businesses to escape the war of attrition and generate substantial growth and margins for extended periods.
The most powerful competitive advantage is an ever-improving customer experiencebuilt into the product fueled by network effects.
The more users your products have, the more data you have regarding product usage, and the more you can improve the product to deliver more value.
Suppose your company has a data-driven culture of collecting user-generated data regularly and systematically. You can continuously improve the product to acquire and retain customers without degrading your margin.
Let's see how Root has used built-in network effect to frame itself as the only winner in its market.
ROOT has leveraged the data-driven culture. The word data appears more than 300 times in the S-1.
Our data represents one of our most prominent competitive advantages because we can uniquely segment risk. — Extract from Root Insurance Company’s S1
Insurance companies aim to price customer protection effectively according to the probability of a customer generating claims in the future.
Traditional risk profile assessments are based primarily on static demographic underwriting variables like age and sex. For example, a 35-year-old man can have a better price than a 50-years-old woman.
However, the actual driving behavior is little to not considered in standard pricing. ROOT's behavior-based pricing is based on active data such as speed limit compliance.
We believe driving behavior is the most powerful predictor of losses, and we measure this through telematics. — Extract from Root Insurance Company’s S1
ROOT's tech-driven approach is based on a specific technology having been around for decades. However, only the advancement of mobile technology this particular technology has made the concept adaptable at a large scale.
ROOT stated having a critical first-mover advantage in behavior-based pricing with a four-year head start thanks to the most comprehensive and proprietary dataset since its inception.
Compared to competitors, ROOT framed itself as a 10x better and cheapersolution:
Better thanks to a mobile-first engagement strategy throughout the value chain to onboard and retain customers.
Cheaper thanks to an individualized pricing strategy to offer a fair price according to the driver behavior based on a data-enabled flywheel (built-in network effects).
Furthermore, like most tech companies, ROOT has declared to be in a winner-takes-all market.
As our flywheel turns and more mispriced risk converts with our competitors, our competitors are put in a position of having to broadly raise prices to meet profit expectations, improving our conversion. — Extract from Root Insurance Company’s S1
As ROOT converts the most profitable customers, competitors are left with high-risk drivers.
The more ROOT gains market share, competitors will experience an increase in their Loss Ratio. They will have to increase prices, so ROOT will become even more competitive.
In summary, they framed themselves as the first-mover in a winner-takes-all market thanks to two types of network effects:
a positive network effects around its product to assess customer profitability
an adverse network effects around its competitors with increasing complexity in managing their Loss Ratio.
Long-term investors are well aware of the high defensible nature of network effect-powered business models.
From a cash flow perspective, it's the opportunity to buy highly defensible future cash flows thanks to the most powerful competitive advantage.
In essence, ROOT has offered the opportunity to buy predictable, growing, and defensible future cash flows for shareholders at a discount regarding the high-growth profile of the company.
Indeed, nothing contributes more to a higher valuation multiple than growth. The faster you are growing, the larger and larger future revenues and cash flows will be, which has direct implications for a DCF.
Even if the company has incurred significant losses, it’s a part of the well-known growth-at-all-cost strategy.
ROOT's 6-billion IPO valuation illustrates perfectly how a well-construct equity story can generate powerful cognitive bias.
Fueled by the Halo Effect (what is growing fast is good) and confirmation bias(seeing the glass half full), ROOT IPO's investors gave a 10x+ revenue multiple valuation.
The Ultimate Software Company Framework:
Compounding growth or the ability of your business to retain customers
High Operating Leverage or the ability of your business to increase profit margin while growing
Negative Working Capital or the ability of your business to produce economic profits
Built-in Network Effects or the ability of your business to create long-term, defensible economic profits