John is a member of RBCx’s banking team, where he predominantly supports early-stage clients across capital fundraising and strategic growth. In addition to this role, John works alongside RBCx’s capital team on both direct, indirect (fund-of-funds), and strategic investment opportunities.
Ideas Worth Noting
For readers with only a few minutes to spare, here are this piece’s key takeaways
- Unicorns are beginning to look like puppies. As 2013 had a total of 39 unicorns, 2021 alone bred over 500. The term once used to categorise companies that were as rare as a mythical creature, has evolved into one as common as a household pet. Those bred in 2021 are known for being both the hungriest (with the largest burn) and youngest (with the greatest proportion following an early-stage round) pack of all-time.
- Taking ‘at all costs’ too literally. As our tech ecosystem adopted the ‘growth at all costs’ playbook from the unicorn pioneers that came before them, a favourable macro environment enabled companies to get enamoured with burning and raising more and more capital – all with increasing valuations. This established numerous public cases of unethical business practices from companies cutting corners to literally grow ‘at all costs’.
- BNPL = buy now, prove later. A sector that accumulated over $8B of venture funding in 2021 and allowed over 100 global players to co-exist, thrived during the black-swan bull. Mass ecommerce growth, near-zero rates, low inflation, and categorical expansion fueled the model. Unfortunately, while the sector may have thrived in a strong macroeconomic environment, the unproven BNPL model is now at risk of mass consolidation.
- On-demand is out. Though the pandemic forced a new medium for grocery delivery, on-demand as a category has not yet proven to be a profitable model. Without having access to troves of marketing dollars to be used in the form of consumer bribery, investors have since realized that ordering a single avocado to be delivered in under 15-minutes may not be as lucrative as they once thought.
- Going all-in on the cloud. The black-swan bull accelerated the world’s transition in becoming digitally dominant, which is entirely led by cloud technology across both software and infrastructure. While the past decade revolved around cloud software adoption, the next decade will focus on cloud security and data infrastructure. With surprisingly low IT penetration, natural economic resilience, and a proven lever to combat inflation – the future of cloud technology could not be any brighter.
In 2013, Aileen Lee posted an article in TechCrunch titled, “Welcome to the Unicorn Club: Learning From Billion-Dollar Startups”. Since then, our technology ecosystem has both embraced and rallied around a mission of building companies with a private valuation over one billion dollars. The rarity of this species was designed to emulate one of a unicorn, seeing as in 2013, only 39 existed (which was equivalent to 0.07% of all venture-backed companies funded from 2003 – 2013). With the global recognition that these now public, once-unicorns have established since – from the likes of Uber, Snapchat, Slack, Shopify, and Airbnb – every single entrepreneur, employee, or investor has made it their mission to do the same. The goal of becoming ‘the next Uber’ or ‘the Shopify for [insert here]’ inevitably took over.
This then begs the question – what was the so-called ‘unicorn playbook’ and how could companies replicate its mentality and execution? It came down to a few key points:
- Prioritize building in a huge, high projected-growth total addressable market (i.e. TAM) that will never saturate
- Capture the market by leveraging speed, while remaining solely focused on top-line growth (i.e. acquisitions, transactions, gross-merchandise value)
- Utilize widely available capital to compete and scale faster by investing in every aspect of the business
More precisely, the fundamental playbook that our tech ecosystem adopted over the past decade, which was further highlighted by the outward-facing nature of being recognized as a unicorn, was one of ‘growth at all costs’. With high-flying unicorns focused on capturing the market and utilizing capital as a weapon, the market began to value growth as the primary driver of valuation, which naturally trickled down the entire spectrum as private companies adopted their own ‘blitzscaling’ playbook. Though founders were the ones that made the decision to emulate aspects of this playbook in their respective companies, the structural incentives across employees, investors, and limited partners (LPs) were all equally on board for it. With a hyper-focus on growth naturally leading to an increased private valuation:
- Employee compensation packages (inclusive of stock options and registered stock units or RSUs) would be worth more
- Founder equity positions and net worth would be worth more
- GP portfolio values and total value to paid-in-capital (TVPI) would be marked up higher
- LP return expectations and portfolio values would be marked up higher
As private tech companies leveraged the growth playbook and raised more capital on higher valuations in later rounds, the plausibility of becoming a unicorn became in reach for many. This led to the unicorn path becoming widely understood across private tech:
Unfortunately, this growth-first mandate and market-wide acceptance by founders and investors alike has led to numerous cases of companies cutting corners and establishing unethical business building practices.
- In 2015, Parker Conrad’s company Zenefits was caught manipulating the state’s insurance licensing system and breaking regulatory compliance, after having raised $580M at a $4.5B valuation.
- In 2018, Elizabeth Holmes was caught deceiving investors of the accuracy of Theranos’ blood tests, after having raised $700M at a $10B valuation (and was recently sentenced to 11 years in prison).
- In 2019, Adam Neumann brought forward suspicions of poor corporate governance and questionable management actions following a public filing for his company WeWork, after having raised $10B from Softbank alone, at a $47B valuation.
- Even this past quarter, Twitter’s senior leadership team was accused of misleading their own board of directors by not providing a full accounting of the company’s security vulnerabilities and ‘presenting cherry-picked and misrepresented data to create a false perception of progress’ (i.e. growth).
While it is easier to place the blame entirely on the companies themselves, equally culpable was the reality of the macroeconomic forces in our previous market cycle, which contributed to the widespread adoption of our growth at all costs playbook. A decade-long bull run comprised of low interest rates, controlled inflation, strong consumer confidence, high employment, greater private allocations from institutional LPs, heightened investment aggression from VCs, and an overall market acknowledgment of a technology-first future – underpinned our entire ecosystem. Over the course of our black-swan bull, the perfect macroeconomic storm enabled our ecosystem to take this playbook to a level we never even knew existed.
Not only did 2021 break records as the most fertile unicorn year our ecosystem has ever witnessed, but equally, with record fundraising and venture capital deployed, this unicorn pack has proven to be the hungriest pack of all time. With more capital raised and at their disposal, and with incentives across all stakeholders aligned for companies to spend it aggressively on capturing the market through top-line metrics, record burn rates were normalized. And what is even more remarkable about the 2021 pack is when you compare the number of early-stage unicorns born (following a seed, A, or B round) at 109, to the total number of unicorns born just two years prior in 2019, at 106.
Though unicorns themselves are industry agnostic, following 2021, over half now operate in fintech, retail tech/commerce, or cloud technology. In the US alone, these themes accumulated over $173B of venture capital investment over the past two years, with $120B in 2021. To understand further how operators in these three themes leveraged their own growth-first playbooks and how they are now positioned to build beyond 2022, let’s break it down.
In the US, venture capital investments for fintech amounted to $35B in 2021, an increase of 94% from 2020. As payments experienced the largest YoY growth (doubling to +$8B), the sub sector within the $8 trillion payments industry that gained widespread consumer and investor attention over the past two years was that of Buy Now Pay Later (“BNPL”).
A modern version of factoring accounts receivable, the BNPL model equipped retailers with a new mousetrap by offering consumers the ability to pay for products and services through interest-free loan arrangements. BNPL providers would structure deals with merchants whereby they would receive a 4% discount on the retail price (or re-framed as charging a 4% merchant fee), and once a consumer purchase is made, would take on the full repayment risk equal to the remaining 96%.
The above outlines the first way BNPL providers utilize the growth at all costs playbook. By tapping into consumer psychology, and marketing themselves as a seamless path to instant gratification (from enabling consumers to make purchases they otherwise couldn’t afford), BNPL diverts attention away from the core offering of their business: providing microloans. Using Affirm as a proxy (a publicly traded category leader), their net revenue minus transaction costs equaled 4.3% of GMV in FY2022. This figure highlights the model’s razor thin margins and reliance on mass scale to generate meaningful dollars. To achieve this necessary volume, BNPL providers globally share a very similar growth playbook to generate top-line GMV, merchant, and consumer growth:
- Invest in distribution partners to capitalize on established volumes
- Invest in a seamless checkout experience optimized for conversion
- Deploy mass marketing campaigns to generate mass awareness
- Develop a modern brand to attract a younger demographic
- Expedite a shadow credit review process to remove any qualification barriers
The last point is very important. By expediting the typical credit review process, BNPL providers sacrifice both their understanding of the true affordability criteria of their consumers, as well as their ability to work with regulators and credit bureaus on profile-level loan reporting (i.e. a bank may issue a mortgage without knowing a client’s 50 outstanding BNPL loan arrangements).
The macro environment of the past two years played a pivotal role in democratizing the entire BNPL industry and has helped build a sector with over 100 independent providers to coexist.
- Mass ecommerce growth: The perfect storm for ecommerce adoption was catalysed by ongoing lockdowns, remote living and working, and pandemic-induced government dollars. These factors catapulted growth in the BNPL sector by over 3x in 3 years from $33B dollars in GMV in 2019 to over $120B in 2021.
- Record-low interest rates: As BNPL providers rely on external lending to provide loans to their consumers, near-zero rates juice the entire model and make BNPL a more compelling mousetrap compared to their 2-3% fee credit-card competitors. This structure enabled Affirm’s merchant count to increase over 8x from 29,000 in 2020 to 235,000 in 2021.
- Low inflation: With purchasing power amplified from low inflation, households managed to increase their level of discretionary income for purchases all together, thus further contributing to ecommerce growth.
- Categorical BNPL proliferation: What was once focused on high-ticket luxury products became proliferated across everyday consumer purchases. From electricity bills, health insurance, car servicing, travel, and groceries, BNPL structures have seeped into virtually every consumer discretionary category and captured a greater share of wallet as a result.
Unfortunately, through 2022, BNPL providers globally have been exposed for their heavy reliance on both an abnormally favourable macro environment and our ecosystems’ growth-first mandate. As record inflation continues to tear through the economy, the anticipated perpetual ecommerce growth of 2021 has come and gone. As discretionary income becomes further damaged from lower purchasing power and a higher cost of living, households have been forced to sharpen previous spending habits and drive down demand.
As interest rate hikes continue to be expected, merchants will have a much more difficult time justifying higher take rates with lower anticipated volume and credit-strapped consumers have already begun making their mark. With record levels of demand, Affirm increased their higher-risk loan proportion (measured as ITAC scores below 90 or with none) from 3% in December 2020 to 12% just one-year later.
Following adjustments to the company’s underwriting criteria, Affirm announced delinquency rates hovering at 2.5% and net-charge offs totalling $70M in FY2022, which is 7x larger than 2021 and over 30x larger than 2020. Finally, the fact that 41% and 27% of BNPL consumers have subprime or near-prime credit profiles respectively, (compared to just 12% and 13% for the general population) does not make the industry outlook any stronger.
As competitors such as Apple and other large financial institutions roll-out their own BNPL offerings, the sector is at risk of becoming one singular tool in a larger payments toolkit. As we know, when monolithic companies are forced to compete against platforms, it becomes a very difficult battle to win (think Slack vs. Teams or Zendesk vs. Salesforce). Looking ahead, to avoid massive write-downs and harsh consolidation, the BNPL sector will be forced to prove that their model can operate capital efficiently in macro environments that aren’t predicated on low rates, predictable inflation, and high growth.
Retail technology / commerce
Global retail tech venture capital investments surpassed $109B in 2021, growing 132% YoY from the $47B accumulated in 2020. Though commerce made up the largest portion at $54B, the sub-sector that held the largest average deal size at $106M (2x higher than the next leading sector) and that capitalized on the peak risk-on private market landscape over our black-swan bull, was that of On-Demand Delivery.
On-demand delivery companies, which accounted for $25B (or 3%) of the $8T grocery market last year, implement a model which is universally understood to rely the most on our ecosystems’ growth at all costs mantra and having perpetual access to mountains of investor capital. The pandemic forced the adoption of a new medium for grocery buying and these on-demand players convinced investors (to the tune of nearly $20B invested last year) that it was here to stay. Put simply, on-demand delivery companies:
- Launched in cities with high population density and favourable income demographics (think NYC or London)
- Partnered with direct suppliers and wholesalers on curating a select assortment of products to offer
- Built micro warehouses (i.e. dark stores) in neighbourhoods for their pickers to assemble orders
- Employed a fleet of full-time riders to respond and deliver orders swiftly
- Did everything imaginable both pre and post purchase to keep consumers using their service, with minimal consideration for unit economics.
Whether it was giving out cash for consumers to use their service or discounting over 80% of all orders, the mantra of prioritizing negative unit economics to drive growth became the backbone of the industry. To investors, this lack of economic empathy was framed as ‘an investment that would be later justified through:
- More future users on the platform driving brand awareness and lowering acquisition costs
- Higher future spend velocity from consumers adopting on-demand within their day-to-day lives
- Larger future average order volumes driving higher revenues.
Whether it was Fridge No More recording an average $78 dollar loss for every new customer acquired after 10 months of operating or JOKR doubling that number at $159, this negative unit economics to drive growth model has normalized record burn rates and justified venture capital dollars as the scapegoat to subsidize the model’s lack of profitability and fundamental business value.
So how did a sector with such backwards business fundamentals manage to attract some of the highest levels of investor capital and market attraction over the past two years?
- Mass capital availability: With the on-demand model proliferating over the past two years and many companies launching, they did so at a time where investors were furthest along their risk curves, capital was treated like a commodity, and private valuation methodology went awry – thanks to the massive troves of crossover capital entering venture markets.
- Pandemic lockdowns: With the pandemic forcing mass initial lockdowns, delivery came to the rescue and demand flourished, giving heightened awareness to the on-demand sector. With tight government restrictions, customer delivery increased 50% and instant delivery increased by 41%, both YoY.
- Transitory ‘wealth’ generation: With the government pumping trillions of dollars into circulation through pandemic relief packages and record quantitative easing, consumers became ‘wealthier’. Though these dollars were intended to be allocated towards productive businesses and subsequent job creation, consumers and investors flowed capital into building bubbly assets – with on-demand delivery being one prime example.
The outlook for on-demand delivery will be faced with numerous headwinds for founders and investors to navigate. As public and private investors embody an investment philosophy based on capital efficiency and free cash flow (as noted in Part 2), cash guzzlers are no longer in vogue and will be forced to pivot their model (if they can). Already in 2022, the music has stopped for many – with Fridge No More, Buyk, and 1520 all ceasing operations due to a sharp and unexpected lack of funding. Additionally, modelling growth figures off a year in lockdown is not sustainable.
When consumer growth starts to dwindle, on-demand players will need to find a new lever to pull beyond consumer bribery in the form of free groceries or mass discounts. ‘Capturing the market’ will only be a growth strategy available for those that can do it efficiently. But most importantly, on-demand players will be forced to prove their model to stay alive. Whereas a typical grocer achieves a positive net margin of roughly 4% on purchases made in-store, that number plummets to -13% for those that require pick, pack, and delivery. Having built consumer bases predicated on offering expensive discounts, on-demand delivery companies may find themselves unable to offset acquisition dollars by price increases without experiencing meaningful churn; especially as inflation continues to damage consumer purchasing power.
As Uber set a distorted acceptable precedent of being able to raise over $25B of private capital before generating cash, the on-demand delivery sector will be one that experiences mass consolidation, further company wind downs, and a sobering realization from investors that ordering a single avocado to be delivered in under 15-minutes may not as lucrative as they once thought.
Whereas the previous two themes established business models predicated on an abnormally favourable macroeconomic environment and a flush private capital landscape, the cloud market has grown in a fundamentally different manner. That is, in equipping enterprises, across all stages and sectors, with innovation that is built to i) drive deeper impact from placing customers and data at the centre of their respective businesses, and ii) embrace our world’s transition in becoming digitally dominant. The cloud model has proven to be one of the most important paradigm shifts since the invention of the internet, and over our black-swan bull, only further solidified its permanent long-term potential.
By the end of 2022, global end-user spending for public cloud services is anticipated to hit $494B, up over 20% from 2021’s record of $410B and on track to hit $600B by 2023. Breaking the sector down further, both infrastructure-as-a-service (IaaS) and platform-as-a-service (PaaS) segments are expected to incur the highest annual end-user spending growth, at over 30% and 26% respectively. As expected, software-as-a-service (SaaS) comfortably maintains the largest share of the entire global market, at $177B (or 35%). As companies were forced to implement and accelerate their digital transformation plans through 2021, both private and public markets flourished. Specifically, over 900 private cloud start-ups raised over $21.5B globally and the total public cloud market capitalization hit new heights at $2.7 trillion in November 2021.
Over the past decade, businesses globally have been initially introduced to ‘the cloud’ from the various software application pioneers that once defined the category – including HubSpot, Salesforce, Slack, Adobe, and Dropbox – whereby the delivery model of SaaS received widespread adoption. Equally, in addition to software applications, infrastructure providers utilized the cloud to offer businesses greater agility, flexibility, and cost-efficiency in their data hosting. What once required physical, on-premise data warehouses and support teams could now be exchanged for a cloud-native, elastic, and scalable digital infrastructure, thanks to Amazon Web Services (AWS), Microsoft Azure, and Google Cloud. Though cloud technologies have earned a greater share of IT budgets over the years, the pandemic served as a catalyst to further accelerate digital innovation and the adoption of cloud services altogether.
Entering 2022, only 24% of global application workloads resided in the public cloud. Looking ahead, by the end of 2024, this figure is expected to grow over 1.5x to 37%; a phenomenon that meets the criteria for Satya Nadella’s infamous “two years in two months” digital transformation quote. What took over a decade to establish 24% cloud penetration will now be compared to 13% in just two years, post-pandemic. Whether that be in the form of remote working and learning, collaboration and experience management, sales and customer service, or cybersecurity and infrastructure, companies will require cloud technology and its partners to build through this next era. With margins recorded to be over 19% higher for companies who undergo cloud migrations versus their industry peers, growth will come from both new enterprise migrations and existing CIO’s looking to further deepen their cloud stack. And with a new inflationary regime among us, the cloud’s ability to mitigate the effects of a rising cost base will only further strengthen adoption tailwinds altogether.
In reviewing a report by Morgan Stanley Research, looking ahead, CIO’s plan to further expand their IT budgets across three core areas: cloud computing (+12.3%), digital transformation (+9.7%) and cybersecurity (+9.7%). Furthermore, CIO’s also reported that these three areas are the most defensive IT streams in a worsening economic environment. What does this tell us? Firstly, it further emphasizes the permanent pull forward expected in cloud adoption. But more importantly, it emphasizes the inelastic demand and overall resilience for cloud technology and its providers to be recognized as ‘bloodline businesses’; where if they were to get ripped out, the enterprise-wide damage would be detrimental.
As 2022 injected a sobering cost-cutting mandate across the entirety of our technology ecosystem, CFO’s have been forced to consolidate their operating spend, including the technology partners they work with. Though expectations of sizable headwinds disseminated across public technology, Q2 ’22 earnings season for cloud companies painted a slightly different story, as 88% of companies beat consensus and maintained a median net-revenue retention of 120%. Whether it was Gitlab noting that ‘the current environment is not slowing down customer decisions, nor elongating our sales cycles’ or MongoDB experiencing ‘a record number of net additions of direct sales customers’, cloud technology providers have proven to be inherently unique in their ability to generate new business while progressively expanding existing customer relationships, at a time where most tech companies are experiencing the exact opposite.
But perhaps the most standout factor that differentiates cloud players from the various other technology companies that exist, is in their ability to operate and scale without relying on our ecosystems’ growth at all cost playbook. Looking at the two leading cloud infrastructure players, AWS and Azure (included within the total Microsoft Intelligent Cloud segment), not only did they cap-off Q3 ‘22 with revenue run-rates equal to $82B and ~$48B respectively, growing each over 28% YoY, but they also managed to generate $17.6B and $15.7B of operating income[34,35].
On the software application side, there are many instances of companies that generated strong FCF margins ending Q2 ‘22 (not all have reported Q3 yet), across various cloud categories, including Adobe (41%), Zendesk (40%), ZoomInfo (32%), Atlassian (31%), Dropbox (33%) and Workday (21%). And at risk of cherry-picking, the median FCF margin for all public cloud companies ending Q2 ’22 was 0% – representing their ability to balance high-growth with disciplined capital allocation. Lastly, and probably a segment that remains unfamiliar to most given its only recent explosive growth, is in cloud data and security infrastructure. Though players in this segment have been around for many years previously, their financial profile is one equally rare to that of cloud infrastructure; where you have hundred-million dollar run-rates, steep early s-curve growth rates, and mature cash-flow margins. Whether that be Crowdstrike ending Q2 ‘22 with $535M total revenue, 58% annualized growth, and 25% FCF margin or DataDog ending Q3 ‘22 with $435M total revenue, 61% annualized growth, and 15% FCF – this segment is poised to drive deeper cloud innovation (and subsequent investor yield) in the coming decade.
Though the cloud market has been less adversely affected by the black-swan bull, there are still various macroeconomic and market factors that have impacted the sector all together.
- Currency ramifications: With the Fed most recently hiking rates by 75 bps to 4.00%, foreign investors are continuing to expand their US-based investment allocations from a high-yielding bond market, especially as the European Central bank (ECB) and Bank of Japan instil a more relaxed monetary policy. As a result, demand for the US greenback has skyrocketed. Though attracting foreign investment supports a growing economy, a stronger US currency damages the value of revenues produced overseas (making them worth less when converted and reported in USD). And unfortunately, given the borderless nature of software, the sharp monetary tightening by the Fed has had an over-indexed impact on the technology sector. As Goldman Sachs noted that 60% of all technology company revenues on the S&P came from international markets in 2021 – compared to just 29% for all other companies on the index – the big-run up in the US dollar is expected to further impact software earnings over the quarters ahead.
- Geopolitical conflicts: Though record distributed denial-of-service (DDoS) and cybersecurity attacks spawned in Ukraine immediately following their invasion by Russia, the cyber warfare was not confined to the same geographical boundaries as the conflict itself. As Q1 2022 witnessed an all-time high number of DDoS attacks globally, over a quarter of enterprises involved in a global Gartner survey noted that they took cybersecurity action in response to Russia’s invasion. In EMEA specifically, they recorded an over 220% surge in cyber-attacks when compared to the previous four years, and as a result, the ECB demanded all European banks to bolster their cyber defence capabilities. Looking ahead, as more enterprises deepen their cloud migrations and cyber-attacks become increasingly prevalent and more sophisticated, cybersecurity will grow its importance as an executive-wide priority.
- Hybrid working models: The most obvious application and pull-forward of cloud technology was driven by the immediate pivot to remote and hybrid working models. 81% of organizations said that COVID accelerated their cloud timelines, and as the market learnt from the previous great resignation during the black-swan bull, flexible working models are here to say. For businesses who want to remain a top contender for A+ talent, continuously investing in both experience and remote enablement will remain paramount.
Though the cloud sector outlook in aggregate remains strong, cloud companies will adapt differently to a normalized economic environment based on the impact they received from the black-swan bull, whether that was in the form of shock, step, or permanent growth.
Cloud companies that underwent ‘shock’ growth experienced inflated addressable markets, abnormally high rates of customer acquisition, and looking ahead, remain exposed to a high level of customer churn and revenue contraction. A company like Zoom, who had a peak market cap of $66B at the end of 2020 compared to just $24B as of writing, is one example. Or a company like Olo, that currently holds a market cap one-fifth of their Aug ’21 high and who drew the worst consensus FY23 revenue estimate change following their Q2 ’22 earnings (-12%).
Cloud companies that underwent ‘step’ growth, experienced abnormally high revenue growth driven from customers pulling buying cycles forward in response to the pandemic, but looking ahead, are anticipating pre-pandemic, normalized volumes. A great example in this category would be Shopify, which benefited from the pandemic-induced ecommerce rush, but have since experienced normalized growth throughout their core business. Additionally, companies like DocuSign or Okta, who benefitted from a mandated remote-only working model are expected to endure normalized volumes as working styles become less binary.
The last category of cloud companies are those which have had their sectors undergo a permanent pull-forward in demand. As noted above, areas such as cloud infrastructure (AWS / Azure), data (Snowflake / DataDog), and cybersecurity (Crowdstrike / Zscaler) are expected to scale alongside the world’s transition in becoming digitally dominant, and benefit from the secular cloud tailwinds ahead.
It is no doubt that the macroeconomic environment of the past two years played a pivotal role in enabling all sectors of our tech ecosystem to flourish, access capital, and accelerate their own versions of the ‘growth at all costs’ playbook. But looking ahead, as investors and the market begin to prioritize metrics beyond top-line revenue growth when evaluating prospective businesses and setting valuations, it is clear that a new technology playbook will emerge. The new era of generational businesses (not unicorns) will no longer be built on the old growth playbook of 2013. Instead, they will be built using one based on capital efficient growth.