After IPOs Like Lyft and Uber, Markets Demand a Business Model

(Bloomberg Opinion) -- Lyft Inc.'s first quarterly earnings report as a publicly traded company brought out the predictable question from analysts covering the company: When is it going to make money? This is likely going to become a familiar refrain as a glut of money-losing companies go public in 2019 and start to report quarterly earnings.

While there's an understandable concern that all of these money-losing startups choosing to go public now says something ominous about where we are in the business cycle – they must see the sky falling soon, or why else would they rush to market now!? – another interpretation is that companies have responded to incentives rationally and have focused on revenue growth and market share, which is what private markets have valued highly, and are saving their "pivot to profitability" until they become public companies. Once your stock is publicly traded, profits are taken more seriously.

It's not that many of these companies lack viable business models. They've just chosen, so far, not to figure out exactly how to break even.

Lyft's earnings call shows this thinking and approach in action. CEO Logan Green said it's "Day One of a $1.2 trillion market opportunity." Revenue growth in the first quarter was 95% year-over-year. The company is still losing money, but it expressed the belief that 2019 would be the worst year for losses with 2020 likely to show improvement. Some of the losses were caused by investments in new services like bikes and scooters. It'd be crazy not to invest in a few experiments when you've got a $1.2 trillion opportunity in front of you, right?

In this era of startups, the goal has been to identify the largest possible addressable market – all vehicle miles traveled, the total value of all homes sold per year, all meals consumed, etc. – and show how your idea is best positioned to win a sizable chunk of that market. Produce a few years of fast user and revenue growth, and talk up the nature of winner-take-all economics in tech, and with any luck investors will give your company a huge valuation even if profitability is nowhere in sight.

This mindset is well suited for the culture of Silicon Valley, where privately held companies produce valuations only when new rounds of fundraising come in. Investors in said private companies have long time horizons and know what they're signing up for when they write checks to early-stage companies. But public markets are more fickle and impatient, and while they may tolerate perpetual losses when generated by celebrity CEOs like Elon Musk, most public executives won't be given that kind of runway for profitability.

An optimist would look at this and say that young companies now have two distinct phases in their development. The first, when they're private, is identifying their market opportunity, building a product, finding users and revenue, and growing as quickly and as large as possible without worrying about profits. A company that can produce a dollar of revenue at a cost of 80 cents is leaving revenue growth on the table by not charging 80 or even 60 cents for the service, the thinking goes. Then, once the company has grown large enough, and perhaps as growth is slowing, the business will go public, at which point it is time to pivot from revenue growth to profitability.

There's a certain logic to this: If private investors care only about revenue growth and not profits, then focus on revenue growth with them, and if public investors care about profits, then focus on profits once you're public. It's just an earlier stage version of the fact that mature companies like IBM pay out most of their profits to shareholders in the form of buybacks and dividends since that's what their investor base wants.

The problem is that nobody really knows what steady-state, profit-maximizing business models for a lot of these tech companies will look like. They would like to think that they're all high-margin software companies like Alphabet or Microsoft, worthy of high valuations because their users are committed and their business models are highly profitable. But a lot of them may end up being low-margin, commoditized services without much sustainable pricing power. That would justify lower valuations.

Once the glow of the public offerings wears off and markets have their inevitable spells of turbulence, this distinction may separate the winners from the losers as the IPO class of 2019 looks to raise prices and cut costs in an effort to achieve profitability.

For some of the larger companies, the process may have some second-order efforts on the economy: What happens if Uber, Lyft and WeWork all raise their prices by 20%? But regardless of the pain, all the cash-burning is going to come to an end sometime – and it'll be up to the public markets to decide when.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg Opinion columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

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