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The Key To Consumer-Marketplace Success In 2020: Efficiency And The Rule Of 40

Roger is a former entrepreneur who is now a general partner at Battery Ventures focusing on consumer-marketplace and software companies.

Early last year, it was easy to see why so many investors plunked money into consumer-marketplace businesses, which connect buyers and sellers online. The Battery Marketplace Index, which our company launched to track the stock performance of well-known public companies such as Netflix, Spotify, Alibaba and others, surged nearly 200% during a seven-year period in which the tech-heavy Nasdaq rose 158%.

But the rest of 2019 saw a series of high-profile marketplace stumbles, including by giant marketplaces Uber and WeWork — which led investors to lose some faith. The Marketplace Index actually declined from March 2019 to late October 2019, according to our analysis of data from CapIQ.

What happened? In short, investors decided they would no longer tolerate companies posting massive losses quarter after quarter. As Uber CEO Dara Khosrowshahi said after a three-month period in which the company lost more than a billion dollars: “We recognize that the era of growth at all costs is over…investors increasingly demand not just growth, but profitable growth.”

And then Covid-19 happened. Some marketplace businesses took only a minor hit, but many companies in the travel, hospitality and retail industries saw revenues plummet in just weeks. The average publicly traded marketplace company saw its stock decline 18% year-over-year through the end of April, though the index rose in May and June, thanks partly to better performance by international marketplaces.

In fact, our analysis found that companies in the top 10% of the index actually saw significant share price growth, while the bottom decile declined. As the country transitions from pandemic lockdown into an uneasy “new normal,” it’s becoming clear that the Covid-19 crisis has separated the weak from the strong — and the strong are still thriving.

What separated the marketplace winners from the losers? In a word: efficiency. Investors are flocking to efficient marketplaces and fleeing those still pursuing unsustainable growth.

A classic rule of thumb to track efficiency is back in style: the Rule of 40. The rule involves adding together a business’s revenue growth (expressed as a percentage) plus its EBITDA margin. If the answer is greater than 40, the business is efficient. If it’s much lower than 40, the business is inefficient. If your revenue is growing 30% per year and your EBITDA margin is 10%, you pass. It’s a simple, back-of-the-envelope calculation that captures something crucial about how a company is growing, particularly in its early stages before profitability. You can immediately see that very strong growth can balance out low or negative profit margins.

Let’s look at a couple of real-world examples. Chegg is a textbook-rental company that also provides online tutoring and associated services. Looking at data from CapIQ, the company’s revenue grew 28% last year, and its EBITDA margin was 13%. Add them together, and you get 41. So they pass the Rule of 40 measure.

On the other hand, consider Uber. Revenue at the ride-hailing giant grew 26% last year, per CapIQ data, on par with Chegg’s healthy growth. But Uber’s EBITDA margin was negative 56% — and this was before Covid-19 walloped the transportation sector. That gave the company a negative 30 on the Rule of 40 scale.

That difference is also reflected in these two companies’ share prices. Chegg’s stock price was up roughly 73% for the 12 months ending June 30, according to MarketWatch. During that same period, Uber’s stock fell 30%.

According to our analysis, marketplace companies with a Rule of 40 figure above 40 trade at an average revenue multiple of 10.9X, while companies whose metric sits below 40 trade at just 4.1X, on average.

But how do companies operating by the Rule of 40 actually do it? And what are some tactics or strategies the most efficient sales and marketing organizations employ to optimize performance?

Ultimately, I believe a lot of it relates to what I call organic, product-led growth versus paid or human-led growth. In other words, the more you can organically grow traffic and revenue due to a great product experience — and the less you rely on paid acquisition channels (e.g., buying traffic from Facebook or Google) or monetizing your site through an expensive sales force — the better.

Etsy, the marketplace for homemade crafts, clothing and other items, is a great example. The company is not reliant on paid traffic to drive visitors to its site. Instead, visitors come directly to its website because shoppers know they offer unique items — in marketplace parlance, “heterogeneous supply” — that typically can’t be found on other e-commerce sites.

The company reported that a 2019 survey of customers found 88% believed Etsy sells items “you can’t find anywhere else.” The company’s Rule of 40 number is 48, and its shares were up 73% in the 12 months ending June 30, when looking at the data from CapIQ. The company boasted revenue growth of 35% in 2019 and is worth $13 billion — mainly driven by a great product experience.

Contrast that with user-review website Yelp. The company grew 8% in 2019, per CapIQ, and has a Rule of 40 number of 11. Its shares were down 32% in the 12 months ending June 30. Why? One big reason is that employee headcount drives so much of the company’s costs. Yelp is dependent on its thousands of local sales reps to drive business development and generate ad revenue. This is an expensive and operationally complex business model and isn’t as scalable as those at other product-led companies.

Efficiency, including how it’s measured by the Rule of 40, has always been a good idea for marketplace companies. But in this environment, it’s even more critical.

Battery Ventures provides investment advisory services solely to privately offered funds. Battery Ventures neither solicits nor makes its services available to the public or other advisory clients. Content obtained from third-party sources, although believed to be reliable, has not been independently verified as to its accuracy or completeness and cannot be guaranteed.


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