Over the years, descriptions, or “boxes,” for various type of privately-held companies like “middle market,” “venture-backed,” “startups,” “small and medium-sized enterprises (SME’s),” to name a few, have been tossed around so much as to obscure and confuse their original meaning and intent.
This is highly unfortunate, as it creates opaqueness and inefficiency in an asset class already plagued with too much of both.
Let’s leave the official classifications aside for now and focus on developing an identification process for the kinds of private companies that are worthwhile for the growth investor to consider for their portfolio.
At Growthink the catch-all term we use for the private companies we like best is “emerging.” It does not suffer from “commentary fatigue” as do private equity and venture capital, and it effectively carves out the large mass of startups and small businesses destined to stay small.
Webster defines “emerging” as follows:
- To rise from an obscure or inferior position or condition
- To rise from or to come out into view
- To become manifest
- To come into being through evolution
Let’s elaborate on these definitions in the context of an investable company.
1. To Rise From an Obscure or Inferior Position or Condition: Emerging companies are, in their most common and interesting form, small and obscure. Microsoft and Google were once just a small group of programmers and were deep under-the-radar. And if you were invested in them then, your life changed dramatically for the better as they emerged. Less famously but still extremely lucrative were companies like the below that emerged to significant exits for themselves and their investors:
- About.com: acquired for $410 million by the New York Times
- Advertising.com: acquired for $435 million by AOL Time Warner
- Affinity Labs: acquired for $61 million by Monster Worldwide
- AllBusiness.com: acquired for $55 million by Dun & Bradstreet
- Aruba Networks: IPO at a $1 billion valuation
- Club Penguin: acquired for $350 million cash (and possible $350 million earnout) by Disney
- FraudSciences: acquired for $169 million by PayPal
- Glu Mobile: IPO at a $371 million valuation
- Last.fm: acquired for $280 million by CBS
- Mellanox Technologies: IPO at a $579 million valuation
- Orbital Data Corp.: acquired for $50 million by Citrix Systems
- Overture: acquired for $1.63 billion by Yahoo!
- Photobucket: acquired for $300 million by Fox Interactive Media
- Speedera Networks: acquired for $130 million by Akamai
- Skype: acquired for $2.6 billion by eBay
- The Generations Network: acquired for $300 million by Spectrum Equity Investors
2. To Rise From or To Come Into View: Emerging companies are often ones that have fallen on hard times and are seeking to “rise from” their current distress via turning around and restructuring their businesses. The banking and real estate sectors are right now treasure troves of fantastic distress and turnaround opportunities, as are arenas like publishing and the automotive industry. As adversity intensifies, so does emerging opportunity.
3. To Become Manifest: Here we need Webster’s help again – to become manifest, or to be “readily perceived,” or to be “easily understood or recognized.” Emerging company businesses are SIMPLE businesses. They make things or provide services, and sell them for more than they cost to make or deliver. And every quarter and every year, they just “chop more wood” and “carry more water,” and thus drive revenue and earnings growth. It usually isn’t fancy nor often even terribly interesting. But it almost always is easy-to-understand and recognizable in the company’s financial statements. An important note here is that emerging companies, contrary to popular belief, are usually NOT venture capital-backed companies. Why? Because they don’t need to deficit finance their businesses because they are cash flow positive. In fact, the very sign that a company needs outside financing (see GM, AIG, et al.) is often the best sign that it is NOT an emerging company because they can’t make any money.
4. To Come Into Being Through Evolution: This is perhaps my favorite because it references the essence of any business – the talent of its people and the quality of its corporate culture. The best emerging companies are always run by a group of hard-working, thoughtful, creative, persistent, and fantastically committed owner-operators. They devote their lives to their businesses for multiple, non-contradictory motives. They want to offer true value to the marketplace with their product and service offerings. They want to leave a legacy via building enterprises of lasting value and character. And they want to make a lot of money. Accomplishing these 3 objectives in a big way involves a lot of trial-and-error and a lot of figuring out all of the ways not to invent the light bulb. While popular business culture is fascinated with the “golden boy entrepreneur” stories (i.e. Microsoft and Google), these are much more the exceptions than the rule. Far more common are stories like Amazon, Kinkos, The Body Shop, Outback Steakhouse, or even Wal-Mart and Hewlett-Packard – companies that had reasonably long gestation periods, and a lot of slow or no growth periods, before evolving to successful forms. And then continuing to evolve as market and competitive conditions dictate.
If you are a fundamental investor, look for the above qualities in companies you are considering for your portfolio. Look for them quantitatively with the key metric of operating cash flow growth (everything else is subject to accounting whim) and look for them qualitatively in the mindset of management and in the tenor of the corporate culture. If both the numbers and the business tone align and you can get in before the whole world knows about it, then you have yourself a money-maker. Or, another way of saying it, an emerging company.