I meet all sorts of people starting new companies. A ton of them are starting hot new tech startups and are out there looking for funding and often succeeding. Many more are starting much-needed service firms in high tech—providing much-needed services along the lines of iOS app development, web development, marketing, PR, content creation, and backend development. There are massively talented people in both types of companies. They do the same work. They hang out together, they have the same skills. They need each other.
Yet one segment of them have the potential to earn millions, and the other doesn’t.
It makes no sense.
Red Hat doesn’t really sell anything at all other than the consulting and support services around their open source Linux products. And I remember back when they IPO’d, everyone hailed it as a stroke of genius, the way of the future, the dawn of a new era, etc., etc. That struck me as really strange—most service companies are saddled with low revenue multiples, but for some reason Red Hat bypassed that. Removing all traditional revenue streams was part of the dot-com zeitgeist, and in 1999, Red Hat rode their service company to an IPO.
Of course, in 1999, service companies could still go public with decent multiples, with Agency.com and Razorfish mooting successful IPOs in 1999 as well. Of course, Razorfish and Agency.com took a dive in the dot com crash, and with them the dreams of any service company of ever having a major tech IPO again. And while they both survived, it was in different forms, neither being an independent, publicly traded company again.
Red Hat, however, survived. Today, Red Hat’s PE ratio is a staggering 67. For a service company.
I was reading yesterday that Dell is going to become an IT company now. HP was thinking about this a few months ago, too, right? They bought a company called Autonomy and were going to turn into some sort of consulting company. Reason prevailed on that one.
I can see why both companies would consider this, because the strategy proved golden for IBM some years back. IBM became more of a consulting services company, and in doing so shed their image of a loser in the operating system wars and became more of a bad ass, high tech McKinsey. Their stock commensurately rebounded. IBM has a price to earnings ratio of 13 (a price to earnings ratio is essentially the market cap, or value, divided by its annual revenue).
But start a services business today, in the tech industry, and you’ll be lucky to get a value-to-earnings ratio of 2 from investors and VCs, or private buyers. The public market seems to be far more generous with revenue multiples for service firms than tech VCs.
So, now, why is that? What does the tech industry have against services companies?
The traditional answer has been that services companies are heavily reliant on specialists, and if those specialists left, the company wasn’t worth as much. But it’s not clear to me how this is any more true for, say, McKinsey or IBM than it is for Google, Groupon or Facebook. The other argument in the old days used to be that non-services companies were selling concrete goods, and had factories and the like, and even if a key person left, they could keep on selling. That makes sense, of course, though the transition of IBM and the hoped-for transitions of HP and Dell make me wonder if that logic hasn’t been turned on its head. They still own factories, but their PE ratio goes up when they focus on consulting? And I suppose Facebook and Google have some physical property in the way of expensive data centers, but I hardly think that’s what their value is based on.
Then, of course, there’s the mythical algorithm—the belief that tech companies are somehow doing things in a more automated way, and make money with fewer people. Never mind Google has some 20,000 people (with a PE ratio of around 20) and Groupon has over 10,000 and no profit.
Okay, okay, I keep harping on this, I know. What’s the big deal? Tech companies are just awesome and doing cool shit and worth a lot of money and if they’re overvalued, then what’s the harm, right?
But these things have consequences. I love tech, I love the ability for it to disrupt so many industries. But the fact is that the valuations of tech companies, and the commensurate stock options that they can offer, divert employees from other industries. Because you can’t offer really sweet stock options if there’s no real chance your company’s ever gonna break a revenue multiplier of 2. Believe me, I tried. This creates an economic incentive for talented employees to flock to the tech industry over other industries. What industries? Banking! Okay, that’s probably for the better. Advertising! Oh no! Quelle horreur! Ha. Okay, but, what about health care? Green tech? Education? It can make a difference. Sure, if you have a high tech, dot com education, green tech or health care company, you can have a high multiple. But, then, I have yet to see education, green tech or health care be very disrupted by dot-com companies (though we are all, of course, keeping our fingers crossed.) But that is a topic for another day. Fact is, tech siphons good people away from lower-paying, important industries every bit as much as banking does.
Concretely, think about this the next time you need a kid to build your new iPhone app, and can’t find one, because they are all working at tech startups. Why wouldn’t they? If they choose the right one, they can make a payout ten times what they’d ever make building your app freelance. And if they choose the wrong one, they’ll still make just as much as you’d pay them. I see this all the time. And it’s directly tied to the tech industry’s inexplicable, misplaced fetish for product companies over service companies.