Fidelity Writes Down Dropbox, Snapchat – The Substitution Principle Illustrated in the Difference Between Companies and Features

This week, Fidelity reduced the value of its stake in Snapchat by 25%, and Fidelity, along with BlackRock, reduced the value of its stake in Dropbox by roughly 20%.  There were warnings for Dropbox.  Dropbox’s investment bankers warned that it didn’t expect to be able to achieve the $10 billion valuation in the public markets that it did in its most recent capital raise.

Snapchat’s write down didn’t quite have the same warning.  But, the causes for the value reductions have the same roots.  What explains these write-downs, and are there broader implications for the venture capital and angel capital markets?  Much is being written about a bubble bursting, and investors suddenly getting smart.  The down-round Square IPO is touted as Exhibit A of the bubble bursting.   However, I think this is too simplistic.  What these re-valuations boil down to is a re-evaluation of Dropbox and Snapchat on a fundamental level.  Are Dropbox and Snapchat viable, stand-alone companies, or are they just high-priced features to ultimately be subsumed into someone else’s platform(s)?

This is a subtle, yet critical difference that was taught to me by a mentor back in my merchant banking days.  How do we tell the difference, and why do investors care?

The difference between a company and a feature lies in that whereas a company has a robust, institutional source of value that is very hard (or impossible) for competitors to emulate or replicate, a feature has a narrow scope of application and, eventually, will come to be emulated or replicated.  Some other, helpful distinctions:

  • A company will enjoy success across a spectrum of products and services; a feature will enjoy success in one or two capability sets.
  • A company has a clearly identifiable core competency; a feature is the product of a skill set and an idea.
  • A company’s value is greater than the sum of the values of its assets, which is why buyers are willing to pay up for them.  A feature’s value lies in the value of its assets (tangible and intangible).
  • From an accounting perspective, a feature has no goodwill in its value.  A company enjoys barriers to entry.  A feature generally does not.
  • A company has (or has a path to) multiple products and services to multiple kinds of customers; a feature has a narrow scope of features aimed at a relatively defined user base.
  • A company is a portfolio; feature is a stock.

Dropbox and Snapchat are being increasingly viewed by investors as features, rather than companies.

Making this distinction between company and feature is not easy.  As analysts, we have to be able to imagine the strategic path the company will take in the future. Of course, projecting the future always engenders a margin for error – the only variable is how wide the margin.  A great example of a company that was incorrectly categorized as such was King Digital Entertainment (the maker of Candy Crush), went public, performed horribly after going public, and was finally put out of tis and its shareholders’ misery when Activision acquired it for $5.9 billion in February 2015.  They made one hit game, and now they are a feature, or part of Activision’s portfolio.

The Candy Crush story illustrates the challenge that category into which a venture falls is not static.  Companies can become de facto features as technology evolves and competition intensifies.  Dropbox and Snapchat are great examples of this phenomenon.  Dropbox is now confronted by an industry environment in which  storage is rapidly being commoditized and barriers to entry have become quite low and are going even lower as storage and bandwidth are becoming ever cheaper.  conventional competition from Amazon, Box, Evernote, OneNote, Google Drive, and others.    Dropbox simply doesn’t have the market to itself anymore and, what’s worse, Dropbox’s competitors are not just the well-funded startups, such as Box, but also giants such as Amazon, Google, and Microsoft, who can match Dropbox dollar for dollar and can choose to simply offer cloud storage as a loss leader to promote other products.  The argument is quite plausible that Dropbox is more valuable as a feature within the Microsoft platform than as a stand-alone entity.

Snapchat faces its own competitive challenges, with Instagram refusing to go away, and Facebook promoting its own platform.  Twitter is incorporating Snapchat-like capabilities, and, with mobile devices offering ever-increasing memory and integration with cloud storage (such as Dropbox), the importance of fleeting photos in chats is starting to diminish.  It’s easy to see Snapchat integrated into Twitter, or LinkedIn, or Facebook if they give up on their own platform.

Another great example of this distinction between company and feature is to compare Google and Yahoo.  They are in the same business (search) yet Google is far more successful because it offers many other products and is clearly a technology innovation company in many, diverse directions.  Yahoo remains a search and Internet ad company – one feature of Google.  Marissa Mayer has her work cut out for her.  Right now, Yahoo is a feature masquerading as a company.

Features can grow into companies as well.  PayPal is a great example of this.  PayPal’s bread and butter was to facilitate eBay transactions (I was a user of eBay well before it went public and I remember having to buy money orders to pay for stuff).  Over time, PayPal evolved into a broader payments company, facilitating all kinds of peer to peer and garden-variety retail transactions.  PayPal spun off on July 20, 2015.

Now that we understand the difference between company and feature, how does this impact value?  The answer lies in one of the fundamental rules of finance and business valuation, known as the substitution principle.  The substitution principle says that a buyer will not pay more for an asset than the cost the buyer would have to pay or invest to replicate it.

Consider the three approaches to business valuation:

The Income Approach – the company’s value is equal to the value of expected future cash flows, adjusted for risk.

The Market Approach – the company’s value is indicated by the market prices paid for similar assets in the market (both public shares and private company transactions)

The Asset Approach – the company’s value is a function of the values of its constituent assets, less liabilities

With a company, the income and market approaches can be very relevant (I argue that the market approach is not used enough with startups, but that is another post), because they do a good job at capturing goodwill – those hard-to-identify characteristics that make the value of the company more than the sum of the values of its parts.

With a feature, the asset approach should dominate the value discussion.  By definition, a feature can be replicated, so it makes no sense to pay much more than it would cost to simply copy the asset you are contemplating buying, adjusted for risk and the time involved in executing the replication.

For this reason, companies tend to be more valuable than features.  As the market starts to view Dropbox and Snapchat more like features and less like companies, their values will suffer.  The market also tends to provide exit opportunities to features in the form of acquisition, while companies are more suited to public offerings.

No valuation analysis can be completely covered with a discussion of one element.  There are other forces at work in the valuation of Dropbox, Snapchat, Square, and other companies.  A cooling off of the venture exit and IPO markets almost certainly has some influence, as well as the slowing global economic outlook.  However, the feature/company discussion is a big part of this story, and it’s one that offers a wonderful teachable moment.

As you think about the ventures you are running, building and advising, be mindful of the distinction between company and feature.  The distinction, while it can be hard to see, is critical in understanding its current and prospective value.

What if you find out that you really have a feature, rather than a company?  This isn’t the end of the world.  Features can be very lucrative – Beats Audio became a feature of Apple for $3 billion.  What’sApp became a feature of Facebook for $22 billion.  Skype became a feature of Microsoft for $8.5 billion.  But, positioning a feature for growth and exit is a different path than for a company.  It means you must focus your resources and attention on depth, rather than breadth.  You must focus on speed of exit (if you’re a feature, your first move advantage only lasts so long).  And, it means you need to put an IPO out of your mind and focus like a laser on being acquired.  Focus on who you’d like to acquire you and understand what it is those buyers like to buy – then make your “company” look like that.

The killer isn’t so much being a feature, but failing to realize it for too long.  The investors and Dropbox and Snapchat (and, undoubtedly, other “companies”) are realizing too late.  This company vs. feature framework can help you avoid their mistake.

 

 

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