The Why

There are many reasons why companies might choose to go private. One of the main benefits is that the company is no longer subjected to the scrutiny of being a public company. It’s tough being in the lime light. There are a lot of expectations around performance.

As a private company you can generally operate with less transparency, which can allow you to make decisions more quickly. This can be beneficial if the company wants to pursue a strategy that might not be popular with investors, or take a long time to materialize, such as a re-org.

Going private can also allow the company to take on greater debt, which in turn can provide more money for growth or other purposes.

Finally, taking a company private can allow the stakeholders to reap the benefits of a company without the cost of keeping everyone up to date. The administrative burden that goes along with reporting quarterly results is huge. There are entire departments of people at public companies focused legal and communication.

Real World Examples

Some of the most well-known companies that have been taken private include Dell, Toys R Us, and Burger King.

• In 2013, Dell announced that it would be taken private in a deal worth $25 billion.
• Toys R Us was taken private in 2005 in a deal worth $6.6 billion.
• Burger King was taken private in 2010 in a deal worth $3.3 billion.

At the top of this post is a larger sample from the tech world, which we used in the analysis below.

Private Equity Players

Private equity firms are often the ones that take companies private.

Some of the most active private equity firms in this area include Thoma Bravo, Vista Equity, KKR, Carlyle, and TPG Capital.

Together, these 5 firms have been involved in some of the biggest take private transactions in recent years.

Leading Indicators

I teamed up with our friends at Virtua to investigate the financial profiles of companies in the lead up to being taken private. They crunched the data from 50 tech take privates over the last decade using their powerful lifecycle analysis tool.

The charts below represent Take Private company performance vs Tech Sector performance, with Q = 0 representing the time of being taken private. This neutralizes for whatever the market volatility was at the time (also known as financial benchmarking voodoo).

Signal #1: Lower EV / Sales

• As a reminder, EV / Sales = Enterprise Value / Revenue
• Enterprise value is calculated as market cap plus its debt (total debt) less any cash and cash equivalents
• From an investor perspective, higher value of EV/Sales can be indicative of the “expensiveness” of the valuation of the company
• Conversely lower EV/Sales ratio is considered better investment opportunity as the company is considered undervalued (in relationship to its peers)
• A low EV / Sales may also indicate lower growth expectations, while a high EV / Sales may indicate that investors expect big things (and big growth)
• Takeaway: Companies with lower growth are in the cross hairs (single digit to high teens); especially those who were growing REALLY fast and slowed to medium fast

Signal #2: Lower EV / EBITDA

• Generally, the lower the EV-to-EBITDA ratio, the more attractive the company may be as a potential investment, as it spits out cash
• A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued
• A lower EV/EBITDA means you're spending less money for a $1 of earnings. So that's a good thing
• Takeaway: Investors pony up for profitability, especially when it’s cheap.

Signal #3: Lower Price to Book Value

• Investors use the price-to-book value to gauge whether a company's stock price is valued properly
• A P/B ratio of one means that the stock price is trading in line with the book value of the company
• A P/B ratio with lower values signals to investors that a stock may be undervalued
• In other words, if a company liquidated all of its assets and paid off all its debt, the value remaining would be the company's book value
• Takeaway: The P/B ratio provides a valuable reality check for investors seeking growth at a reasonable price

Who Could Be Taken Private in 2023?

Potential names that have been floated include Peloton, Shake Shack, and AMC Entertainment.

The biggest potential headwind for take privates in 2023 - the cost of debt. Many take privates are financed with a heavy dose of debt. In fact, Twitter owes at least $1B annually in interest payments on the $13B in debt required to take it private.

But then again, rising interest rates do contribute to the stock market dips that make take privates a lot more appetizing… soo….

But, if I was a betting man (disclaimer: this is not financial advice, I just have a degenerate streak and like to watch the ponies run from time to time), I’d say SumoLogic.

But only time will tell.

Smart Stuff I Read at 2AM:

• Private Equity de-listings - Reuters
• Twitter debt - Press Herald
• EV / Sales - Full Ratio
• EV / EBITDA - Wall Street Prep
• P / B - Investopedia

What I’ve Been Reading

My buddy Matteo writes “Work3” - a weekly column on the changing nature of work.

He interviewed me on my career journey, starting Most metrics, and where I see the “future of work” going. Spoiler alert: I think people will increasingly see their networks as the businesses they work for, not the C corps themselves. More in the link below:

I’d recommend you give Work3 a subscribe for a fresh take on workplace evolution.

Quote I’ve Been Pondering

Every culture has its own way of teaching the same lesson: Memento mori, the Romans would remind themselves. Remember you are mortal.
-Ryan Holiday, The Obstacle is the Way

The Art:

Trying to measure efficiency when you’re losing money can be a mixed bag of burritos. Some businesses raise a ton of money so they can prioritize growth at all costs (see: Gitlab). Other businesses are designed to run like a money printer, spitting out free cash flow and fat dividends for shareholders (see: Qualcomm).

But for many businesses, the truth lies somewhere in the middle. Some investors validate a “good” balance between growth and profitability by checking if revenue growth rate plus profit (or loss) rate exceeds 40%.

The Science:

Source: OpenView 2022 Benchmarking Report

Rule of 40 = YoY ARR Growth + LTM EBITDA Margin > 40%

So, if you’re growing at 50% y/y and have a -15% EBITDA margin, your Rule of 40% = 35%…womp womp.

Where does the Rule of 40 go wrong?

I have four bones to pick with the Rule of 40:

1. It ignores where you are in your business lifecycle.

2. You can game it with superior growth.

3. It’s a hard target to keep consistent in all periods, due to seasonality

4. It’s a lowish bar if you want to be great.

I took a trip in the way back machine using Virtua Research’s lifecycle analysis tool to stress test a cohort of companies in the four quarters leading up to (Q-4 through Q-1) and immediately preceding (Q+1 through Q+4) their IPO (Q0).

The research is based on a selection of 60 PLG companies, in honor of OpenView.

Here are my arguments against a dogmatic adherence to the Rule of 40:

It ignores where you are in your business lifecycle

WorkDay was a solid investment if you bought in when they went public, and maintains a strong financial profile to this day. However, their Rule of 40 took a major dip at time of IPO as they made some investments in the business to scale.

Nonetheless, their stock price jumped 72% on day of IPO. If you religiously followed the Rule of 40 you would have dumped them, and kicked yourself down the road.

Source: Virtua Research, $WORK Rule of 40

There are times to step on the gas pedal and say damn the torpedoes. There are also times to get to an efficient P&L in a hurry. Just because you are in one season rather than another doesn’t mean you are necessarily a “bad” company.

Takeaway: Not all periods are the same. And not all periods should be 40%.

You can game it by going big on just growth

I also think there are diminishing returns past a certain growth rate. Investors aren’t necessarily going to pay any extra for 125% growth vs 110% growth if you are losing 50% per year.

However, adhering to the Rule of 40 in a bubble would give you the vote of approval on growth of 140% and losses of 100%. Talk about false signals.

Takeaway: Not all growth percentage points are created equal.

It’s a hard target to keep consistent in all periods, due to seasonality

$SMAR Rule of 40

Here’s SmartSheet. They oscillate between a low of 35% and a high of 48%. It looks like one of those Inflatable Whacky Willys at the used car markets.

I highly doubt when they touched 35% their CEO yelled “HALT THE PRESS! We must get back to 40!”

It’s difficult to run your operations and stay at a consistent Rule of 40 output. Life just doesn’t work like that, especially if you skew heavily towards Q4 seasonality and an elongated enterprise sales motion.

Takeaway: The Rule of 40 is a a general target to work to in the long term, not something to nail period to period.

It’s a lowish bar

$SNOW Rule of 40

Peep Snowflake’s Rule of 40. They have every right to rename the metric the Rule of 60, since that’s where the Y axis starts. They were able to become efficient with scale, driving better bottom line margins at the same time their revenue grew leaps and bounds.

And here’s DataDog. It’s a similar story. The closest they come to 40% is 70%, a full 30% ahead of the “target”.

$DDOG Rule of 40

Finally, here’s the average and median across that cohort of 60 PLG SaaS companies.

PLG Average and Median Rule of 40

You can see the average is closer to 50% and median closer to 45%.

Takeaway: Hitting 40 is more average than excellent, and no one wants to build an average company.

Conclusion

As OpenView explains,

Rule of 40 has always been a solid gut check for the general balance of a company’s growth and profitability. However, it’s become increasingly important as a driver of how businesses are valued. For earlier stage companies, Rule of 40 can vary widely from quarter to quarter. Achieving 40 each quarter is not required. But, it is required to have a grasp on what caused a drop or spike, and what can be done to get to 40 long term.

I’d go a step further and amend the last phrase to: “what can be done to consistently operate above 40 in the long term.”

Maybe it makes sense for stock market pickers to use the Rule of 40 as a “sanity” check. But as someone responsible for making sure the trains run on time, I don’t think the Rule of 40 is very useful, for all the reasons outlined above.

Agree? Disagree? Come tell us at the event on Thursday November 12th at 12 EST. When you register you’ll get a copy of the report.

What I’ve Been Reading

Speaking of PLG… I was recently turned on to Top of the Lyne: Hard data. Deep research. Jaw-dropping insights. And the freshest memes. The art and science of product-led growth. Recommended by 7,000+ revenue leaders from Canva, Stripe, Notion, Figma, and 1,000s of other PLG companies.

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Quote I’ve Been Pondering

“If you can fill the unforgiving minute

With sixty seconds’ of distance run,

Yours is the Earth and everything that’s in it…”

-Rudyard Kipling, If