Category: Public Markets

Why The Instacart IPO is More Significant Than You Think?

A Consumer Internet company, operating in the cut-throat Grocery vertical, going public in a tough macro environment, amidst a widespread venture downturn and without a prominent AI narrative – Instacart’s recent IPO contradicts every mainstream belief.

The long-awaited Instacart IPO finally happened on Tuesday, Sep 19. The offering price was $30 a share, valuing the company at ~$10Bn on a fully diluted basis. This was a significant mark-down from the $39Bn valuation that private market investors ascribed to the company in early 2021 at the peak of the post-Covid tech cycle.

Given this is the first IPO of a notable venture-backed company since Dec 2021, I would like to share some nuances that other analysts and media reports might have missed, and which strongly underline the significance of this event in the current venture downcycle:

1/ Consumer Internet IPOs are tougher to pull off – compared to asset-backed brick-and-mortar industries, as well as enterprise software, Consumer Internet companies find it harder to go public given their business models don’t lend themselves well to sustainable profitability.

While these companies do show growth and scalability, they suffer from high marketing costs. The underlying metric that’s commonly used for this is Customer Acquisition Cost (CAC). Consumer Internet companies have high CACs, driven mainly by costs of FAANG distribution channels and discounts/ promotions to entice customers.

Public markets essentially evaluate companies on profitability (starting with EBITDA, but ultimately on Earnings), leading to Free Cash Flow (FCF). That’s why the standard valuation methods for public companies are the Price/Earnings Ratio (P/E) and Discounted Cash Flow (DCF).

Given the low or non-existent profitability of Consumer Internet companies, it becomes hard to robustly value them. That’s why they get held to a higher bar in public markets, as we have seen with the likes of Uber and Airbnb in recent years.

In that regard, it’s much more commendable when the management teams of say Instacart or Robinhood pull off an IPO vs. a Monday.com or Freshworks, given the default odds are stacked against the former.

2/ Bonus points for delivering a new IPO story in a tough space like Grocery – Several aspects make Grocery incredibly challenging as a space. It’s highly competitive with large incumbents (Walmart, Whole Foods, Target, Kroger, Costco etc.) coexisting with regional, mid-sized chains (Trader Joe’s, Ralphs, Gus’s Supermarket etc.) and mom-and-pop stores (eg. ethnic grocery stores like Asian, Indian, Mediterranean etc.). These players compete in an environment that is a lethal combination of low growth and low margins.

Historical US Grocery Sales (Source: Aswath Damodaran)

If one were to think of a legacy vertical that can be fruitfully disrupted by tech, Grocery wouldn’t even make the shortlist of most analysts and investors. That Instacart pulled this off and on top of it, also delivered a liquidity event, is a humongous achievement.

Source: Aswath Damodaran

3/ A venture-backed IPO amidst super-tight macros – while fighting against the above odds, what makes this event even more significant is that it has been pulled off in a high-interest rate environment driven by a hawkish Fed, an IPO window that has been pretty much closed for typical venture-backed models since late 2021, and where late-stage private companies are hurting from inflated last-round valuations, weakening customer demand and lack of profitability (refer my post ‘When will the next venture bull run begin?‘).

To choose this environment to go public in shows real courage, and I congratulate the management team and shareholders for this brave call.

4/ Pulling off a non-AI IPO in 2023 – Instacart closely followed on the heels of the chip design company Arm’s IPO. Given AI is seeing a hype cycle right now, the outperformance of Arm’s IPO was expected. But kudos to Instacart for pulling off an online grocery IPO when the only thing investors seem to be wanting right now is AI.

5/ Setting strong precedence for prioritizing liquidity for employees – Interestingly, only ~8% of Instacart’s outstanding shares were floated in this IPO, with ~36% of those sold coming from existing shareholders. In the words of the company’s CEO:

“We felt that it was really important to give our employees liquidity. This IPO is not about raising money for us. It’s really about making sure that all employees can have liquidity on stocks that they work very hard for. We weren’t looking for a perfect market window.”

Fidji Simo, Instacart CEO

This is an amazing stance taken by the company. As someone who has both founded and worked in early-stage startups, I have seen how demotivating holding illiquid stock can be for employees. In fact, this has been one of the major ecosystem-wide downsides of tech startups staying private for longer during the ZIRP decade.

Instacart has demonstrated that rewarding employees via liquidity events is at least as important as generating returns for VCs on the cap table and that it is the responsibility of Boards and management teams to make it happen.

6/ Proving that entry price matters – WSJ recently wrote about how almost all growth-stage investors in Instacart are at a loss on the IPO offering price. An even more insightful analysis was put together by the ‘Dean of Valuation’ – Aswath Damodaran, Prof. at NYU.

Source: Putting the (Insta)cart before the (Grocery) horse: A COVID Favorite’s Reality Check! – by Aswath Damodaran

This analysis shows that at the offering price, only the Seed, Series A, and Series B investors are sitting on substantial profits that also beat the S&P500 benchmark returns during their respective hold periods. Series C onwards, none of the investors have beaten comparable benchmark returns, with the late-stage rounds in 2020 and 2021 sitting on substantial haircuts.

While a common VC narrative is that “irrespective of the price, the only thing that matters is getting into the best companies”, my own experience is contrary to this (I wrote about it in my post ‘An angel’s struggle with entry valuations‘).

The actual returns profile of various types of VCs and Growth Investors who invested in Instacart at different stages of maturity and valuations provides more evidence for this age-old wisdom of OG investors like Buffet, Munger, and Howard Marks.

Source: Random Thoughts on the Identification of Investment Opportunities, by Howard Marks (1994)

Sobering thoughts for Instacart’s way forward:

As an active participant in the venture ecosystem, while I am wholeheartedly celebrating Instacart’s IPO and the way it has overcome all the above odds, it’s important to acknowledge that the business faces significant risks going forward.

1/ Market share – will it be able to grow, or even retain market share, as traditional grocers expand their online shopping experiences?

2/ Topline metrics – Instacart’s AOV has been pretty much static at ~$100 over the last five years. Given grocery is a low-margin business, it will also find it hard to significantly increase its take rate from the current ~7.5% levels*.

Further, while Covid saw a massive spike in customers leveraging online grocery, it seems that the use case seems to be settling down at relatively lower levels of purchase frequency.

Given these dynamics, what are the levers at Instacart’s disposal to improve its cohort metrics?

*As a comparison, Airbnb and Doordash have much higher take rates at 14% and 11.79% respectively. These reflect the higher operating margin profiles of the underlying businesses (both hospitality and restaurants operate in the ~15% range).

3/ Bottom line metrics – Instacart’s Selling Cost (Marketing + Incentives and promotion) as % of Revenue has been steadily going up (from ~12% in 2020 to 24.50% in 2022).

Though its customer retention is strong, will the company be able to convince these customers to buy more frequently, as well as keep attracting new customers, without a commensurate increase in CAC?

4/ Talent – While it’s tempting to perceive an IPO event as the finish line, it’s rarely so. In fact, as Yahoo, Google and Facebook have shown in the past, exponentially more value gets created in the years post-IPO, compared to pre.

This especially applies to Instacart, where the IPO valuation is much lower than the last private round, and therefore, much work needs to be put in to generate returns for these late-stage investors. See the amount of post-IPO heavy lifting that the likes of Dara at Uber and Brian Chesky at Airbnb have had to do to create shareholder value.

From here on, Instacart will need to ‘grow up’ as a public company and attract a fresh set of talent that can design & execute its next phase of growth. Will it be able to create a culture and working environment that can help achieve this?

All in all, Instacart’s IPO being a milestone for Silicon Valley is beyond doubt, especially considering the tough macroeconomic and venture environment over the last year. But I can also say with equal confidence that a lot of value still remains to be captured by the company, and the next few years are going to be a tough execution grind for the management team.

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Munger’s Tao

Image Source

I recently came across this awesome Tweet & Podcast from David Senra of Founders Podcast, wherein he captures learnings from his dinner with Charlie Munger, as well as his reading of The Tao of Charlier Munger.

Here are some insightful ideas & quotes from Munger that stayed with me from David’s experience:

1/ Buy wonderful businesses at fair prices

Before Munger joined Berkshire, Buffet used to invest in Ben Graham’s “cigar-butt” style – buying super-cheap stocks, often trading below book value.

Munger gave him a new blueprint: “Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices”. This is what led to Berkshire becoming the compounding machine it is today.

2/ Cash is king

Through a company called Blue Chip Stamp, Munger & Buffet learned about the value of “float”- excess cash that a business throws up due to the timing difference between receiving payments & settling payouts. This excess cash could then be re-invested in profitable companies.

Through his early investing experiences, Munger started seeing the advantages of investing in better businesses that didn’t have big capital requirements and did have lots of free cash that could be reinvested in expanding operations or buying new businesses.

Munger advises keeping enough cash at all times, in order to take advantage of stock market crashes.

We made so much money because when the great deals came during an economic crisis, we had cash and could move fast.

Charlie Munger

3/ Acting on the few big ideas that matter

Munger says that very few times, you will be presented with an opportunity to buy a great business run by a great manager. Not buying enough when presented with this opportunity is a big mistake.

You have to be willing to act when the right opportunity comes along. ‘Cos great opportunities don’t last very long in this world.

Good ideas are rare. When you find one, bet big.

Charlier Munger

4/ Portfolio concentration creates outlier outcomes

Real wealth is created via concentration. Or to put it in another way, over time, one should expect 1-2 outlier winners to constitute a majority of the portfolio.

When Munger wrapped up his pre-Berkshire fund, Blue Chip Stamp accounted for ~61% of his portfolio.

Worshipping at the altar of diversification is crazy. One truly great business will make your unborn grand children wealthy.

Charlie Munger

5/ Chase unfair advantage

Competition is for losers! Why would you want to compete with people?

Some quotes from Munger on this:

  • “My idea of shooting fish in the barrel is to first drain the barrel”.
  • “Only play games where you have an edge”.
  • “Differentiation is survival”.
  • “Aim for durability”.

Munger talks about how size and market domination has its own kind of competitive advantage. When a company is deeply entrenched with customers, it acts as a deterrent for other players to enter the space.

Sectors that are generally considered to be “bad businesses” (eg. retail, textile, airlines etc.) are intensely competitive. Players beat each other over price and drive down profit margins for everyone, killing cash flows and bringing down chances for long term survival.

That’s why Berskhire looks for great businesses that have a durable competitive advantage. 

Mimicking the herd invites regression to the mean. 

Charlier Munger

6/ The power of Compounding

Find an exceptional business where underlying economics are going to keep increasing its value, and then hold on to it over time.

Quoting Munger – “Time is the greatest friend of an exceptional business. It’s the greatest enemy of a mediocre business”.

Compounding also works in knowledge. Munger gives an example of how over 50 years of consistently reading Barrons, he found just 1 idea worth investing in but that made him $80Mn, which he then gave to Chinese fund manager Li Lu, who turned it into $400-500Mn!

7/ The value of Rationality

To quote Munger:

  • “We don’t let other people’s opinions interfere with our rationality”.
  • “Life is like poker. You have to be willing to fold a much loved hand when new info or facts come to light“.
  • “It’s remarkable how much long term advantage people like us have got by trying to be consistently not-stupid, instead of being highly intelligent”.

8/ Focus is a super-power

Munger says:

  • “I succeed because I have long attention spans. People who multi-task give up their advantage”.
  • “You will always lose in a race to that one guy who sacrifices everything he has in service of one idea”.
  • “Extreme specialization is the key to success”.
  • “Intense interest in a subject matter is super powerful”.

He cites examples of how great companies tend to focus on optimizing one specific lever in their business:

  • Costco – optimizes costs
  • Geico – optimizes distribution via direct-to-consumer
  • Nebraska Furniture Mart – optimizes price for the end customer

What’s the one thing that both Warren Buffet & Bill Gates said was the key to success? Focus!

9/ Frugality drives value

Munger cites one common quality amongst all Berkshire businesses – they will go to great lengths to keep operating costs low. Even Berkshire itself demonstrates the same behavior:

  • It has no PR department.
  • It has no investor relations office.
  • For many years, its annual report was published on the cheapest possible paper & had no expensive color photos.

10/ Brands are magic

Munger says – “A great brand is a piece of magic”.

Brands like Coca Cola & See’s Candies have a piece of a consumer’s mind & therefore, have no competition. Charlie calls them “consumer monopolies”.

A lot changed the day Berkshire realized the power of brands.

11/ Business plans are useless

Munger says Berkshire has no master plan – “We always wants to be accounting for new information. We are individual-opportunity driven. Our acquisition style is driven by simplicity”.

He shares an interesting anecdote. When Mrs. B (Rose Blumkin), Founder of Nebraska Furniture Mart, was asked about having a business plan, she said – “yes, sell cheap & tell the truth”.

12/ Patience is rare

Human nature is all about being impatient. People just can’t sit around, waiting patiently. They want to feel useful. So they end up taking action and doing something stupid.

13/ Learning from mistakes is crucial

Learning from history is a big form of leverage. The biggest financial disasters get forgotten in a few years.

Munger says:

  • “Wise people step on troubles early”.
  • “Every missed chance is an opportunity to learn”.
  • “Be willing to take life’s blows”. 

I love rubbing my nose in my mistakes. It’s an extremely smart thing to do.

Charlier Munger

14/ It takes many, many attempts to find your life’s work

For context, Munger started working on Berkshire in its current form only in his 40s.

15/ Finally, lots of life advice…

“Build relationships with A players”.

“Problems are a part of life. So why are you letting them bother you?”.

“The best way of reducing problems is to go for quality – Go for Great!”.

“It’s the strong swimmers who drown”.

“Envy has no utility. The key to living a well-lived life is killing envy”.

“The best armor for old age is a well spent life preceding it”.

PS: If you love Charlie Munger’s wisdom, you might enjoy my post capturing his musings from the 2o23 Daily Journal Shareholder’s Meeting.

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The real risk is the unknowable, not the unknown

Image Source: BBC Wildlife

I was discussing the SVB blowup situation yesterday with one of my friends who manages the public markets portfolio for a large family office. He and I both have deep financial services backgrounds, having worked across diverse services & asset classes (VC, PE, public markets, Investment Banking, debt etc.). Both of us came to the same conclusion regarding what has unfolded:

Given the complexity of financial markets, with many direct & indirect stakeholders, influencers, interconnections, interdependencies, manual & robo decision engines at play, it’s almost impossible for even the smartest operating teams & regulators to stay on top of systemic risks building up across thousands of organizations in our financial system.

Of course, this risk management challenge gets further exacerbated in pure capitalist markets such as the US, that consciously allow free market cycles, driven by excessive greed followed by excessive fear, to play out without much intervention.

Going beyond the macro discourse around SVB, of which there is enough now in the media & on Twitter, I want to highlight one learning that all of us need to pay attention to from this episode – the real risk in most things in life is in the “unknowable”, not the “unknown”.

What does this mean? In most planning exercises we do around risk management both professionally (eg. what’s the sensitivity around my company’s 2023 revenue?) & personally (if I plan to do a startup, how much personal runway do I need to be able to operate without a salary?), we focus mainly on outlining the “unknowns” – variations in outcomes of visible & obvious elements. Things like revenue from existing customers, attrition of top performers, house rent, holiday budgets etc.

Planning for unknowns is largely driven by first-order thinking. This includes the classic sensitivity analysis playbook of (1) listing out all obvious elements of the game, (2) thinking of a range of values for them (best case/ likely case/ worse case) & (3) using these values as inputs to model out various output scenarios that consequently drive the overall decision-making process.

But if most organizations & individuals follow this kind of solid decision-making framework, why is the real-world full of surprising blow-ups – bank runs, hedge fund unravels, fast-growing companies unexpectedly going bankrupt etc.?

It’s because the real world is a complex adaptive system with emotion-driven humans as actors. Michael Mauboussin, legendary analyst, academic & public markets investor, beautifully outlined the qualities of this type of system in his recent conversation with Tim Ferris:

So, “complex” means lots of agents. Those could be neurons in your brain, ants in an ant colony, people in a city, whatever it is. “Adaptive” means that those agents operate with decision rules. They think about how the world works, and so they go out in there and try to do their thing. And as the environment changes, they change their decision rules. So that’s the adaptive part, their decision rules that are attempting to be appropriate for the environment. And then, “system” is the whole is greater than the sum of the parts. It’s very difficult to understand how a system works, an emergent system works, by looking at the underlying components.

Michael Mauboussin

In such a system, while some risks fall under “unknowns”, a majority of them are “unknowable” given the system is self-evolving & therefore, impossible to predict at a granular level. Many words are used to describe these unknowables – edge cases, tail events, black swans etc.

Even if we do get some additional visibility into a few of these probabilistic unknowables & can foresee their 1st-order impact to an extent, their 2nd & 3rd order effects are really hard to model out.

Given this context, classic risk management approaches work well most of the time, until they don’t. And when they don’t, participants are caught unaware, unprepared, & often facing the Risk of Ruin.

So, how can organizations & individuals prepare better to deal with the unknowables? The following steps can help:

  1. Start by recognizing the presence of “unknowables” – a major first step is to acknowledge one’s ignorance, & consciously keep overconfidence bias at bay by reminding oneself that even after all this data & analysis, there is a lot that is just not possible to predict. Approaching risk management with humility & in defense mode creates a conducive mindset for this.

2. Add a significant “Margin of Safety” on top of your analysis – while a rigorous Sensitivity Analysis will cover the unknowns well, adding a Margin of Safety goes a long way in providing a buffer for the unknowables. How much of it you want to add depends on context but given we live in a highly risky world, it should be significant enough. As an example, legendary value investors like Buffet & Munger insist on a 50% Margin of Safety while buying public securities (buying at half of the intrinsic value of a company).

Btw, this isn’t anything new. Engineers who design everything from trains & storage tanks to nuclear reactors & space shuttles, recognize error rates in their assumptions & therefore, always include an “allowance” in their computations. Millions of lives depend on this method!

3. Routinely stress-test & update your assumptions – with software continuing to eat the world at an exponential pace, cycles are becoming shorter & feedback loops quicker. The Fed raised rates from under 0.5% in Mar’22 to ~5% in less than a year! With information transmitted in real-time, especially via networks like Twitter, & decisions manifested at the push of a button, we saw how SVB unraveled in literally a day. Given this speed of change, it’s important to frequently stress-test your state-of-state, accounting for changes in external & internal environments & updating your assumptions (esp. Margin of Safety) accordingly.

While the Treasury, the Fed & FDIC have joined forces to save everyone impacted by this specific SVB case, most of us can’t count on such White Knights bailing out our families or our startups each time. A pragmatic & defensive risk management approach that accounts for unknowables, incorporates a healthy Margin of Safety, & includes periodic stress testing, can help us cope with outlier events & keep us in the game.

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Munger Musings – Notes from DJCO Shareholders Meeting 2023

As a long-time student of Charlie Munger, I eagerly wait for his musings at the Daily Journal Shareholders Meeting every year. This time was no different! Here are some of my notes capturing Charlie’s wisdom at the DJCO 2023 meeting:

  1. Importance of under-served markets in software

Both Munger & Buffet are big believers in moats. Having witnessed the natural creative destruction of even the best companies like Kodak & Xerox, they understand the power of competition & what it can do to long term returns of investors.

Munger spoke about how the software business of DJCO, which offers a solution to automate legal courts, is operating in a large yet unaddressed market that incumbent software companies hate. It’s an unsexy business that has long sales cycles & as Munger himself said – “it will be a long grind”.

However, these same reasons also limit competition in the space. Munger believes that this combination of a large, underserved TAM + low competition is likely to drive superior long-term returns, as long as DJCO shareholders are prepared to ride through the grind & hold over the long term.

In my view, this idea also has some interesting insights for venture investors in the enterprise software/ SaaS space. Too often, investors start chasing the hot market of the year without realizing that a space that is obviously popular will end up attracting disproportionate competition & investor $$. And as history shows us, too much competition in a market drives down returns for everyone.

Therefore, there is some merit in looking at startups going after unsexy or under-served verticals. These non-obvious nooks & crannies often hold the most potential for contrarian-and-right bets.

2. Holding is tax-efficient

Munger spoke about how he hates to sell his holdings as California would straight-up take 40% away in taxes. As he went on a brief rant about how California is driving businesses away with its tax policies, the underlying insight stayed with me – how holding securities over the long term is a brilliant strategy for tax efficiency. A simple rule that anyone from Berkshire & DJCO to common folks like you and me can follow in our lives.

As the likes of Robinhood have leveraged the excess liquidity environment over the last several years to create a generation of young day traders, many of them don’t realize how tax-inefficient frequent trading is.

3. #1 bias is denial

When asked what the #1 behavioral bias is, Munger said “denial”. And it’s so true. Often times, when the present reality is too brutal to bear, our brain tricks us into living in a delusion. While this stems from an evolutionary survival mechanism our brains have developed, taking major decisions under this denial state can cause havoc in our lives.

Proactively trying to see & live in one’s reality at any point in time is the best way to behave rationally. If one thinks of all of grandma’s wisdom handed down to us in popular sayings (eg. “live within your means”), they all urge us to recognize & live within our own realities.

4. Betting big when the right opportunity knocks

I loved this sentence from Munger – “What % of your networth should you put in a stock if it’s an absolute cinch? The answer is 100%”.

While I am positive that Charlie wouldn’t like this to be construed as a stance against diversification, which is important for almost all portfolios in varying degrees, the spirit of this sentence is this – a few times in your life, you will come across a no-brainer opportunity with massive asymmetric upside. It will happen very infrequently, but when it knocks on your door & you are convinced about it, go all in & bet really big. Over a lifetime, these bets will drive the majority of your returns, financial or otherwise.

If there is one thing that separates the likes of Buffet & Munger from other investors, it’s the mindset of betting really big when the odds are extraordinarily in your favor. During the meeting, Munger mentioned how Ben Graham made 50% of his money from just 1 stock – GEICO. Also, he illustrated the importance of power laws by sharing how Berkshire’s initial $270Mn investment in BYD (made in 2008) is now worth $8Bn!

PS: I have previously riffed on this idea in my post ‘Only need to get a few right‘.

5. On using leverage

Munger admitted to having used leverage to buy Alibaba stock in the DJCO portfolio. When asked why he violated his own rule (his famous quote being “there are only 3 ways a smart person can go broke – liquor, ladies & leverage”), Munger responded with another fascinating quote:

The young man knows the rules. The old man knows the exceptions.

Charlie Munger

The insight behind this is something I say a lot – context is everything! Rules & checklists are great for driving overall discipline & avoiding foolish behavior but as Munger demonstrates, it’s not wise to become a prisoner of your own rules. With experience, one should learn to spot exceptions & when the context is favorable, be bold enough to break the rules.

6. On long-term economic trends

While both Munger & Buffet generally hate to predict macro trends, Charlie mentioned a few interesting observations:

-Inflation is here to stay over the long run, given most democratic govts. globally have shown an ever-increasing inclination to print money.

-Most govts. across the world are going to be increasingly anti-business, with tax rates steadily going up.

-If one looks at economic history, the best way to grow GDP per capita is to have property in private hands & make exchange easy so economic transactions happen (the essence of capitalism).

If these trends are even directionally true, it makes sense to hold assets that can fight inflation (eg. stocks), as well as invest in a tax-efficient way, over the long term. Developing an investor mindset that can operate in a high-inflation environment will be important.

7. The playbook for success in life – Rationality + Patience + Deferred Gratification

When asked the thing that’s helped him the most in life, Munger said – rationality! Loved this line from him:

If you are constantly not crazy, you have a huge advantage over 90% of people.

Charlie Munger

To significantly improve the odds in your favor, Munger prescribes combining 3 things:

-Rationality (which is often, just doing the obvious)

-Patience (take advantage of compounding)

-Deferred gratification (live within means, save & invest)

Like most things Munger says, the above ideas are simple & profound, yet hard to consistently follow for most people as their biases come in the way.

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