Toast Raises $101MM to Win, Or Die

Most startups outcomes are binary. By that we mean they either produce great returns, or become a write off. Toast has been attacking the POS industry at full-bore, and their recent $101MM financing tells us it’s either IPO/large acquisition, or die.

We’re going to discuss toast’s recent financing, and what that means for the company and the industry.

First, we need to know where we’ve been if we want to know where we’re going. In January of year we wrote an article that shined a light on toast’s operations. Our takeaway from that article was this:

Toast is burning through a ridiculous amount of money and, from all the data we could see, not gaining much market share. 

This is to be expected, however, as there is no such thing as B2B (business to business) virality in brick and mortar. To put that another way, when you think of B2C (business to consumer) companies like Facebook or Linkedin, you’re rewarded by telling your friends and contacts about the service; if they sign up, you now have more ways to follow their lives.

In B2B, virality is rare. Slack, a B2B tool, achieved virality by the nature of its product. That is, Slack would improve your collaboration if more of your colleagues were using the tool. This underlying truth has made Slack the fastest growing B2B SaaS tool ever.

B2B2C tools – like OpenTable or GrubHub – scaled quickly relative to B2B tools because there was a consumer lever. In other words, these types of companies leveraged consumers to convince more businesses to sign up. And since brick and mortar merchants are horrible at rational business decisions (look no further than the math for Groupon), they did enroll. For the record, we’re staunch believers that OpenTable and GrubHub will be replaced by much cheaper alternatives once more of the POS industry goes to cloud and realizes the value they can facilitate.

The POS industry, on the other hand, exhibits none of these viral characteristics. There’s no value in telling your neighbors to use the POS systems you use. Replacing a POS is a sensitive business change as all the merchant’s data resides on that machine; it’s data that (if used properly) helps the business run marketing, operations, accounting and other necessary functions.

Yet given these truisms, hardly any innovation ever permeates brick and mortar. This has left merchants unchanged for literal decades (or depending on what we’re measuring, millennia). Toast’s theory for existing, then, is actually spot on. Their lead investor on their latest round, Generation Investment Management, couldn’t have said it any better,

The restaurant industry has historically been slower than others to adopt technology, leading to operational inefficiencies and missed opportunities. Advances in hardware, software and cloud computing are shifting that dynamic. Toast is… democratizing access to… technology. [With the right POS] restaurants can maximize revenue, optimize operations, digitize paper processes, reduce food waste and other costs, and ultimately deliver a superior dining experience.

We can confirm toast’s thesis by looking at our own transactional data across tens of thousands of restaurants, from the SMB to the public chain: every brick and mortar merchant can drastically improve their businesses with technology and sophistication. The problem, of course, is that merchants – particularly chains – are personally incentivized not to improve.

That aside, we need to think about the underlying mechanics for toast’s $101MM raise, and if that will get them any closer to their worthy goal of modernizing the restaurant industry.

First we’ll talk about financing velocity. As a rule of thumb, healthy companies increase the size of their fundraising rounds each successive round. This happens because the company is growing quickly, so it takes a larger amount of money to buy a percentage of the company. Our article about Touchbistro’s fundraising lays out this math.

Toast’s rounds have increased progressively, which is to be expected for a fast growing company. However, it’s entirely possible that toast is giving up a large percentage of ownership on their most recent round. That they didn’t disclose this figure means this is most likely the case. Ideally, fast growing companies will give up ~10% on a Series C and they’ll show that they’re healthy by disclosing the valuation. For example, Microsoft purchased only 1.6% of Facebook for $240MM as the company’s Series C. Slack raised $120MM at a $1.12B valuation for their Series C/D and then raised $200MM at a $3.8B valuation shortly thereafter.

Second, we need to look at the investor mix. Toast raised $30MM from Bessemer Ventures and Google Ventures in 2016. Both of these firms have large funds and could easily fill toast’s entire Series C. In fact Google ponied up most of the $130MM round for Flatiron Health’s raise in 2014. Yet neither of these investment firms led the latest round. Instead, toast needed to find unconventional financing in the way of lower middle market growth equity firms Generation Investment Management and Lead Edge Capital.

Third, we need to look at growth trajectory. According to the press release, toast employs 500 people today with an expectation to hire 1,000 more over the next 18 months. This would be 1,500 people by 2019. As in our last post, we feel comfortable stating that a fully-weighted toast employee costs $100,000 per year. Thus toast would need to be earning $150MM in revenue by 2019 to be profitable.

But toast likely needs to earn even more than that.

Some of toast’s revenue comes from hardware sales and payment processing. In payments, for $100 in payments revenue, toast is only seeing a small portion of that, with the difference going to interchange and other payouts. The same underlying mechanics are happening on hardware: toast is not earning much on hardware, and on several deals we were privy to they sold the hardware below cost. So toast needs to get their gross margin up to $150MM to be profitable.

Still, we find it odd that toast’s announcement only discussed how much money they’re going to spend, not how fast they’re growing customer counts or dollars processed…

If we had to put pen to paper on the back of an envelope, here’s how we would estimate toast’s financial position in absence of anything more concrete from toast.

Toast has 5,000 merchants that earn an average gross margin of $3,600 per merchant per year. We’re coming up with this number by saying that each merchant has 2.5 terminals ($2,400 per year), and uses toast’s payments at a margin of ~$1,200/year (assume rate matching).

This would put toast at $18MM in gross annual margin (or really the “revenue” number we should care about). Against a current employee count of 500, toast is likely losing ~$30MM annually. However, toast’s top line revenues – including payments and hardware – might be $40MM per year. This would mean toast could raise $100MM at a $400MM valuation depending on growth (we got the $400MM valuation by giving toast a 10x on top line, which is not unreasonable for SaaS companies that grow fast enough).

If you really want to nuance this valuation, do this: take public SaaS revenue multiples and subtract 1.3. Then look at growth. If your growth rate is 100% faster than comparable market growth rates from the below chart, add a 50% premium to the multiple.

Right now the average public SaaS revenue multiple is 5.8, so we’ll subtract 1.3 to get 4.5. The average revenue growth rate is 33% for companies (like toast) that are earning $20-50MM in revenue. Toast’s revenue has probably grown 100% on an annualized pace over the past year, which is ~2x the mean growth rate. Therefore, toast would get to add another 4.5 to it’s multiple, which is ~10x revenue.

However, it’s entirely possible that investors applied the 10x multiple on a blended gross margin given how toast’s revenue is being earned – i.e. top line payments and hardware revenue never make it into toast’s coffers. Under this scenario toast’s valuation could be 10x $18-$30MM, meaning that their $101M raise ate up a lot of equity or was partially debt.

This, of course, is if you believe toast is trading on some level of fundamentals. It’s also possible that a larger theory about the strategic value of the underlying data is driving the valuation, but that Google didn’t then lead the round could be a strong indicator that this is not the case.

We mention these two scenarios only to demonstrate how much fudge factor there might be in toast’s financing.

Where does toast go from here? By looking at their hiring plan and what they subtly announced in their press release, we think we have an answer:

toast wants to increase revenue per account and grow its direct sales efforts.

Here’s what toast said its new money would be used for:

• Investing further in Toast Online Ordering, enabling a best-in-class ordering experience across various devices and channels
• Enhancing key areas of the platform such as self-ordering kiosks, handheld pay-at the-table experiences, CRM and marketing tools, advanced reporting, inventory, loyalty, and more
• Creating the industry’s most robust cloud-based restaurant platform, including modern, commercial grade hardware
• Leveraging the immense amount of data restaurants collect to enable a more personalized guest experience and  improve labor and food cost profiles

Our first concern, though not unexpected, is toast’s desire to own everything within the ecosystem. Toast has undoubtedly discovered that, despite ~$37MM of funding prior to their most recent round, acquiring merchants is fucking hard. It took Micros 35+ years to be a market leader in POS, and those timeframes are not workable for venture capitalists. While Silicon Valley likes to believe sales come easily when you have the best product, we’ve seen this fail time and time again with brick and mortar merchants.

Toast has surely confronted this reality by now and recognizes it needs to change its model. Instead of the “large merchant base” approach, toast is going to take the “platform” approach, earning revenue on a myriad of solutions it offers to its merchants. In fact we published our concern specific to toast’s platform approach in October of 2016.

It appears that toast will be building, “CRM and marketing tools, advanced reporting, inventory, loyalty, and more.” Toast will also start, “Leveraging the immense amount of data restaurants collect to enable a more personalized guest experience and improve labor and food cost profiles.”

If we were a third party partner of toast that fell into any one of the above categories (which, by the way, is basically everyone), we’re shitting our pants.

Toast, by default, has access to the POS transaction data. This gives them substantial leverage over any third party provider as they can already demonstrate the product and ROI without needing to “sell” anything. Third parties that partner with toast need to be acutely aware that toast appears to want to cannibalize their partners’ business.

We also question the viability of this platform approach on the whole… at least in the manner toast seems to want to execute it. While the undeniable value of cloud POS is in the ease of connectivity, it’s incredibly dangerous to believe you can build the world’s best POS and every possible bolt-on. For proof, look no further than Micros or NCR, whose homegrown bolt-on solutions are mocked across the industry. Toast may argue that it was a cultural problem that plagued the legacy POS providers, but is that honest? Remember when Lightspeed POS, a cloud provider with new-age culture, had to white label assets to offer best-of-breed solutions to its merchants?

Our second concern, though not apparent in the press release text, is how toast will work with its dealer channel going forward. If you glance at toast’s list of openings for Sales and Customer Success roles, it appears that toast is doubling down on its direct efforts. Nowhere in the job listings do we see anything that resembles a channel management approach. It’s possible toast will add these later, or that toast calls these positions something else entirely, but this investment in direct sales efforts is something to note.

Many of toast’s current resellers are former Micros dealers. These dealers have admitted to us that they make very little selling toast (though to be fair the same could be said for any dealer selling cloud POS), and a healthy number of them are actually shopping their dealerships for a suitor. Could this be because cloud POS companies are making it easier for merchants to purchase product directly?

We continue to maintain that the best value for customers, and the most responsible use of POS funds, is to partner with best-of-breeds. We even go so far as to advocate white labeling solutions. This lets the POS companies focus on their core business operations while the third parties continue investing in the best possible products in their categories.

Realistically, toast cannot go down this path.

Because they’ve raised so much money, and are spending it hand-over-fist in pursuit of growth, toast needs to improve their unit economics ASAP. Based on our previous analysis we believed toast’s unit economics pre-Series C were unfavorable – with a CAC:LTV ratio and recovery period that were in dire need of repair. And unless we see some numbers that prove otherwise, we’re not convinced that toast’s unit economics will be much better after the infusion of $101MM: it’s just really hard to be good at everything.

It’s a shame because POS companies are going to make money like they never have in the data markets, though it will take a few more years for those markets to mature. The greed of toast’s investors might actually kneecap the company before they can become the billion-dollar company they set out to be.

As we stated in our last post about toast, they would either need to raise significant funds or terminate much of their workforce by 2018 given their burn rate. Well, they’ve raised the funds and avoided the alternative for now. But with their continued hiring plan, we’re going to make the same prediction for the end of 2018 as well:

toast will either need to raise more money or cull their ranks by 2019.

Toast is spending so much money they’re either going to win big or become a Revel 2.0. As a refresher, Revel was a POS company that seemed on an upward trajectory, yet had to mysteriously raise money from a private equity firm with little history in the space. Revel struggled to convince existing investors to put up money in consecutive rounds, and ultimately ended in a fire sale of epic proportions. Silicon Valley likes to pattern match, and that might be why toast has had to find unconventional investors for their Series C…

But that’s not to say we aren’t rooting for modernization in brick and mortar – merchants badly need it. If toast makes it happen, it’s the industry that wins, and we’re all for that outcome.