Reforming Retail

Toast’s $115M Raise Should Worry Them More Than It Worries Their Competitors

Whenever a POS or payments company has big news, you can rely on us to give you our honest analysis. It doesn’t mean we’re always right, but at least we’ll explain our assumptions.

Toast has raised $115M at a staggering $1.4B valuation. This is the first time Toast has announced a valuation on a round because it’s both a nominal unicorn valuation and it demonstrates Toast was able to sell a small amount of their company (8%) for a large amount of capital. Given the valuation and Toast’s ongoing burn (we’ll get to that shortly) our guess is that the $115M is primary capital, meaning money that will be directly invested into the business as opposed to buying out previous shareholders (i.e. investors).

Our first thought in reading the press release is how badly it must feel to be an API “partner” of Toast’s right now.

At its core, Toast is a point-of-sale for restaurants, though over time it’s added more and more services on top of that. Now the goal is to be not just a point of sale, but offer a whole system to help restaurants operate efficiently. That can range from the actual point of sale all the way to loyalty programs and reporting on that information… ‘We’re just trying to keep our finger on the pulse to what matters to restauranteurs,’ CFO Tim Barash said. We hear a lot about the labor side of the equation. We’re working through what to do there.’

We told our readers a year ago that Toast wanted to build everything in addition to the POS. Don’t get us wrong, we understand the thesis here (as we conveniently laid out two years ago): merchants are so expensive to acquire that you need to find more revenue streams than just the ones emanating from traditional POS (hardware, software, and services). Undoubtedly this is what led Toast to locking the merchant into their payments as well.

Of course those of us who are students of POS have seen just how disastrous these non-core bolt-on solutions can be when undertaken by the POS company. At least when the legacy POS companies tried their hands at these bolt-ons there were ways for superior third party bolt-ons to offer their solutions. For example, if Micros wanted to force their merchants to use homegrown solution X, the merchant at least had their POS transaction data available on their local server and could find a much better third party competitor to access said data to deliver their version of solution X.

Granted it’s not a preferred method to access the merchant’s transaction data (it should all be open APIs now), but what happens when that transaction data only exists on the POS company’s cloud? Do you think Toast is going to openly give a third party competitor access to this data when they have their own solution they need to sell in order to hit their investors’ revenue targets? We predicted precisely this problem 18 months ago and this may become painfully true as Toast has set such a high valuation for itself.

Lastly on this point, nobody seems to be considering how complicated support becomes when you’ve got multiple products under your umbrella. POS resellers traditionally only carried one or two types of hardware specifically because of these complexities. Now you’re going to add 10 new software products to your offering? Good luck.

Next we need to talk about valuation and fundamentals. Let’s start with valuation.

It’s no secret that there are ungodly sums of money in the private equity markets these days. This is a natural consequence of government involvement in the financial markets: Federal reserves around the world lowered interest rates to the point where capital had to seek equity placements to find any sort of return.

This truth has meant that private equity has become incredibly competitive, driving up valuations. We advise and talk with funds all the time. Most recently a partner at a venture fund in Silicon Valley told us that software deals that would normally be getting done at 10x revenue are getting done at 30x, 40x, and 50x revenues. However, he noted that there are serious downside protections for the investors. So while a founder’s ego gets boosted by joining the unicorn club, they have to deliver. Otherwise the investor effectively owns the majority of the company. The most common financial vehicle used here would be a ratchet. Below is a copy-paste from Investopedia, but what it really means is that if Toast doesn’t hit some financial goal agreed to by its investors, Toast’s employees will get hosed (remind anyone of what happened to Revel?)

For example, an investor who paid $2 per share for a 10% stake would get more shares in order to maintain that stake if a subsequent round of financing were to come through at $1 per share. The early round investor would have the right to convert his shares at the $1 price, thereby doubling his number of shares.

Toast’s valuation comes with some other troubling news, at least if you’re an employee. See, Toast’s latest investors will most certainly want a 3x return on their capital: that’s how these later rounds typically work. At Toast’s current valuation, that means Toast needs to become a $4.2B company. At a valuation of $4.2B Toast’s only reasonable option is to go public: $4.2B is nearly too large for any private equity company to acquire, especially if it’s burning cash. Here’s a list of the largest PE deals of 2017 to show you what we mean.

That means Toast will need to IPO. In fact this is why we believe Toast did the deal with Jamba Juice: retail investors (the kind that invest in IPOs) like household names and things they can relate to. Jamba Juice becomes part of Toast’s story in an IPO roadshow even if Toast makes no money on the deal with Jamba Juice. In fact we bet Toast prefers not to have customers like Jamba Juice because they can’t make any money on merchants who scrutinize their processing statements.

But the problem with public markets is that they’re not as forgiving when it comes to profitability. At least if your name isn’t Jeff Bezos. Which brings us to Toast’s fundamentals.

How many merchant locations does Toast represent, how fast are they growing that number, what do the economics on each account look like, and what is Toast’s burn? We’re obviously going to have to make some assumptions here, but the picture looks troubled for Toast.

Toast’s press release said they grew revenue 150% over last year. We’re going to assume revenue growth was attributed to account growth, not incremental sales of bolt-ons to existing customers or rising ARPU – average revenue per user. We pegged last year’s locations at about 5K merchants… which means they have around 12,500 merchants today. So they’re adding around 7,500 merchant locations annually. If we want to give Toast the benefit of the doubt (and, frankly, to make some of this math easier), we can just say Toast is adding 10,000 locations annually after churn.

What do the economics on these accounts look like? We’ve seen Toast quote merchants prices that are all over the place. Sometimes there’s an effective processing rate of 2%. Other times it’s 3%. Hardware and software seem to be consistently marked down, however. So for our next assumption let’s split the difference and say that Toast’s merchants pay an average effective rate of 2.5% and get 50% off the hardware and first year of software.

We also thought that Toast’s average merchant did $750K in annual revenue when they raised their $30M round. With wins at brands like Jamba Juice they’ve probably moved upmarket since then. For our next assumption – and again because it makes math easier – let’s assume Toast’s average merchant does $1M in annual processing revenue.

Now we calculate Toast’s annual revenues.

12,500 merchants processing $1M through Toast at an effective rate of 2.5% = $312.5M in gross processing revenues. Now let’s assume interchange of 1.8%, and Vantiv’s cut is probably 1 basis point and $0.02 per transaction, which is effectively $500/year per merchant location. Doing this math gets us to $87.5M – $6.25M = $81.25M in payments revenue.

For the POS let’s assume the below per location.

  • 3 terminals at $1,000 a piece = $3,000
  • Cash drawer and printers = $1,000
  • KDS = $1,000
  • Implementation = $2,000
  • Software for 3 terminals = $200/mo or $2,400 per year

We’ll assume everything here is marked down by 50% as well. So for the software let’s assume merchants are locked into 3-year terms. 50% off the first year but full price on the remaining two years give us an annual blended average of $2,000 per account per year * 12,500 locations = $25M in software revenue.

Hardware and installation services sold at a 50% discount mean Toast is taking an initial loss. However we’re just concerned with revenue right now, so an additional $3,500 in revenue * 10,000 accounts they’re adding annually = $35M in revenue.

Summing this gets to $141.25M in total revenue.

Admittedly this feels super high.

Why?

We have to return to this logic.

Current public company SaaS revenue multiples are 7.6. We then subtract 1.3 from this to get 6.3. The median growth rate for a company larger than $50M is 25%. Toast says they’re growing 150%, or 6x that rate. For every doubling of rate we add 3.2 (half of 6.3) to the multiple. This means we’d add 5x 3.2 to 6.3 to get a revenue multiplier.

So now we come up with a multiplier of roughly 22x revenue, which means if we followed this convention Toast would have received a value of 22x $141M, or $3.1B. But we said the markets were super competitive, meaning there’s no way Toast would have taken a lower valuation.

So we have two possible areas for error in our assumptions.

First, Toast might have lower effective processing rates. We feel good about the hardware and software numbers but there’s definitely wiggle room in the processing. Second, many of Toast’s merchants might not be processing $1M in annual volume because they’re fast casual (or similar-type) merchants with high numbers of cash transactions. That would similarly affect the processing revenue.

Using the above formula a fair revenue for a $1.4B valuation would be 62% of $141M, or $88M. This is probably a more reasonable number: $25M of software revenue, $35M of hardware revenue, and $28M of processing revenue.

Let’s talk about burn, then what this means for Toast in the long run.

Toast has 1,000 employees. To continue growing they’ve announced that they will hire upwards of 500 more. Linkedin says they have roughly 200 engineers and we’ll guess at an average overhead of $150K. Their sales people probably average $65K a year. Then there are admins and corporate folks that are likely $100K a year with full fringe (Boston ain’t cheap). So they’re probably spending $100M a year on personnel costs.

They also dump a good bit on marketing. How much? Let’s assume $15M.

We’re tempted to add the $35M in hardware discounts here but they’re likely recouping those costs on the payments over time. Yes this has an impact to short term working capital but we’re not going to build a whole model in a blog post.

So Toast is losing roughly $25M a year at their current rate. If you believe that Toast’s current round was inflated due to market competition – for instance that Toast was only doing $70M in revenue but still secured a $1.4B valuation at effectively 20x revenues – then Toast’s burn goes up to $45M a year. At these rates their fresh $115M of capital won’t last but 2-3 more years, which is conveniently the same number of years last-money-in investors expect to 3x their investment. It’s almost as if investors did some math before handing over a check…

Lastly we need to talk about what this means for Toast and the overall restaurant market.

As we mentioned above Toast’s latest investors will want a 3x return, likely in 2-3 years. That means Toast has no more than 3 years to reach a $4.2B valuation. And since a company of that size is nearly too large to be acquired by a Private Equity fund, they’ll have to IPO. Which means Toast will need to demonstrate growth rates of > 40% or solid profitability at that juncture. Even if Toast satiates these public market demands they’re not going to receive a $4.2B valuation without revenues or profits to back up their enterprise value.

Based on the revenue composition above it looks like software is 30% of their revenues, hardware is 40%, and payments is the remaining 30%. Toast undoubtedly wants software to represent a larger percentage of their overall revenues since software commands a much higher revenue multiple. Generally here’s how the public markets are valuing these revenue streams today:

  • Hardware: generously 1x, or in the case of NCR less than 1x
  • Software:  7.6x
  • Payments: 4x

At these ratios Toast will need to do roughly the following in revenue:

  • Hardware: $370M
  • Software:  $278M
  • Payments: $278M

That’s total revenue of $925M, which is 10.5X Toast’s current revenue if you believe their $1.4B round was priced on current fundamentals, and 13X if you believe their current round was priced at 20x current revenues. (Personally, we’re somewhere in the middle.)

Here’s why this proves really difficult for Toast.

Radiant, the company that owned Aloha POS, was dominant. Aloha POS and Micros POS became market leaders in restaurant POS because they had solid dealers, a good business model for the time, and the only POS products that resonated with larger merchants – the same kinds of merchants Toast is going after ($1M+/year locations). That said, Radiant grew from 50K locations to 100K locations over from December 2004 to December 2010: a period of 6 years. That’s across retail, hospitality, and a number of other niche verticals (concessions, stadiums, etc). For some quick math that’s 8,300 locations per year with likely only half of those going to restaurants.

And remember, this was when POS was much less competitive than it is today: there weren’t glutinous amounts of venture capital, nor were there balance sheets of merchant acquirers to subsidize the POS.

In order for Toast to hit their revenue numbers they’re going to need to 10x their existing merchant base of 12,500 locations. Even if we give them some amount of fudge factor – like they increase ARPU by cross-selling more of their own bolt-ons and ratchet up their payments revenue – they’re still going to need to 5x their number of current locations.

That means Toast needs to add another 60K locations. And in no more than three years if they want to meet their investors’ expectations. That’s 20,000 locations per year.

Can they do it?

Here’s a table to help us.

This data comes from NPD and Datassential. What it shows is the percentage of the restaurant industry that makes up certain revenue bands. In other words only ~25% of restaurants do more than a million dollars in revenue per location – the type of merchant Toast is targeting.

We’ve done some math to estimate that there are 70K restaurants (12% of the industry) shopping for a new POS every year. If we assume there’s equal representation by revenue band, then only 25% of those 70K – or 17,500 – do more than $1M in annual revenues. If Toast needs to reach to reach 60K locations in the next three years, they’re going to need to win all of those deals.

If you think that annual merchant churn is higher – like 25% a year – then there are twice as many restaurants shopping annually (140K). That puts 35,000 merchants up for grabs in the > $1M/year segment. To reach 60K locations in three years Toast will still need to win nearly 60% of those deals.

To us this just feels impossible. It’s not as if all the other POS competition just decided to roll over and die. We also think these larger merchants, the type Toast is targeting, prefer local support – something the dealer model lends itself to doing well. Unfortunately Toast seems to be pushing its dealers out, maybe since they couldn’t control growth rates through the channel which, by the way, is 100% aligned with how venture capital thinks.

So how might Toast reach their lofty financial goals if they come up short on merchant locations?

  1. Increase payments revenue by increasing their rates on existing, locked-in accounts
  2. Increase software revenue by cross-selling their own bolt-ons, possibly booting 3rd party “partners” from their API
  3. Convince investors to give them more than three years to reach $925M in collective revenues
  4. They won’t

Maybe hiring 500 more people helps them grow accounts faster, but it also comes with the double-edged sword of increasing burn. And even then, when we do the math, there are only so many accounts to win. So unless Toast is able to secure a longer timeline from their investors or be so disruptive that they’re influencing merchant churn (i.e. Toast is so revolutionary that merchants that just spent a nontrivial amount of money on a new POS can’t wait to throw it out to be locked into Toast’s payments) then Toast is going to get ratcheted.

Woe is the Toast employee counting on their equity to be worth something, and woe is the customer if Toast must really meet these tight deadlines.


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