Toast S-1 Analysis: Part 1 of 3

We’re breaking our Toast analysis into a three part series. We’ll publish each piece roughly every other week, so it will take over a month to consume our entire analysis.

Between our first part of the series (this post) and the last article, we’ll host a Q&A webinar where users can anonymously ask any questions and we’ll answer them to the best of our abilities.

Because we have a large number of funds that subscribe to this blog, we’re placing an admission fee of $150 to the Q&A webinar, and we’ll cap the session at 45 minutes. If we don’t cover all the questions in that window we can have another webinar.

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Toast Is a Product of Abuse

Our first thought in reading Toast’s S-1 is that Toast is a product of abuse. To think that Toast was inspired by the difficulty of dealing with the legacy POS assets that now reside at Shift4, Heartland, NCR, and Micros is hilarious.

Our first attempt at solving this problem failed miserably. It was too difficult to integrate with legacy systems…

Toast Management

This is (almost) too accurate to be considered funny.

You can’t work with (most) of the legacy providers because they’re all smarter than everyone. Or they’re ethically corrupt. Or they’re greedy. Or all three.

We don’t agree with Toast’s business model (which could be unquestionably positioned as corrupt in its own right), but you have to respect that they beat the shit out of incumbents who refused to innovate, partner, and do just about anything else a good industry supplier would be expected to do.

Seriously, until Toast – and their ilk of cloud POS competitors – legacy POS companies couldn’t be bothered to modernize their software to improve their customers’ experiences.

Hat tip to Toast.

How funny to think that if the incumbent POS companies had the wherewithal to partner with Toast they wouldn’t be staring at their own death warrants.

But, like we said: they’re all so much smarter than everyone.

Turns out cheap capital said otherwise.

The moral of the story is that startups almost always out-execute large incumbents, particularly incumbents where the founder has departed.

Scaling SMB is Still Very, Very Hard

We’ve had a few people comment that it took Toast nearly four years to reach 1,000 locations, and six years to reach 6,000. Toast has been at it for ~10 years and raised over a billion dollars and still only penetrated ~10% of the market (we believe there to be 650,000 restaurants, not the 800,000 Toast counts).

Toast’s below graphic makes this clear.

SMB is still the achilles heel of virtually any entrepreneur. SMBs need tons of help, but they don’t self-discover. So they have to be sold into.

The problem is that SMBs also won’t pay for f*ck all. This makes distribution very, very challenging.

How did cloud POS companies like Toast solve this problem?

Payments.

Payments processing is a requirement for any business owner, yet the pricing is intentionally as clear as mud, leaving a lot of margin on the table. So while the SMB thinks they’re paying X for some solution they’re actually paying 4x, 5x, 6x, or even more for the solution through the payments stream and are totally clueless.

It’s nearly exclusively this model that funds the direct sales motion to SMBs, because SMBs just won’t pay for value.

Sure, they understand why a Mercedes costs so much more than a Daewoo, and they’re happy to pay for the premium quality of the Mercedes in their personal lives, but charging anything above “free” for literally the most important system their business will use may as well be illegal.

Annnnnnd that’s why they get taken advantage of.

Toast was one of the first to really understand this dynamic and execute the crap out of it. Others understood the opportunity (Clover), but didn’t execute well, and still others executed well (Touchbistro) but without the aggressive capital infusions wound up on a much smaller plot of land.

With that said we should examine Toast’s growth by revenue, not absolute number of locations.

Each of Toast’s locations earned about $10,000 a year for Toast, and Toast really didn’t “start” until late 2012, meaning Toast grew to $10M “ARR” (we use quotation marks because payments revenue really isn’t ARR – although Toast terms it as such – and shouldn’t carry the same multiple as SaaS, which has actual IP value) in 2.5 years, $30M in 4, $60M in 5.

If memory serves Toast reached $10M of revenue having only raised something like $7.5M over 3 years, which is great capital efficiency compared with today’s funding rounds being done at a billion times revenue.

Toast Needs to Report Churn Numbers

At 48,000 sites – most of which are SMB due to 1) Toast’s product shortcomings for enterprise merchants, and 2) Toast’s locked-in payments model – Toast has to start worrying about churn.

Micros (now Oracle) and NCR Aloha (basically dead) were the two largest players in the restaurant POS space. They peaked at around 60,000 and 70,000 locations respectively.

But a third of their installations were “enterprise”, generally defined as 50+ location groups.

This helped them keep a more stable installation base, as SMBs churn themselves out.

We don’t care how thoughtful a service provider is in choosing their SMB customers, math is math, and some material percentage of Toast merchants are churning annually.

This isn’t up for debate.

Toast has kept voluntary churn lower with multi-year contracts and onerous termination clauses (i.e. merchants must pay Toast the entire value of their contract if they’re to leave, often calculated in the tens of thousands of dollars) but this isn’t going to affect involuntary churn, where merchants just become insolvent.

Toast can hide churn in their net retention numbers by juicing payments margin (more on that in a later post) but if we were covering the company this is a metric we’d ask for. Our reasoning is pretty simple:

Toast is now in uncharted territory. No other restaurant POS has ever had so many “large” SMBs (entities that do more than a million in revenue) and the ones that got close (Micros, Aloha) couldn’t keep their head above water and were adding as many sites as they were losing.

Companies with smaller restaurant customers (Square, Clover, Lightspeed) know that churn is about 20% per annum and they’re constantly working to grow their absolute numbers accordingly… in our opinion it’s why Lightspeed has had to buy so many assets: organic growth is really hard to come by when you’re losing 20% of your customers annually.

Toast Needs to Think Through TAM

Toast has a brand, and with a massive direct sales force they can much more effectively control sales velocity than their legacy counterparts who used (nearly exclusively) unreliable resellers. And the average Toast merchant should churn at lower rates than those of smaller merchants, but…

There’s a finite number of US restaurants that do $1M in annual sales.

We wouldn’t go as far as to call these locations unicorns, but Toast is at the limits of the market they’ve traditionally well-penetrated: larger table service restaurants with 1-5 locations.

20% of the US restaurant market does more than $1M in revenue per location, and this is heavily skewed towards chains in the QSR/Fast Casual segment of the market: enterprise brands (think McDonald’s) where Toast doesn’t yet have product-market fit.

Toast will need to improve their product to crack into enterprise in a meaningful way, and more importantly Toast will not be ripping 55 basis points of payments margin on these accounts (what Toast reports to be their average payments margin) because McDonald’s can do math.

Toast might think about acquiring a more enterprise-ready POS system to give them non-organic growth and a faster path to market, but saying that there’s a lot of hubris at Toast is an understatement.

If Toast were to buy something, you’re realistically talking about:

• Par (Brink)
• Revel
• Qu

All three have their own pros and cons, and Toast must weigh them accordingly.

Toast said that their SAM (service addressable market) was $15B. For quick math, $15B SAM / 860,000 restaurant locations as reported by Toast = $17,400 per location per year.

That’s more reasonable than earlier figures Toast put out where Toast thought their TAM was $70,000 per location per year but it’s still really high. Toast would need to double the revenue they earn per customer, and we’re not so sure Toast is going to build every ancillary solution all that well.

Actually, we know they can’t.

We’ll post the next part in this series in a few weeks. Catch you then.