A blogger posed this question, and posited that the reason anyone would is to achieve devious ends, in this case, to destabilize the government.
The blogger had three problems about Rappler’s financial affairs: its disclosures in its GIS and financial statements, its issuance of Philippine Depository Receipts to foreign investors, and the reasons why these investors would invest in a media company that was losing money.
Oscar Tan adequately addressed the first two in his Inquirer column. I want to talk about the third. According to the blogger, it was obviously irrational for savvy foreign investors to invest in Rappler if it generated a cumulative loss of PHP 163 million from 2011 to 2015.
Thus, there must be some other non-economic reason why these investors keep infusing their capital – to destabilize the government perhaps?
Believing this sends the wrong message to Filipino founders and is bad for promoting entrepreneurship. Full disclosure: some of Rappler’s founders have also invested in one of my businesses.
The blogger makes a ridiculously inappropriate comparison to a sari-sari store that is losing money. Why would the store owner keep injecting cash to fund an unprofitable operation?
And therein lies the problem. Rappler is not just a media company, it’s also a technology startup. And early stage venture capital investing in the technology industry works differently.
What makes Rappler a technology company? It’s not just because it’s online or it has an app. Rappler’s built it own infrastructure to manage and process its content, via a proprietary content management system, its mood meter, and its own data science operation.
Unfortunately, the sari-sari store analogy doesn’t capture the fundamental nature of how Rappler does business.
So why would two big foreign investors infuse capital in a money-losing technology startup?
Since people are fond of easy analogies, let me offer a more apt one.
Let’s say Ramon and Joey decide to start a company to launch a news app. They put in PHP 100,000 each of their own money. Their total capital is Php 200,000. They incorporate with 200,000 shares and a par value of Php 1 per share. So Ramon and Joey each own 100,000 shares, for a total of 200,000 shares.
Thus, their ownership split is 50-50. Ramon has 50% ownership. Joey has 50% ownership.
They use the Php 200,000 in 6 months to fund development of their app, and by the 7th month, they enter into a deal with Alibaba’s Jack Ma. Jack likes media investments. Previously, he also acquired a stake in the South China Morning Post.
At month 6, Ramon and Joey’s company is losing money.
Jack Ma’s offer is to give Ramon and Joey’s company Php 1 million in exchange for a 20% ownership of the company.
To do this, the company issues 50,000 new shares to Jack. Why 50,000? Because 50,000 shares is the equivalent of Jack’s desired 20% ownership stake in the company.
Thus, the total number of outstanding shares in now 250,000 shares, broken down into:
Joey = 100,000 shares (40% of the company = 100,000 shares / 250,000 total shares)
Ramon = 100,000 shares (40% of the company)
Jack = 50,000 shares (20% of the company)
Why would Ramon and Joey accept a deal wherein their ownership stake in the business is reduced from 50% to 40%? (We call this “dilution”).
Because the value of Ramon and Joey’s shares went up 20x. Twenty times.
“WTF OLIVERSEGOVIA, how did this alchemy happen???” you might say. “In just 6 months??? For a company that is losing money??? That is magic. Or deception. Or both. You are destabilizing the stock market. I will report you to SEC Chairperson Teresita Herbosa. You must also be on drugs???”
Well, I can tell you if you aren’t so angry. (I’ve actually had reactions like this when I run my Startup Valuation workshops. The concept of equity value is so abstract for most people to understand!)
This is why. Recall that Ramon and Joey started the company by incorporating with PHP 200,000 in capital, 200,000 shares and thus, a value of P1 per share.
When Jack Ma invested his Php 1 million, he is buying new shares at a price of PHP 20 per share (P1 million divided by 50,000 shares). And because all shares in the same class must have the same value at any point in time, Jack’s investment implies that Ramon and Joey’s shares are also worth PHP 20.
Note that Ramon and Joey personally did NOT receive PHP 20 for each of their shares. Jack’s money goes to the company, not to Ramon and Joey. But Ramon and Joey each increased their net worth by PHP 2,000,000, at least on paper.
Where does the value come from? In simple terms: it comes from the past, the present, and the future.
The company created an app in the past 6 months. A customer can buy the app for a certain price. Jack is implicitly saying that the app is worth PHP 4 million.
Why? By investing PHP 1 million for 20% of the company, Jack is saying that the whole company (100% of it) is worth PHP 5 million. Minus his PHP 1 million cash infusion, their app is worth the residual: PHP 4 million.
It also comes from some estimate of the future value. Because of Jack’s investment, the app can grow its user base. It can start to sell advertising, or sell premium reports in its app. If all of these revenue streams resulted in the Ramon and Joey’s company being acquired by a bigger media company (say, ABS-CBN or GMA) for PHP 100 million in 5 years time, then Jack’s stake will be worth PHP 20 million at that point. Jack grew his PHP 1 million investment by 20x in 5 years. You can’t get a deal like this investing your savings in a bank.
At its core, borrowing money or investing money is all about forecasting the future value of something and estimating what price one has to pay for that future value, at the present time. This is what enables a bank to give you an auto loan or a housing loan – because you can continue to grow your salary and thus pay down the loan, or the house can appreciate in value in the future. This is also why the state invests in public education. Because the collective output of the iskolars ng bayan will be worth a lot to the country one day.
You might be wondering, why would Jack only invest in a minority stake? Because he knows that for the company to be worth more in the future, Ramon and Joey need to feel that they are true owners in the business, and not just employees. To achieve that, Ramon and Joey must retain a majority stake. Investors call this an alignment of interests. Otherwise, why would Ramon and Joey continue to work hard when majority of the gains go to Jack?
So, back to the original question: why would two big foreign investors infuse capital in a money-losing technology startup?
Because they believe their stake in Rappler will be worth more in the future. Plain and simple.
And like ABS-CBN and GMA – media companies with foreign investors – Rappler opted to use PDRs as the financial instrument rather than common shares.
The heart of the blogger’s dilemma is that most people do not understand how venture capital valuation works.
Now you might say: the analogy of Ramon and Joey assumes a venture that’s been around for only 6 months. Rappler has been losing money for 5 years!
It will likely continue to lose money for the next 5 years. And that’s what could actually make it a good investment.
Amazon first registered an annual profit in 2004, a full 10 years after it was founded. It continued to lose money for the next 10 years after that. It’s only today that Amazon’s started generating profits.
Why? Because Amazon continues to reinvest its operating cash-flows into new technology, platforms, products, and services. That’s brought us affordable cloud computing, Prime delivery, video streaming, the Kindle, the Amazon Echo, and more. And I don’t doubt for a second that anyone would turn down a deal to invest in Amazon circa 1995.
That’s because profit isn’t the only measure of value. In technology, it’s actually a very poor measure of value as startups need to keep re-investing its cash flows to fund the best talent and to launch new products. So rather than profits, venture capital investors also look for milestones over the long term to measure value.
For anyone in the know, digital media is also a particularly hard business to monetize. From my understanding, other media sites like Tech in Asia, e27, and Vox are also unprofitable. So Rappler isn’t doing anything out of the ordinary, investment-wise. If Maria Ressa pushed Rappler to be profitable by Year 2 – she is actually not doing her job right!
Now that is something very hard for you to fathom, if your model of entrepreneurial success has been Henry Sy, John Gokongwei, or Lucio tan.
In the 1970s, Xerox funded a lab in California, called the Palo Alto Research Center – or PARC. For many years, PARC lost huge amounts of money doing research on information systems. One early result was the Alto: an integrated desktop workstation, with a keyboard, memory, processing power, and connected to a laser printer and other workstations via an ethernet.
If that sounds familiar, that’s because it is: the Alto was the early prototype of the personal computer and the rest, as we know, is history. If Xerox purely focused on PARC’s bottom-line, you wouldn’t be reading this post in your PC, Mac, or smartphone.
Measured within this frame, the correct question is not “Why invest in Rappler when it is losing money?” but “Why can’t Rappler be investing more to build new products, acquire the best editorial talent, and expand to other countries?“
Will Rappler turn out to have as big an impact on Philippine media? We don’t know yet. That uncertainty is what makes technology investing fun.
But singly them out for issuing PDRs when it is a perfectly legal financial instrument and imputing some nefarious motive on the part of its investors without first understanding how venture capital investing works or the broader nature of technological revolutions is just hilariously foolish.