Category Archives: Palantir

Why Palantir Makes My Head Hurt

While I’ve blogged before about Palantir Technologies (e.g., Beware the Spectacular B-Round Valuation), this will probably be my last post about them because, since leaving MarkLogic, I am no longer terribly involved in the Intelligence Community space nor engaged against them as an indirect competitor.

I initially became interested in Palantir for several reasons:

Part of the marketing was making controversial claims, such as:

  1. We have no sales.  (e.g., at minute 5:40)
  2. We have no marketing.
  3. We have no services.  (Our field technical staff aren’t consultants, they are forward-deployed engineers.)
  4. Positioning as a billion-dollar company when sales were probably in the tens of millions.
  5. Talking about valuation on funding rounds.

Now, as a credibility-is-key marketer, these kinds of claims bug me at two levels:  first, that people would make them and second, that the media would report them.  Here’s my take on these 5 claims:

  1. Whether you want to call it sales or not, someone meets customers, talks about what your software does, discusses how to price it, negotiates and signs a contract.  In the normal world, that is called sales.
  2. Whether you want to call it marketing or not, someone made the website, spent money to sponsor a party, setup the Charlie Rose interview, and designed and paid for the DC subway ads.  In the normal world, that is called marketing.
  3. Whether you want to call it services or forward-deployed engineering, you are sending smart people with engineering and computer science degrees to customers’ sites and helping them solve problems using your software.  In the normal world, those tasks are called pre-sales engineering and consulting, depending on whether they happen before or after a sale.
  4. The standard way, in the real world, to refer to a company’s size is by revenue.  The one and only time I frequently heard people referring to company size by market capitalization (or valuation) was during the Internet bubble.
  5. While this is primarily a style issue, most companies do not disclose valuation on venture funding rounds.  I believe those who do are trying to generate hype.  (And for a company that insists it has no marketing to want to generate hype is doubly irritating.)

At the big picture level, Palantir reminded me of MicroStrategy:  big claims and hype, DC-centricity,  elite school hiring focus, youth focus, a large field technical team, and a work hard / party hard ethos.

At this point I should admit to having some scars from having run marketing at Business Objects during MicroStrategy’s rise.  Let demonstrate what a day in life looked like:

  • Dave, MicroStrategy says their mission is to “purge ignorance from the planet.”  How come we can’t say anything visionary like that in our mission?
  • Dave, Michael Saylor says he’s going to build a modern-day Versailles just outside of DC.  How come our CEO never says stuff like that?
  • Dave, MicroStrategy says they’re building a service where people will wear tiny microphones in their ears and it will notify them if their house catches fire.  How come we don’t have product vision like that?
  • Dave, MicroStrategy just did a $52.5M deal in an industry where average sales prices are $250K and a big deal is a few million.  Why can’t we do huge deals like that?
  • Dave, Michael Saylor says that there will be riots if his software doesn’t work and that this year people will die — literally — because they didn’t buy his software.  How come we’re not mission-critical like that?

To which for several years I had to say “it’s all bullshit, it’s all bullshit, it’s a barter transaction and they’re double counting, and it’s all bullshit.”

It turns out being a naysayer isn’t fun work:  for three years you sound like a whining, doubting-Thomas constantly on the back foot, constantly playing defense and then one day you’re proven right.  But there’s no joy in it.  And the naysaying doesn’t help sell newspapers so you don’t get much press coverage.  And, in the end, all people remember is that “MicroStrategy was pretty cool back in the day” and “Dave’s a grump.”

It was during this period that I got interested in Corporate Cults because MicroStrategy struck me as one.

  • Hire young people with similar profiles from the best schools (e.g., MIT)
  • Work them long hours
  • Isolate them from friends and family
  • Blur distinctions between work life and personal life (e.g., company cruise, work hard / play together)
  • Tell them they’re the best
  • Tell them naysayers don’t get it

Six steps to make MIT engineers cult members.  Thus, in addition to other MicroStrategy parallels, Palantir struck me as a corporate cult.  Kind of a Logan’s Run (where no one is over 30) meets the Apple 1984 commercial (conformism à la the black jackets).

Since I left MarkLogic in January, Palantir got tangled up in the HBGary WikiLeaks mess (proposal here), generated some positive press in Forbes, and raised a $60M round of financing at a valuation rumored to be as high as $3B, bringing the total invested capital to an estimated $175M, a lot of money for an enterprise software company.

This begs the perennial question of “if they’re doing so well, then why do they need so much cash?”  While there are potentially both good and bad answers to that question, my guess is the answer is roughly:

  • Because they can raise it at huge valuations for relatively little dilution.  (Peter Thiel may be a huge help on this front.)
  • Because they intend to spend it to continue hiring and perpetuate the lavish-spending culture and hype machine.
  • Because they are executing a go-big or go-home strategy that is cash intensive and will, they hope, result in a huge exit valuation.

But why does Palantir make my head hurt?

  • Because, despite my general skepticism, I believe they get some things very right.
  • Because, despite their intent, they may have created a new kind of company.

Because I can be perceived as a Palantir detractor, I’ll say it again:  Palantir gets some things very right.  Which things?

  • They hire brilliant people.  They deliver on the hype in this department.
  • They solve hard problems.  I hear customers are generally quite happy.
  • They solve the whole problem.  They don’t just drop software in your driveway and run away.
  • They aren’t afraid to ask for huge checks, order of magnitude in the tens of millions.

Personally, I don’t buy the argument that all field technical staff are “forward-deployed engineers” as opposed to pre- or post-sales consultants.  But I would believe that you can hire better people by telling them they’re engineers as opposed to pre-sales consultants.  And, I could even believe that someone could convince himself — if perhaps not his accountants — that field technical staff are not customizing an application but instead developing a product.

That last point is important.  Why?

  • If field technical staff are engineers, then the associated revenue is presumably license fees and the cost is R&D.
  • If field technical staff are consultants, then the associated revenue is services and the cost is COGS.

Why does this matter?  Because most software company boards and investors see the world in a pretty black-and-white way:

  • License revenue is good.  Services revenue is bad.  (Largely because gross margins run 98% on the former and 20-30% on the latter).
  • R&D expense is investment and ergo good.  Cost of goods sold is bad.

Almost all Silicon Valley boards will want an emerging enterprise software company to run with a consulting business that’s no more than about 20% of total sales.  In practice this means a company can have at most about 1.5 consultants (pre- and post-sales) per salesperson.  Any work that can’t be done either as R&D investment or by that small consulting team needs to get handed off to partners.  This means the vendor loses control over customer success (which customers don’t like) and the vendor doesn’t end up owning all the IP required to solve the whole problem.

Now, my guess is that Palantir’s board doesn’t care about any of the preceding four paragraphs, probably because of cult arrogance:  we don’t care what pedestrian accountants say because we are changing the world and building the ultimate set of products.  Accounting, schmaccoutning.

This works well as a private company, particularly if you don’t plan on going public.  But the constraint on consulting growth hamstrings most enterprise software companies forcing them into a component-orientation, a drive-by license sales model, and a disregard for customer success — the traditional negatives that helped the drive the SaaS movement.

But, regardless of the reason, Palantir is a different type of company.

  • Like a system integrator (SI), they have a small sales force, a large field technical staff, solve whole problems, and ask for big checks.
  • Like a software company, they hire world-class engineers and try to capture everything in product.

Is Palantir an enterprise software company with no sales, marketing, or services (as they would like to believe) or are they the first SI to figure out how to build a world-class software business as most SI’s aspire?

You can argue the difference is just semantics, but I’d argue the latter.

Beware the Spectacular B-Round Valuation

Visualization tools startup Palantir announced a follow-on financing round yesterday, raising $90M at a claimed $735M valuation.  Since most people aren’t familiar with either finance or VC math, this can generate confusion so I thought I’d do a post explaining a few things.

The first is simple:  do not confuse valuation with revenue.  Valuation (or for public companies, market capitalization) is an implied metric based on per-share price and number of shares outstanding.  For example, a public company with 50M shares and a $20 share price has a valuation of $1B.  That alone says nothing about its revenue.   TechCrunch makes this mistake three times in the story, calling Palantir “the next billion-dollar company” in the headline, saying they’re a “near-billion dollar company” in the middle,  and at the end, saying they are close:

It’s hard to imagine a billion-dollar company without a sales team, but then again Palantir is getting pretty darn close.

This is simply not true.  By my guess, Palantir is doing somewhere between $25M and $50M in GAAP revenues — nowhere near $1B.  Furthermore, while I hate to be technical, I could easily believe they are doing less:  as I understand their model, recognizing GAAP revenues should be a nightmare — e.g., calling all field staff engineers and claiming no services business implies field-based R&D implying the need to defer revenues until product completion for a given customer.

The second confusion is more subtle and relates to a quirk in VC math that makes an early round investor, who believes in the company and has cash to put to work, valuation neutral on subsequent financing rounds.  In fact, you could argue that they’re not valuation neutral, but positively biased because they mark their existing shares to the new valuation when reporting back to their limited partners.

Reminder:  I am no longer talking about Palantir in specific because their capital structure is both private and presumably more complicated than I describe here.  I am trying to show, in general terms, how some quirks result in early-round investors liking higher subsequent-round valuations — even when they’re buying shares at those higher prices.

For a quick primer on VC math and terminology, go here.  Now, let’s examine a spreadsheet I built to concretely demonstrate the mechanics of what I’m talking about.

In my example, a hot company manages to raise a $24M A-round at a pre-money valuation of $36M.  This is unattainable for most entrepreneurs, but let’s say you made a lot of money on your last gig and thus have some friends in the venture capital community who believe in you.  Note that as part of this round, VC1 has invariably negotiated himself the right to avoid dilution in subsequent rounds.  Since he owned 40% of the company after the A-round, he thus has the right to purchase 40% of any new shares sold by the company going forward. This is called exercising his pro rata.

Now it comes time to do the B-round.  Let’s say that things are going well and that the company somehow thinks it should be able to raise $30M at a $180M pre-money valuation. That’s scenario I in my spreadsheet.  Let’s see what happens.  (Click to enlarge.)

  • In the B-round, the company sells 5M new shares at $6/share for $30M.
  • VC1 chooses to fully exercise his pro rata and thus buys 2M shares for $12M.
  • That leaves 3M shares for the new investor, VC2, who pays $18M.

Seems like a pretty good deal, but wait. If you’re executing the go-big-or-go-home strategy which both you and VC1 agree is appropriate, then $30M isn’t enough.  You decide you need $90M.  That’s scenario II in my sheet:

  • You issue 15M shares at $6/share to get $90M.
  • VC1 exercises his pro rata and buys 6M shares for $36M.
  • VC2 buys 9M shares for $54M.

Everybody’s happy, but then you look at founders and employees whose ownership has dropped from 60% before the round to only 40% after.  Most people would call this a 33% dilution (20 divided by 60), though some would call it a 20% dilution (60 minus 40).  Either way, while this scenario raises the money needed, the team loses a lot of ownership in the process and doesn’t like that one bit.

Then, the creative type on the team says: “I can solve the problem.”  See scenario III:

Why sell 15M shares at $6 when we can sell about 4.3M shares at $21 to get the same amount of money?  We’re better off, keeping 52% ownership for ourselves, and the great part is VC1 doesn’t care.  No matter the valuation, if we’re raising $90M and if VC1 is exercising his pro rata, then he’s in for $36M– see the boxed cells on the spreadsheet.  All we need to do is to get together with VC1 and find some dumb money willing to pay $54M for 8% of the company.  There’s plenty of dumb money out there these days and if we can’t get it in one investor, then maybe we can build a little consortium of a few.

And while we might view VC1 as valuation-neutral from one perspective, we shouldn’t forget that he has a boss, too.  He reports back a few times / year to his limited partners.  If we do the deal at $630M pre-money, then he can mark up his A-round shares from $24M to $252M in value, showing a 10x paper return to his investors.

I am not saying this has or has not happened with any given company.  I would like to make the important note that the whole notion of “dumb money” is at odds with free market theory.  I’ll also add that I know some quality VCs advise limited partners to ignore investment marks-to-market, but I doubt they all do.  Nevertheless, I hope this story shows that there’s potentially more than meets the eye in the world of venture financing, driven largely by the dual role (owner and seller) played by the existing VCs and founders/employees.

So what do I think it really means when a company announces a big round at a high valuation?  I think it means that:

  • The company is trying to build and/or sustain a hype bubble and wants to be seen as hot.  Most VC-backed companies do not disclose valuations.
  • The company is executing a “go big or go home” strategy that I’d argue increases the risk for its customers. Remember, Amazon went big.  Webvan went home. See the Fit or Fat Startup Debate launched by Ben Horowitz and countered by Fred Wilson for an examination of such strategies from the VC point of view.  In my estimation, sometimes they produce a great result, often a great crater, and rarely a great business.  Ironically, you can get nice exit valuations off such strategies but not great multiples.
  • The company has a supportive A-round investor willing to invest real money and who believes in the go-big strategy.
  • The company intends to spend the money, either because it must in order to sustain the current burn rate or because it wishes to expand into other areas.  The former signals unsustainable situation, the latter signals a potential loss of focus.
  • If things don’t go as the company plans, the dumb-money will put constant pressure on management to be aggressive, reminding everyone of the expectations they bought into.  This can make it hard to back off and change direction in the event of bumps along the way.
  • The company could have trouble exiting at otherwise reasonable valuations, especially if the dumb-money controls a class of stock.  Think:  “I need at least a 2-3x on this investment.”