One Dollar Test for Tech Startups

Welcome to The Financial Engineer Newsletter.

In today's edition, we are diving deep into a critical aspect of corporate finance that often separates great companies from good ones: capital allocation. We'll explore Warren Buffett's famous One-Dollar Test, how it applies to modern startups, and examine a real-world example with DoorDash.

But first,

Capital allocation might not be the sexiest topic in finance, but it is arguably one of the most important. It is the process by which companies distribute their financial resources to various projects, investments, or activities.

Warren Buffett's One-Dollar Test

Warren Buffett introduced the One-Dollar Test as a method to evaluate whether a company's management is effectively allocating capital. The test assumes that for every $1 of earnings retained by a company, it should generate at least $1 in market value over time. This ensures that retained earnings contribute to shareholder value, either through increased intrinsic value or through dividends and share buybacks.

In his 1983 letter to Berkshire Hathaway shareholders, Buffett highlighted the importance of periodically assessing the wisdom of retaining earnings. He stated, “We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained”.

Modifying the One-Dollar Test for Startups

For startups, especially those in their growth phase, the traditional One-Dollar Test may not be directly applicable. Instead, we can modify it based on the Craft Ventures framework, which emphasizes efficiency metrics alongside growth. Here's how we can adapt the test:

1. Growth Metrics

   • Instead of focusing solely on earnings, look at the growth in key metrics such as Annual Recurring Revenue (ARR) or Gross Merchandise Value (GMV).

   • The modified test could ask: "For every $1 invested, how much growth in ARR/GMV is generated?"

2. Burn Multiple

   • Craft Ventures introduced the concept of the "burn multiple," which measures capital efficiency. The burn multiple is calculated by dividing the net burn by net new ARR added in a given period. A lower burn multiple indicates higher capital efficiency.

   • Modified One-Dollar Test: "For every $1 burned, how much new ARR is added?"

     • Great: Burn Multiple < 1

     • Good: Burn Multiple 1-1.5

     • Concerning: Burn Multiple > 2

3. Net Dollar Retention (NDR)

   • For SaaS startups, NDR is a critical metric that shows the revenue retained from existing customers, including expansions and contractions.

   • Modified One-Dollar Test: "For every $1 of existing ARR, how much is retained and grown in the following year?"

     • Great: NDR > 140%

     • Good: NDR 120-140%

     • Concerning: NDR < 100%

4. Customer Acquisition Cost (CAC) Payback

   • This metric measures how long it takes to recover the cost of acquiring a customer.

   • Modified One-Dollar Test: "How many months of a customer's revenue does it take to repay their acquisition cost?"

     • Great: 6-12 months

     • Good: 12-18 months

     • Concerning: > 24 months

Y Combinator Alumni in the Public Market

Several Y Combinator startups have successfully gone public, including DoorDash ($DASH), Airbnb ($ABNB), and Coinbase ($COIN). Let's see how DoorDash fares against the Modified One-Dollar Test based on its recent financial filings.

DoorDash (DASH): As a leading delivery platform, DoorDash has focused on expanding its delivery network and investing in technology to enhance logistics efficiency. According to its recent Form 10-Q filing for the quarter ended June 30, 2024, DoorDash reported revenues of $2.630 billion for the quarter, a 23% year-over-year increase. However, the company also reported a net loss attributable to common stockholders of $157 million for the same period.

1. Growth Metric:

   • YoY revenue growth of 23% is solid for a company of DoorDash's size.

2. Burn Multiple:

   • DoorDash is cash flow positive, so the traditional burn multiple doesn't apply.

   • Instead, we can look at the ratio of Adjusted EBITDA to revenue growth: $430 million / ($2,630 million - $2,133 million) = 0.87

   • This indicates high efficiency in generating profit from incremental revenue.

3. Net Dollar Retention (NDR):

   • Exact NDR is not reported, but strong revenue growth suggests healthy retention and expansion among existing customers.

   • Assumption: NDR is likely above 120%, which would be considered good.

4. CAC Payback:

   • Specific CAC payback period is not disclosed.

   • However, improving Contribution Margin (4.2% vs 3.8% YoY) suggests efficient customer acquisition.

   • Assumption: CAC payback is likely in the 12-18 month range, which would be considered good.

5. Capital Allocation:

   • DoorDash is reinvesting in growth while also returning capital to shareholders through share repurchases.

   • The $1.1 billion share repurchase program demonstrates confidence in long-term value creation.

Assessing Intrinsic Value Beyond Market Capitalization

Coming back to original One-Dollar Test, while it is a valuable framework. It is essential to consider a company's intrinsic value rather than relying solely on market capitalization, which can be volatile and influenced by market sentiment. Intrinsic value is a measure of what a company is genuinely worth, taking into account its assets, earnings potential, and other fundamental factors.

To effectively perform the One-Dollar Test with intrinsic value in mind:

• Evaluate Return on Retained Earnings: Compare the growth in earnings or cash flows directly attributable to retained earnings against the company's cost of capital and the risk-free rate (RFR). For instance, if the RFR is 4.25%, a company should aim to generate returns significantly above this rate to justify retaining earnings.

• Analyze Strategic Investments: Assess whether the retained earnings are funding initiatives that enhance the company’s competitive position and future earnings potential, such as entering new markets, launching innovative products, or improving operational efficiencies.

• Review Management Decisions: Consider whether the company's leadership has a track record of making decisions that prioritize long-term growth and shareholder value.

Conclusion

The One-Dollar Test serves as a valuable tool for assessing how effectively a company's management allocates capital to generate shareholder value. By focusing on intrinsic value and evaluating the return on retained earnings, investors can gain deeper insights into a company's financial health and growth prospects.

The modified One-Dollar Test for startups focuses on efficiency and growth metrics rather than pure profitability. By examining burn multiple, net dollar retention, and CAC payback alongside growth, investors and founders can better assess a startup's capital allocation effectiveness.

For companies like DoorDash, which are still in high-growth mode, these metrics provide a more nuanced view of their performance and potential. As startups mature, they should aim to align more closely with the traditional One-Dollar Test, demonstrating that each dollar invested or retained truly generates at least a dollar of value for shareholders.

Key Takeaways:

• Capital Allocation: Critical for long-term shareholder value.

• One-Dollar Test: Ensures retained earnings contribute at least $1 in market value per $1 retained.

• Intrinsic Value: Essential for a more accurate assessment beyond market capitalization.

• Real-World Examples: Apple, Amazon, Berkshire Hathaway, DoorDash demonstrate varied applications of the One-Dollar Test and Modified One-Dollar Test.

• Management Quality: A key factor in effective capital allocation and value creation.

Note: Above analysis is for informational purposes only and does not constitute financial or investment advice. If you observe any errors in numbers, figures, or other information presented here, please email me at [email protected].