# What would \$100 Billion Valuation for @Evernote Look Like?

In a recent article in Inc magazine, Evernote CEO, Mr. Phil Libin, wrote

” there is a good chance that it will be worth \$100 billion in a few years”

You likely want to ask what “good chance mean”.

Mr. Libin wrote this in the context of  Evernote’s current one billion valuation and comparing it valuation of The New York Times. Mr. Libin’s makes a very valid point that such comparisons are point less and valuations are based on future expected value from a business’ growth.

I agree.

Most public companies have relatively predictable levels of growth, so their valuations are heavily based on the current values of their businesses. In other words, few investors expect The New York Times‘s profits to grow tenfold in the next few years.

Such valuations on future growth are valid as long as they are computed by taking into account all possible future scenarios and not just the most optimistic outcomes. In many cases, and I don’t mean it is the case with Evernote, we not only overestimate the size of positive outcomes but also overestimate the chances of such outcomes. In such cases the valuations become segregated from reality.

Back to the \$100 billion valuation for Evernote. What would it look like?

Let us say it gets the same revenue multiple of 5.51 (say 5 for ease of math) as Google. That would mean \$20 billion in yearly revenue. Where would that come from?

From its current sources I estimate that Evernote makes \$63 to \$84 million a year from 34 million users (1.4 million paying subscribers). If the current business model is the only option that would mean one of following (or combination)

1. Every customer generates \$45 a year, meaning 444 million paying customers (13 times current user numbers and 31 times current paying subscribers)
2. 50% paying customers, meaning  888 million users
3. 100 million customers (not users), meaning \$200 a year revenue per customer – that means either their subscription price goes up or they found other ways to monetize customer. \$200 a year just from subscription does not make sense (NYTimes yearly subscription costs \$195 and it did not find 100 million subscribers). Regarding other revenue sources even Google and Facebook have not found a way to get \$200.

Even if Evernote does deals like Moleskine tie-up that generate \$4-\$6 million a year, that is a larger number of deals to get to \$20 billion a year sales.

That leaves other sources of revenue that are not yet known from its current strategy. Which means one must consider higher uncertainty in such large outcomes given insufficient information.

Mr. Libin said, “there is a good chance”. Given what is known today and the uncertainties I am not sure what “good chance” means.  But given the current valuation of \$1 billion, investors seem to think the expected value of the valuation (considering all good and bad chances) is \$1 billion. Or in other words, the numeric value of good chance is much less than 1%.

A question you must ask is,

Is there also ‘good chance’ of \$200 million valuation? (See: Zynga)

Finally  I am not going to run a complete scenario analysis here as I have done for other valuations before. That is left as a homework for you.

# A look at Evernote – Moleskine tie-up

Evernote that allows users to save and archive clips, web pages, anything web related (“Remember Everything!”) is taking their game offline with their product tie-up with Moleskine.

Moleskine is known for their black pocket notebooks that costs \$10-\$12 each and comes with exaggerated marketing,

The Moleskine notebook is, in fact, the heir and successor to the legendary notebook used by artists and thinkers over the past two centuries: among them Vincent van Gogh, Pablo Picasso, Ernest Hemingway

Really, it is just a notebook  but look past the product and ask what job is the customer hiring it for and you may see the price premium.

I am a utilitarian buyer and go for the \$3 knockoffs I buy in local bookstores. But millions happily pay \$10 for whatever image they believe their Moleskine conveys to others. We do not know Moleskine’s exact sales numbers. One estimate (clever math too) states  at least 10 million notebooks. Sales estimates for 2010 were \$280 million, growing 26% year over year.

Evernote has 34 million users  of which 1.4 million pay \$45 a year to use the product. It likely makes \$63 to \$84 million a year in revenue. Their product is free up to certain storage capacity then users upgrade by paying more for additional storage.

The Deal:

Until now people wrote ( at least some of those who owned Moleskine notebooks wrote) with pen and what they wrote stayed offline, in the notebook.

While it was easy to store and search online content with Evernote it did not support a way to store and retrieve offline content. So the two are doing the deal to introduce a special Moleskine notebook. With some specially formatted pages it is easy to take a picture (using Evernote  iPhone app) of the written Moleskine page (that is if you indeed write in it) and capture that as a searchable digital Evernote clipping.

The price? While the regular Moleskine goes for \$12 (or \$9.60 in Amazon.com), the special limited Evernote edition costs \$24.95 and \$29.95 (for large). Effective pricing fitting the product and likely set by Moleskine team than the Evernote team.

Deal Dynamics:

So a new media online only business that makes \$63-\$84 million a year managed to do a deal with old media offline business that makes  \$300-\$440 million a year. That in itself a big achievement for the Evernote business development team for convincing a bigger player of the mutual value and attaching to the bigger brand cachet of Moleskine.

Deal Economics:

This is pure speculation.

Let us ask what is in it for a \$300M established player with tremendous brand equity and millions of paying customers to team up with a smaller upstart with limited brand recognition, with millions of users but with less than 5% paying customers?

Likely Moleskine is not able to continue to deliver 26% year over year growth. After all there are only so many who want to hire a notebook just for image. So they either see new market in Evernote customer base or an opportunity to make higher profits from a super premium price.

The first scenario is less likely. By choosing to target a specific segment with a premium priced product they likely realize the limit and it is also likely Evernote customers are already Moleskine customers.  And to think  32 million who do not want to pay \$5 a month  will pay \$24.99 for a notebook is farfetched. Incremental profits is the most likely driver than sales growth for Moleskine.

They likely leaned on Evernote to pay for part of or all of the product development investment needed to introduce the new product. The marginal cost of new notebook is no where near the \$15 jump in its list price. If we assumed it is \$3, the remaining \$12 is split either evenly or \$8 for Moleskine and \$4 for Evernote.

Evernote, the junior partner, has lot more to gain, mainly in the form of brand recognition and a new revenue source. When less than 1.4 million paying customers they need to seek additional ways to monetize the 34 million user base.

Even if 1.4 million of them (any 1.4 million, not just those that pay now) buy  just one notebook a year, and if they were to get \$4-\$6 from Moleskine, that is 10% bump in their revenue.

Netting it out

Very well done partnership by the Evernote business development team. Even at \$4 cut they have created a new revenue stream outside of their core business. In that process they helped create marketing around around the new product.

Every argument I have seen for the freemium model are based on marginal cost. What it costs you to produce and deliver a service is not relevant to your customers or to the price you can charge them.  For the latter case, costs matter only to the extent that you do not sell below what it takes to serve the customer and for you to at least break-even. While costs don’t dictate pricing, it is important to know the relevant costs for decision making.

The two most common costing errors I see are:

1. Treating fixed costs as variable by allocating it over users: Just because you incur the cost periodically and you can  allocate a cost over each customer you serve, it does not become variable. This is especially important to digital media freemium startups because this can make the entrepreneur or the investor focus on the wrong metric – Gross profit. When costs are predominantly fixed costs, Gross profit (revenue less total variable cost ) is misleading in evaluating the profitability and the total value of the venture.
2. Incorrectly distributing costs and revenues over all customers instead of doing incremental math: New costs incurred must be correctly matched only with the incremental revenue from serving new customers. If this new cost does not generate incremental profit then it should be avoided. This incorrect cost distribution combined with cost allocation will skew the true cost per customer lower that it actually is.

Let us take the case of Evernote’s data (which is now widely quoted in most outlets):

Costs per active user started at around 50 cents. Now, that has dropped to around 8 cents or 9 cents per active user. The variable expenses per user include infrastructure such as server hardware, software, hosting, networking, backup storage, and electricity usage. That adds up to about 21 percent of current variable expenses. The customer service salaries are 27 percent of expenses, and network operations salaries are 52 percent of expenses.

A cost is variable only if it is incurred by addition of that user. Let us say Evernote, with its current infrastructure, customer service, operations etc., can serve no more than N customers. To serve N+1 customers it has to add capacity.  If it can do so just for this one customer then it is variable cost. Most likely EverNote adds capacity in large chunks, to support n  customers. Let us say  that cost is C. So the N+1th customer has a variable cost of C, and those who come after her, N+2, N+3 etc to N+n have a variable cost of  \$0.

Should they serve this N+1th customer at cost C? Stated another way, should they invest  C?  They should only if  they can generate a revenue of more than C from the added capacity. If they treated the costs and revenues as cumulative they may end up incorrectly adding capacity because the total gross-profit is still positive even though there is incremental loss.

If you were to do this incremental math before starting the venture then the questions become:

1. What is the urgent customer need my product/service is addressing?
2. What is the price customers are willing to pay for the product/service I offer?
3. How big is the opportunity and how it changes over time?
4. Can I serve these customers at a cost that is profitable?
5. Is this a better investment over all other opportunities  of similar risk profile available for the capital?

For all practical purposes, all costs for digital media offerings should be treated fixed and the marginal cost of each user must be treated as \$0. When the marginal cost is \$0, the gross profit is not anymore relevant, instead the business has to be profitable after paying for all operational costs.

As I wrote before in my article on pricing digital goods:

Success in selling digital goods does not require a whole new way of thinking about business. Rather, it requires the same kind of smart managing and smart marketing that have always set apart the best companies. The real power of versioning is that it enables you to apply tried-and-true product-management techniques-segmentation, differentiation, positioning-in a way that takes into account both the unusual economics of information production and the endless malleability of digital data. [Quote: Hal Varian]

The road to profitability in any market goes through STP! That’s Segmentation – Targeting – Positioning. The rule does not change whether you are selling physical or digital goods.