Is Substack Actually Worth $650M?

Welcome to this week’s edition of CROWDSCALE, where we break down barriers to startup investing. In today’s newsletter, we’re determining whether Substack’s $650M valuation is too rich for our tastes. This deep dive will cover:

• The money trail: What we learned from Substack’s recently released financials

• Substack vs Twitter: Twitter is not a fan of Substack’s growth plans

• Am I investing?: I reserved $1,000 worth of shares… am I keeping them?

Substack dropped their audited financials late last week. They’re disappointing, and not because of their financial performance - but in how recent the data is. None of Substack’s monster 2022 is captured in their audit due to regulatory standards.

Timings aside, there were a couple of interesting nuggets included in the documents.

Substack’s growth is fueled by partnerships, not advertising. Substack, which makes money through a 10% cut of paid subscriptions on its platform, increased its revenue by $9.6M in 2021 - and yet it’s advertising costs only increased by $338,000. They’ve instead poured millions of dollars into attracting top talent to write on their platform. In 2021, those partnership deals cost Substack $16.7M.

A portion of those partnership costs come back to the company in the form of Substack’s paid subscription revenue. Revenue related to these partnerships totaled $5.5M, which means the partnership deals put Substack $11.2M in the hole. Accounting for its normal revenue and all other costs, Substack burned through $23M in 2021.

Salaries were a problem, until Substack fixed it. Substack nearly 5x’d the amount it paid on labor in 2021, going from $2.3M → $10M. While it’s normal for fast-growing startups to scale their workforce, they often fall into the trap of overhiring. Substack course-corrected in 2022 by reducing its workforce by 14%. As of late March, the company had slimmed down even further - a representative confirmed that Substack operated on roughly 75 employees.

It’s encouraging to see them operate leanly, especially given how much the platform was able to advance under this lower headcount: visual improvements, a mobile app, video support, discussion threads, recommendations, a stronger editor, upgraded podcast functionality, a revamped web reader, mentions, and chat were all rolled out in 2022.

Substack made an announcement last week that indicated where the platform may be headed. It announced the coming of Substack Notes, a functionality that would allow creators on the platform to share “posts, quotes, comments, images, and links”. Users even have the option to like or ‘restack’ a post, which very clearly positions the offering as an alternative to Twitter.

It’s been reported that Twitter has blocked Substack links on its platform, and made other changes that stifle mention of the company. Elon made claims that he was buying Twitter to preserve free speech, but we’re seeing that that promise has shortcomings when it affects his business.

Substack derives a good portion of its traffic from Twitter, and so a demotion in the algorithm could definitely hurt its business. It’s unclear if the changes on Twitter are set to remain, or are more so warning shots to deter Substack’s efforts.

Substack Notes makes a lot of sense if you look at the evolution of Substack:

1. Design a platform that entices creators

2. Create a network, interlocking creators (via Recommendation + Cross-Posting features)

3. Consolidate content across publications into one Substack app

4. NOW: Introduce short form content to increase content frequency and provide readers a reason to frequent the app

For those calling this the death of Twitter, I think you’ll end up being somewhat disappointed. Twitter has fended off many well-financed copycats, and it will remain entrenched as the go-to for short form written content.

I think Notes will become a tool to help increase the frequency of interactions between writers & their readers. I also believe it will be a powerful growth tool for writers on the platform. But I believe it will fall short of developing into a full-scale Twitter alternative. There just isn’t enough incentivize for consumers to flock en masse to the platform for that type of content.

Notes will benefit Substack in a different way: creator retention. As another growth lever to pull, it will provide one additional reason for writers to keep their content on the platform.

The question you really want answered: will I be investing in Substack?

There are so many factors to consider for this question, so I’ll do my best to break down some of the major ones:

Current Revenue: Many have tried to estimate Substack’s 2022 revenue based on public data, and I seem to agree that it likely falls between $20-$25M. Let’s be optimistic and say it’s the latter. This would represent a growth rate of 109%.

Future Revenue: This is where it get’s really tricky, and that’s because Substack has so many revenue levers it could pull. They could introduce an events page for writers, and take a cut of ticket sales. They could intro a pro membership for writers with larger followings, or they could roll out an ad network for writers to participate in. The truth is, we just don’t know what they’ll decide to do.

I took a look at a few different scenarios (pictured below). I think the average or pessimistic view are likely the most realistic, for reasons I’ll get into in a moment.

Valuation: Media companies are commonly valued on a multiple of revenue, with most selling for 3-7x the last 12 months of revenue. Substack isn’t a media brand, but I found this to be the most direct comparison. Media brands are much more capital intensive, so Substack would fall on the high end of this scale in my opinion. Substack doesn’t need to pay for its writers’ healthcare, 401k, office space - and in many cases the writers themselves are spending to acquire readers into the Substack eco-system.

Given these unique circumstances, I took the figures from the chart above and plotted hypothetical valuations & annual returns. Based on how rosy you envision Substack’s future, you can get a very rough sense of potential investment returns with the below.

The TAM Conundrum: To defend Substack’s $650M valuation, many people are citing Bill Gurley’s essay, where he explains how Uber’s Total Addressable Market (TAM) was wildly underestimated in its early days. In it, he argues that it was wrong to compare Uber’s potential to the market size of taxis, since it was a category mover that would open up rideshare to a much wider audience. In effect, it was a revolutionary product that altered the trajectory of its own market size.

Substack is indeed opening the publication world up to a much wider audience, so I can see this argument holds some value. However, I don’t believe Substack’s TAM will be as dramatically higher vs traditional publishing. Here’s why.

With Uber (and also Airbnb), the payoff for participating in the platform is instantaneous - start driving/renting and you immediately see money flowing into your pocket. Content creation is a much longer and arduous journey. More people will join the category of publishing, but few have the patience to keep with it. Some supporting stats:

• Many top newsletters gain the majority of their subscribers from paid ad campaigns (meaning organic growth is slow and minor)

• 90% of podcasts don’t get past their 3rd episode

• Most YouTube channels don’t reach 1,000 subscribers within their first year

I think Substack will help grow the market size of traditional publishing, but not to the magnitude that Uber had on its market. Its gratification cycle is too long to elicit explosive growth.

Newsletter Churn: One of the biggest knocks against Substack, is that it derives the bulk of its revenue from the largest publications on its platform. The problem with this is that once a publication gets large enough, it makes more sense to take their subscriber list independent than continue paying a 10% fee to Substack.

Each time one of these large publications leaves, it can be a massive revenue hit to Substack. This is a grave concern, but I actually have confidence in Substack that they’ll be able to address this issue. The new product rollouts have been quick & agile, and they’ll continue to roll out features that will entice writers to stay on platform.

After all this, am I investing in Substack?

Yes. While there remains a lot of question marks, I still perceive this investment to be something that could realistically net a 15% annualized return to investors (with plenty of room for upside). I believe the network effects will begin to truly materialize, which will accelerate their positive flywheel and mitigate some of the major problems it faces.

Being an email service provider will become somewhat of a commodity. Each platform will copy the most popular features of the others. But a network is not something that can easily be copied, and Substack’s competitors are not moving towards this model.

Most successful newsletters get 80%+ of their subscribers from paid advertising. If Substack builds its network into something that fuels organic growth and breaks this model, it’ll be the competitive moat that will vault Substack into undisputed supremacy. And that’s where I believe it is heading.

For more content around startup investing, you should subscribe to me on….Substack :)

Please note that this is not financial advice, nor a recommendation to invest in Substack. Please conduct your own due diligence and understand that investing in startups is extremely risky.