Michael Kitces' previous blog pointed out the projected revenues of Wealthfront, the Silicon Valley online financial adviser, and its status as a potentially major or niche player. The real story behind these ventures is not the venture itself but rather the transformation of money as a digital medium. This will transform the current gatekeepers of capital into new roles. Robo-advisers are the shiny new toys that have garnered significantly more attention than is merited based on their trajectory. Ultimately, the internal rate of return on their businesses, in order to justify their capital outlay, will be the true measure of success. Many of the institutions invested in these companies can roughly afford a five to seven year time horizon and will pull the plug or be significant nuisances if internal IRR hurdles are not achieved. To put it bluntly, Robo-advisers are not running a lifestyle practice.
Let's take Wealthfront. According to TechCrunch, they have raised $30.5M to date. In 2008, Wealthfront, the artist formerly known as kaChing, was established with an angel round of $3M to take on the mutual fund industry. I must stress that these angel investors are not looking to turn $3M into $10M. They want a bigger payout.
kaChing's model consisted of gathering up and certifying “geniuses” to share investment decisions with the public. A year later, they raised another $7.5M, and then in 2013, they raised another $20M. Along the way, the “geniuses” were fired for selling index-based model portfolios directly to consumers.
At this point, the initial capital investors are already five years in. This is not a knock against Wealthfront. This represents the typical journey for these ventures and why capital investors would not take on this huge risk without a high expected return. As an extra bogey, the S&P 500, a very liquid holding, has risen over 120% since 2009.
Now let's play with some numbers and see if we can guesstimate the internal growth estimates Wealthfront needs to justify their capital raises.
Based on Michael's estimate, their top line revenue is $1.25 million at roughly $500 million in AUM. Now, let's assume that they have contained their costs (a very generous assumption at this point in their cycle) and have a 35% margin.
This would generate a $438,000 EBIDTA ($1.25M x 35%).
At 10 times EBIDTA (10 x $438,000; another generous assumption) a traditional advisory firm would be valued at $4.4 million.
To be worth more than Wealthfront's capital raises of $30.5 million, they need to immediately raise their AUM to $3.5B. Assuming that this raise was done on a $50M pre-money valuation, then they need to be at roughly $60 billion in AUM in five years to accommodate a 10 times return for their capital investors. That is roughly a 12,000% AUM growth rate. Oh, did I mention their revenue is largely tied to stock market performance?
As an adviser, Wealthfront does not concern me. I wish them luck. As a business owner, I'm fully aware that advisory offices of tomorrow will be more anchored to a digital interface.