December 8, 2017

Fintech is taking a break for today. Instead, read on for the Christmas edition of “How the Venture Capitalists Stole Common Sense-mas”, featuring Wreath-mart, iWreath, and the venture capitalists whose large infusions of cash disrupt profitable unit economics to drive good companies to do bad things…

Act 1, It’s a Wonderful Wreath
Wreath-mart, the long-standing purveyor of fine Christmas wreaths, owns a Christmas tree farm where it raises its own trees. It costs $1,000,000 to grow a crop of 10,000 trees, so each tree costs $100. This is a relatively fixed cost since they own the land and it takes years to grow the trees. Each tree makes five wreaths that Wreath-mart sells for $25. Revenue = $125, Costs = $100, so they are happy with their steady 20% profit margin. If Wreath-mart wants to make more money, it either need to lower its tree cost, or make the wreaths fancier so they can charge customers more. As a traditional industry incumbent, Wreath-mart’s view is that this is an incremental problem — the goal is just to drive margin from 20% to 22%, so they just try to lower their tree cost to $97.50.

Enter iWreath. Without a fixed cost infrastructure, the young but promising startup iWreath can sell wreaths for much less. In fact, the lack of a fixed cost infrastructure is a direct result of being a startup with little money. The constraint of less money forces iWreath to be more creative. It can’t wait years to raise trees, and certainly can’t afford to pay $100 per tree. So CEO Kris Kringle goes to a Christmas tree lot and strikes a deal. The lot sells trees, not wreaths, and has plenty of extra branches lying around.

iWreath takes the trimmings for free, and then split the profits from the wreaths it sells evenly with the tree lot. To be fair, the trimmings iWreath collects aren’t as nice as what Wreath-mart has, so the company starts off selling wreaths that are smaller and not as fancy. However, because of the embedded cost structure, iWreath is guaranteed a profit on each wreath. Selling wreaths for $10 a piece will net them a $5 per wreath profit, which is the same amount that Wreath-mart earns. However, because of the cost structure, iWreath’s margin is 50%. In addition, iWreath can open up the wreath market to many families who couldn’t afford a $25 wreath, but would happily pay $10.

In the current equilibrium, both companies are happy — they are both profitable and operate in slightly different areas of the market. Extrapolating out the Innovator’s Dilemma scenario, Wreath-mart will eventually face a problem as iWreath moves further up market and Wreath-mart cannot compete with its lower cost structure. The startup has a good chance of being successful and has a solid, profitable, and growing business.

Act 2, Mayday on 34th Street
The big problem for the startup arises when venture capital disrupts the efficiency and innovation of the startup. If a venture capitalist G. Rinch likes what he sees and invests $5 million into iWreath, the company now has to figure out how to deploy the capital and scale up quickly. In an effort to show massive growth, the startup is incentivized to spend like crazy. Kris can’t rely on collecting trimmings from tree lots — now he need tens of thousands of trees. iWreath doesn’t have time to grow its own farms, so it must buy trees in bulk from tree farms for $105 per tree (assume they need to pay the tree farm $5 per tree profit over what Wreath-mart’s costs were).

The trap here is that iWreath can no longer sell its wreaths for $10. The unit economics no longer make sense. If iWreath buys a tree for $105 and sells five wreaths for $50 total, it will lose tons of money on each tree. The other option of raising the price to match the incumbent doesn’t work either, especially since now at the same sales price, they make less margin.

Regrettably, iWreath has $5 million of capital now, so it can continue to sell about 90,000 wreaths at $10 each and take the loss in an effort to scale up before the money runs out, and hope that they can raise even more money and maybe just lose $40 per tree the next cycle. The hope is that iWreath can crowd Wreath-mart out of the market by capturing all the customers, and then either find a way to lower its costs or find a way to upsell customers so they can turn profitable. This is the “winner-take-all” mindset.

Either way, our jolly CEO has now taken a perfectly good, profitable business and made the “rational” decision to lose money on each sale in an effort to “get big.” The venture capital money incentivized the wrong things, and through subsidizing a now-inherently unprofitable business model, has placed iWreath in jeopardy and threatens to destroy Christmas as we know it!!

Act 3, The Uber Clause
Ok, that may be a little dramatic, but it does illustrate what is currently happening now in many “big” startups. Many on-demand food delivery services have closed over the past year specifically due to this unit economics problem. This is also the current situation at Uber. Based on recent financials, Uber seems to be doing great — the company generated $18.5 billion of gross bookings in 2Q and 3Q 2017, and kept about 20% of that as its “net revenue”. However, Uber ended up losing $2.5 billion on that $3.7 billion net revenue number.

In order to reach break-even, Uber must somehow find a way to earn an extra $5 billion per year, either through increasing the amount of each fare they keep (say from 20% to 34%), or by raising their prices by 70% and keeping the same revenue share. But as we just learned with iWreath, Uber can’t afford to raise its prices by 70% or take that much more revenue from its drivers. Uber is dependent on its investors to continue subsidizing the cost of the rides in hopes that it will find a way to become profitable.

Investors often try to dismiss this very real economic imbalance by pointing to Amazon. After all, wasn’t Amazon famous for losing money for nearly 20 years and only stayed consistently profitable in recent years? Amazon is a red herring in this argument. If you look at the numbers for 2014 for example, you’ll see that Amazon posted a $214 million net loss in 2014. However, that is far overshadowed by the fact that it generated $6.8 billion in cash flow from operating activities. Amazon continued to reinvest the cash back into the business, which made it look like it wasn’t making much money.

Due to Amazon’s astute financial management, it raised an $8 million Series A round in 1996 and never had to take venture capital money again because it was actually generating massive cash flow. On the other hand, Uber has raised over $15 billion from investors and is currently negotiating a deal with SoftBank for even more. Clearly it is not generating cash flow to reinvest back in the business — the losses are real.

Bonus Features
Moral of the story — try to keep a disciplined mindset. Venture capital can sometimes be a good solution, but it’s typically much more rewarding to operate within constraints that inspire creativity and innovation. There will always be hot startups burning through cash, but having an actual, profitable business model will never go out of style.

Oh, and maybe you should put something extra in the stocking of your favorite VC — after all, without them you’d be paying double for your Uber rides 😉