The year 2012 was prophesized to be the end of the world. The world did not end but the year was an inflection point for the startups in Silicon Valley. Everything went digital and cloud, the word disruption spread like the plague and every business was ripe and vulnerable to it — credit lines, banking, shaving, music and wedding planning. The optimists called it the future, cynics called it the bubble and the venture capitalists referred to it as the new ecosystem.
Whenever there is a great technological shift, it leads to great uncertainty on what the future would look like and how would the new economic system absorb all the changes. The dotcom era saw the rise of companies like Microsoft, Dell, Intel, and Cisco which contributed to the rise of the Internet and its underlying infrastructure. The current boom lacks a popular name as the range of technologies — from artificial intelligence to blockchain to the Internet of Things — are evolving and tough to label. A single thread which underpins these technologies is the expanding capacity to harness data which Jack Ma calls as the “electricity of the 21st century”.
A major chunk of these new-age companies has rewritten the rules of business growth. They are not generating profits by optimizing cash flow through the exchange of goods and services to customers but by persuading investors to give them money. The idea is that customers would come along eventually but as long as the company finds investors to fund subsequent rounds till an IPO or an acquisition, a company can have users instead of customers and “earning potential” instead of cash flow.
Companies sold for billion dollars are valued not based on some multiple of their sales, profits, but for expectations of what they might become, which spread like fake news in an attention market. Venture capitalists take huge risks to bet on companies that they believe would shape the future with the hope of earning an asymmetric payoff. This is the modern startup playbook.
The risks taken by venture capitalists have extreme outcomes. A single asymmetric payoff obtained through a winner nullifies the accumulated cash losses. Startup ecosystems are running experiments on venture capital money and failure is the core essence of these experiments. When failed experiments are covered under the garb of a success story, problems emerge. The last couple of years witnessed two such instances in WeWork and Theranos trying to deceive the crowds.
The hindsight lessons derived from them are applicable to these companies as well as to the new age startup ecosystem which thrives on cheap access to capital.
- Great ideas and great execution is rare — A combination of having a grandiose vision and agile execution skills differentiates winners from others. Your company’s purpose could be selling intangible emotions like trust and happiness or unlocking human potential to the levels of self-actualization but if you cannot generate positive cash flows then the vision will be shortlived. WeWork’s vision was to elevate the world’s consciousness. Successful startup companies obsess about basics like sales, customer retention, and profitability. Companies need to focus on sales and customer retention with a balanced approach to avoid endless unprofitable acquisitions. Modern startups are characterized by the absence of profitability as they acquire customers at high prices by deep discounts. External funds cannot solve unsustainable business models but only provide the illusion of growth and security. A focus on profitability ensures long term survival and eventual success in the marketplace.
- Digital is discrete but success is continuous — A particular characteristic of digital technologies is that they are fuelled by data which is composed of discrete bits. Discrete signals have a time interval between two events as opposed to continuous signals. There can be periods of progress where the company does exceedingly well on all business parameters. However, the real test of a company is only when it is able to survive the tougher parts of the economic cycle. Growth can be sustained during boom periods pretty easily but sustaining growth with profits during turbulence is a tough task.
- Psychopaths are everywhere so act accordingly — Psychopaths have problems in understanding emotions which makes them selfish and egocentric. The boards of Theranos and WeWork included billionaire CEOs, former renowned politicians who handled multiple levels of ambiguity and analyzed complex business trends before anyone else, yet they could not detect fraud. It is important to recognize trust and integrity in entrepreneurs. Most frauds are self rationalized in the minds of the fraudster. Fraud is complicated because the perpetrators of fraud live in imagined realities. Fraud is a magnified output of irrational behavior and you cannot apply rational logic do irrational things. To paraphrase Tolstoy, all frauds lose money through cheating yet every fraud is unique in its own way. Ponzi schemes are popular because they work on many people. It is important to be self-prepared against cheating.
- Storytelling is important but not everything — Stories are powerful than numbers because the brain takes less effort to contextualize and comprehend it. Profits and steady cashflows have been replaced by grandiose stories and vision statements. Facebook and Google demonstrated profitability when they went public but this hyperbolic trend of storytelling was popularized by Amazon. Jeff Bezos’s ability to portray an extraordinary vision and show stable progress was rewarded by cheap access to capital. Stable progress is important in the narrative. If enough smart people believe the story to be true, and the unsustainable idea gets sustainable life support. Innovative ideas attract a lot of eyeballs but hype does not translate into commercial success as shown by Theranos and WeWork. As expectations meet reality, hype requires concrete evidence to survive itself. Entrepreneurs need to have a realistic view of future expectations as an article in Forbes or a spot in the NYSE can create an illusion of success.
- No shortcuts in building something big — Great businesses cannot be built on the idea of kicking profitability down the road while sugar-coating poor performance with stories of growth and disruption. Entrepreneurs should recognize that building a business is a time-consuming process. Investors and venture capitalists should reflect on how they encourage rapid growth at the cost of sustainability.
- Balance scalability with prudence — For companies, the definition of scalability varies as per their models and context. Scalable business models tend to have positive word of mouth, lower incremental marginal costs, low customer acquisition costs, huge total addressable market, demonstrate economies of scale, enable high pricing power, strong network effects, high user retention, and low regulatory barriers. Scalability has both supply-side and demand-side effects. Demand-side scalability involves harnessing network effects when customers interact with the product or service. Supply-side scalability involves the use of capital and labor in an efficient manner. IT outsourcing companies optimize around labour to build scale. Social media networks like Tiktok and Instagram use network effects to build scale. Netflix burns capital to produce more original content with an objective to acquire more users. WeWork raised $14 bn — 7 times of what Facebook required before its IPO and have $47 bn in lease commitments with a portfolio of oversized office workspaces that need maintenance. A balance between scalability and prudence is necessary to ensure sustainable growth for startups.
Conclusion: The Bottom Line
Media businesses are conquered and venture capitalists are looking for their adventures in the next idea where internet-enabled services will help them earn a share from what we eat, ride, work and live. For all the criticism faced by WeWork and Theranos, they remain great business ideas with flawed business models and lapses in corporate governance.
The problem lies in selling billion-dollar dreams with trillion-dollar losses in cash flow statements. The solution is valuation with positive cash flow and a reliable business model that has earning potential that resembles a business and not speculative adventure capitalism.
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