Build a Money Machine, Not a Burn Machine
Originally a thread on X/Twitter:
The #startup ecosystem has been turbocharged in recent years due to massive capital inflows.
A downside is that the playbook has been lost around how to build a healthy business.
Being able to make money with a single product at low levels of scale needs to be re-learned!
Many Founders exist solely to will into existence their product/service offering. They get up in the morning ready to tackle the challenges presented by their ecosystem and obsess about delivering a superior option to their target customers.
Sounds good? Only kind-of-sort-of….
GREAT Founders exist to build DURABLE and PROFITABLE businesses. They know that the best way to build a great business is to solve a profound problem with a product/service that a set of target customers is willing to pay more for than the solution costs to manufacture.
Great Founders care about their customers but they also insist on getting paid.
Great Founders care about solving a profound problem but they also insist on getting paid.
Great Founders care that they’re making the world a better place but they also insist on getting paid.
Unless capital is sourced from an altruistic benefactor, profit and success are inextricably linked.
Engagement is an input. Customer satisfaction is an input. Revenue is an input.
And while profit isn’t everything, it is the most important thing that matters in the long run.
Building a startup typically requires getting a “yes” answer to the following question:
“If a rational consumer were faced with perfect information, would they pick your product?”
From there, scaling focuses on building awareness and reducing onboarding/switching costs.
But there’s a second “yes” that’s needed:
“Are customers willing to pay more for the product/service than it costs to manufacture?”
Herein is where the narrative has been lost.
Trap #1: Solid unit economics with high corporate costs
The availability of capital has encouraged Founders to think big. For many startups, this shows up as investing in infrastructure, people and projects that theoretically create long-term enterprise value.
This raises the bar for what it will take for a startup to be self-sufficient. Increasing OpEx and SG&A before a startup has proven the ability for its core product to make money is common. And it’s a trap that can build a machine that’s good at one thing: burning money.
The truth that Founders don’t like to hear is that the market share they’re likely to capture is less than they think.
It’s easier to build a product/service that serves a segment of the market than for the whole market and expansion products fail more often than they succeed.
Using TAM to justify a high burn rate is sloppy, naïve and has led many Founders and VCs to build crappy manufacturing machines.
Having great unit economics matters, but not if it takes a gazillion units to overcome a bloated corporate structure and overly ambitious agenda.
Trap #2: Negative unit economics forecasted to improve over time
Scaling before cracking the code on the unit economics of a product/service is a dangerous game to play. Ask the graveyard of 2000s era dot com companies how it worked out for them.
A common cause of negative unit economics happens when a startup sells a dollar’s worth of value for seventy-five cents.
Underpricing can give a false read on market appetite because it’s not a given that the market will be there when full-freight pricing kicks in.
Unit economics frequently improve with scale. Systems and people can be amortized, vendor pricing can contractually improve, etc.
But many startups bake “unknown” improvements into their models which makes scaling with negative unit economics a risky proposition.
Trap #3: Wedge product is a loss leader
Most operators understand the concept that “Great businesses are built on top of good businesses”.
It’s rare that a business emerges as “great” without being “good” first.
Great businesses are dominant, profitable and stable players in their respective ecosystems.
They have brand permission and have assembled the resources needed to capture additional profitable market share in their current markets and expand into new ones.
Good businesses don’t yet dominate their ecosystems but serve enough customers that they make money or will with a modest increase in scale.
They’re working to build their brand permission but typically only have enough resources to grow their core business.
The concept is simple but it’s been ignored by many VCs and Founders given the recent availability of capital.
Without the creation of an intermediate stable and profitable business, capital needs to underwrite the destination and every leap of faith needed to get there.
From a risk/return standpoint, the destination better be exceptional because the probability of assembling the pieces and cracking the code imply low odds of success.
Add to this dilution from future capital raises and failed experiments and the return profile only gets worse.
Many of these businesses are “Act 2” businesses because their first Act isn’t interesting by itself because it doesn’t create a “good business”.
It’s only with the successful delivery of “Act 2” that something of value will be built.
This isn’t right or wrong, it just “is”.
Underwriting this type of business requires a very particular capital stack and mentality.
It requires a willingness to infuse multiple rounds of capital knowing there’s very little salvage/exit value being created along the way due to “Act 1” being intrinsically worthless.
Many “Act 2” businesses are terrible investments at the price it takes to win them.
In retrospect they’ll appear to be brilliant investments, but an honest analysis of the probability adjusted distribution of outcomes would reveal that most “Act 2” investments are EV negative.
The pullback of capital in today’s market is going to force a re-learning of how healthy businesses are built.
Many startups will have to refactor their manufacturing processes and shed excess overhead.
Others will find they have more profound issues that aren’t easily fixed.