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August 2018

When to be lean

By | Startup general interest | No Comments

Ben Horowitz, founder of leading venture firm Andreessen Horowitz and a successful entrepreneur prior to that published a post over the weekend: The Case for the Fat Start-Up.

In it he argues that lean thinking has been overdone and that startup CEOs should be more aggressive raising capital and investing in building value in their companies. His reasoning is that being number one in a market is the only thing that counts, and that it therefore makes sense to go all out to achieve that goal. Running lean means going slower, increasing the chances that another company takes that coveted number one spot.

I have a ton of respect for Ben. He was produced large volumes of beautifully written guidance for startups that I have enjoyed reading and quote frequently. I’ve also agreed with pretty much all of it.

Until now.

Even this time I think he is partially right. But his advice needs a major qualification, because whilst it is right for some companies to go all out to secure the number one slot, there are plenty of others for whom raising a ton of cash and investing heavily is the wrong answer. For some it’s because they haven’t reached that point yet, and for others it will never be the right answer.

Let me start by defining the group of companies for whom a ‘Fat start-up’ strategy is the right strategy. I think they have the following characteristics:

  • They operate in a very large market
  • They know how investing heavily will drive growth – i.e. have some form of product market fit
  • They have a path to profitability or confidence they can raise future funds

It is likely all the companies that a large fund like Andreessen Horowitz wants to invest in have all three of these characteristics, making Ben’s advice appropriate for his universe.

However, for earlier stage funds like Forward Partners the picture is a little different.

Some of our portfolio companies have these three characteristics, and most of those are raising as much as they can to maximise their chances of being number one in their market. We love and support that firstly because it’s what the founders want and we are behind them, but also because we are shareholders and know that in nearly all markets the number one company is much more valuable than the number two.

But a lot of our portfolio don’t have all three of those characteristics, and for them it makes sense to run lean, at least for a while. Most of those companies fall into one of these two categories:

  • They don’t yet know for sure how big their truly addressable market is. We invest in lots of companies that are playing early in emerging new markets. We believe the markets have a good chance of being large, but at the outset we don’t know for sure. For those companies it is important to make sure they don’t over-fund for their truly addressable market size. If a company’s market ends up being small relative to the amount of capital they have raised then the outcome won’t be good. The exit will likely be similar to or smaller than the amount of capital they raised, meaning investors will be unhappy because they lost money or only just made their investment back, whilst management and founders will only make what they can negotiate out of a side deal.In his post Ben talks about a startup purgatory where under-investment leads to coming second in the market and low returns after years of effort. This is the other type of startup purgatory, where over-investment leads to low returns despite winning the market, again after years of effort. There are few things more annoying than working hard, building a successful business, exiting for a decent, but not huge, amount, and having all the stakeholders be disappointed with the outcome.

    Companies in this group should start raising relatively small amounts and then scale up as it becomes clear the opportunity size merits it. Putting that in fat startup vs lean startup terms, these businesses should start lean and only move to fat once they are sure they are in a big market.

  • They are in a big market but haven’t found product market fit yet. Most of our investments are pre-product market fit. Many are pre-product entirely – no product, no code, no team, just a great founder and an amazing idea. For these pre-product market fit companies raising a lot of money early is occasionally the right thing to do – mostly when the competition is, or is likely to be, fierce – but for most of them it makes sense to keep things lean until the unit economics are established and it’s clear how more cash will drive growth and enable the next round. Raising a lot of money before this point – which you can consider a working definition of product market fit – is dangerous because of the increased expectations that come with a big round.Getting investors to back you in a big round generally requires showing them a big plan, i.e. one that has rapid revenue growth to make them excited and rapid expense growth to justify the fundraise. Most founders who raise a round like this follow the expense side of the plan, but if they are pre-product market fit they don’t know if the revenues will follow. If those revenues don’t come then the company quickly falls into a precarious position, with a big burn, a big valuation to live up to and little progress to show to potential investors in the next round.

    Companies in this group should generally stay lean until they have found product market fit.

I’m as excited about being part of massive companies as everyone else in this industry, but it’s important to recognise that there are lots of great companies that don’t reach $1bn in value, but do make a meaningful contribution to society and deliver great outcomes for their founders and early investors. The overarching point of this post is to note that these sub $1bn companies need to be funded appropriately. Generally speaking, and to simplify, that means staying lean unless or until it’s clear the outcome can be very big, or, in more detail, start lean and become progressively less lean only as the scale of the opportunity becomes clear.