Fred Wilson wrote a great post over the weekend which was largely dedicated to making the point that in the final analysis profitability is what makes a business attractive, and that being small or medium sized and highly profitable is often a better idea than being large and loss making. I couldn’t agree more, moreover, one of the unfortunate side effects of the venture industry’s need to produce home runs is that some companies are over-encouraged to pursue scale and end up on the wrong side of this equation.
As Fred says, the fundamentals of corporate finance are that a business is worth the discounted value of it’s future cash flows, and no matter how big a company is if those cashflows add up to a negative number the business isn’t worth anything. Full stop.
When markets are a bit heady companies, and even stock markets, sometimes allow themselves to forget this reality (or more often allow themselves to put wild assumptions in their models) but when times get tough people get back to focusing on fundamentals. In many ways Fred’s post is a call to do just that.
I welcome this renewed focus on fundamentals and profitability and the disappearance of some of the more excessive ‘build it to flip’ thinking that has been in circulation in recent years. But, having said that, much of what we in the startup ecosystem are doing remains the same., and there are some tenets of VC/startup strategy which in my opinion shouldn’t be casualties of the current climate. I have two I want to highlight here.
- The credit crunch doesn’t necessarily change the trade-off between pursuing traffic growth or revenues in the early days of a company. If the average life time value for a customer of your service is only ever going to be low, and you are therefore going to need a lot of them, I still think it often makes sense to prioritise growing the customer base over revenues in the early days. This is not a naive ‘build it to flip’ proposition though, and there are some important caveats – this only applies for companies that genuinely have the potential to be very large, have a customer acquisition cost of very close to £0, can still maintain cost discipline, and are sure finance will be available (in the current climate one needs to think carefully about future funding and milestones for valuation growth – I will post on this later in the week). A number of companies in Fred’s portfolio pursue this ‘traffic growth first’ strategy, including Twitter, which if you think about it has all the elements I describe above, indeed Fred notes in his post that they only have around 20 employees.
- For VC funded businesses scale still matters, and whilst small and profitable is certainly a safe place to be right now, over the medium term I would hate to see any lessening of the ambition to build genuinely world changing companies – and I say that both personally and professionally. To focus on the world of DFJ Esprit for a second – if you are going to raise VC (and this should be a big ‘if’ – venture capital is only appropriate for a small percentage of companies – i.e. those that can grow to be very valuable AND need a few £million to get there) then you need to have profit potential measuring in the tens of millions of pounds. You might not get to that point before you float or sell your company but the potential needs to be there to achieve the valuation and implied cash return that is going to make a difference to any reasonably sized VC fund. The reason VCs are obsessed with addressable market is that without a big one this scale of profits is unlikely to be possible.
So I think these two things haven’t really changed much. There are, of course, many more things that have changed, most concerning short term tactics for surviving the next couple of years (e.g sell something because venture and advertising dollars will be harder to come by) and some concerning inconvenient truths that can no longer be ignored (e.g. banner ads don’t perform well, particularly on social media sites) – but I don’t think we should be ripping up the rulebook entirely. As I’ve said before, at the end of the day this is only a cycle.
As an aside Chris Anderson has an interesting WSJ article this weekend making a similar ‘some things are different whilst other things stay the same’ argument. In it he argues whilst the downturn changes the short term tactics for businesses the inexorable shift towards ‘free’ as a business model continues.