Here's a SaaS example: if it costs you $1000 to acquire a customer that pays you $100/month, the PBP is 10. That doesn't sound amazing. But you have options! If you give the customer a 20% discount to pay annually, they're now paying you ~$1000 upfront, for a PBP of 0. Tweak the numbers slightly and you can get a negative payback period. Suddenly your "capital inefficient" business has a big flywheel without the need for outside capital.
It's easy to think decreasing acquisition costs is what you need to do in the current market (and believe me, that's not a bad idea!), but that's the denominator. There's also a numerator - how much cash you bring in, and how quickly - that matters just as much. It's cash flow that matters, not profit.
People start businesses for emotional reasons, not logical ones, and vastly, vastly underestimate the amount of money they'll need to get the thing off the ground. Entrepreneurial people are inherently optimistic, (and they have to be), but he said their estimates were typically off by ~5x. If you think you need a million dollars of runway, you probably need 5 million. If you think it'll take a year to achieve profitability, it'll probably take 5 years.
There are a lot of moving parts, a lot to learn, and timing/luck are also factors. Until they all hit at the same time, it looks like a flop. It takes time to find, learn, or assemble all the key bits.
Sorry your dad's impatience was so persistent. Sense of urgency is important, but impatience is deadly. Thanks for sharing such a clear example.
They had a massive churn issue around 3 months. They knew this was a cash cow that was printing money but someday it'd come to a end abruptly.
I suggested to them to offer 20% to their existing customers to switch to annual. They made ~$60k in a day and knew they'd have to refund if things went south before the annual contract ended. They were able to deploy the capital into marketing and explode.
In the end they had to shutdown but not before each founder had taken home +$250k and invested into legitimate means.
This sounds like a huge assumption being made here - as in, this is not as easy as it sounds.
We do this all the time so if I’m missing something I’m keen to hear it :)
Reasonable growth that balances LTV and CAC is nice and pragmatic but it's not a winning strategy when your competitors are putting the pedal to the metal.
For any that are unfamiliar:
https://insight.kellogg.northwestern.edu/article/the_second_...
I believe this for broad markets with network effects (though see how quickly tiktok obviated facebook), but for companies that send out text messages to your customers or host your application in the cloud, which are examples of the creme de la creme of 10s startup success, it matters a lot less. These companies have no moat, no future, and are purely designed to be vehicles that take money out of the pockets of pension funds and give it to financiers.
I thought this was a pertinent quote.
You’re going to see many companies deciding to become cash flow positive instead of growing. And if the business is stable, the quickest way to get there is to drastically cut operating costs…
Or or do a public stock offering at a relatively high stock price after a short squeeze.
I have recently started a course in corporate finance at my local uni because my new role requires me to understand accounting, making business decision and so on.
I haven’t finished my course, and I have to admit that I skimmed the article. So what I am about to say is probably wrong. It’s a feeling I have.
I have the feeling that a lot of theses articles are pretty basic corporate finance. What I mean is that if you study and try to understand basic CF, you will gain the insights that many of these articles talk about.
When I then read in the comments that there are cases where tech leads with no business experience get millions in funding and basically are learning by doing. Silicon Valley seems to be on another planet for me. It’s sounds surreal to me.
If I was an investor I would never give that person money since projects are so extremely difficult. The wicked problem is a real thing. Or maybe I am just poor and don’t get how people with large amounts of cash think. I get that it’s a numbers game and you have a portfolio of companies, but still.
Guys that are closer to SV, I would love to hear your thoughts on my thoughts.
Specifically, construction is more tied to either real estate, hospitality or government contracts. These often raise money via a bond (debt) offering or an equity with a very well-worn finance model. These projects require a lot of upfront capital (billions not unusual for roads) and have long time horizons, with log() or linear returns, and have a very well understood model for packaging as a risk asset. These risk assets attract a certain kind of investor, or a certain risk profile in a large fund's portfolio.
Venture capital as an asset class is a bit different. The expectation is that an idea can be proven out relatively cheaply, and the business will scale since the major leverage is intellectual property (vs physical assets). The expectation is also that most business will fail, with maybe a handful of successes capturing most of your return. VC's investing in startups with risk-appetite LPs, is very different than a real estate developer going to a large bank to build a housing project. The VC model is closer to investing in a TV show than a construction project.
Put simply: Investing in a moderately sized government construction project ($2b or so for a toll road in latin America) is a totally different finance product than a startup that leverages IP. The aggregation of risk is also different (VC vs say, REITs) and the devices are different (equity vs debt / leverage). Most investors either run a balanced fund at a large size, or specialize, since they are so different.
EDIT: Also important is relative size of each investment asset class. VC is hilariously small (222 billion in 2022) in comparison to something like energy (2.4 trillion in 2022). VC gets a lot of press but for most professional investors "real funds" start at about a billion table stakes.
Sure, construction and high-growth tech startups are different investment opportunities. They have different risk profiles. As someone managing money, shouldn’t you be looking to mitigate risk to maximize returns? Why give money to the startup which has an idea and no experience running a business, managing capital, accounting, etc.? Wouldn’t money be much better spent on a startup that had all those things?
I have heard in the past that the majority of startups fail, and that successful startups are often founded by people who have founded (often unsuccessful) startups before. When looking for a company to invest in, shouldn’t these be top priority? I don’t buy that VC and high growth companies need to be as risky as they are. I suspect a lot of it is bad decisions and lack of due diligence.
One take: yes, and venture-backed companies often forget or ignore the basics of corporate finance.
Another take: orthodox corporate finance isn’t tailored for start-ups. If you’re developing a product, GAAP income is meaningless. So we bootstrap interim financial metrics, e.g. eyeballs and ARPUs and DAUs (oh my!).
In truth, the latter dominates at the early stage. But firms grow. Some founders and VCs (see: Andreessen) are late to recognise when nontraditional metrics do more harm than good. When that ignorance becomes a point of pride, the former gains explanatory power.
When in reality they should be acting like a small business e.g. florist.
Often these startups are failing because of basic cash-flow management.
AirBnB hasn’t had a long stretch of profitability. But I will give it the benefit of the doubt that it can maintain profitability.
However: if your software product has struck gold, it will have “rocket ship” nearly-free growth and negligible incremental costs. In that regime, only the top line really matters. This is the kind of home run that many people are looking for in Silicon Valley, both founders and investors, which explains the relative “traditional” financial illiteracy in startups around here.
Yes, articles like this seem rudimentary to folks with MBA/accounting backgrounds.
Yes, tech startups can get millions in seeds funding, even where the company doesn’t have a CFO (or anyone with an MBA).
However, at those super early stages for sw startups, it doesn’t really matter. The money is to finance a product, prove the product’s value, and build a team. And its that journey where that company may start looking for a CFO.
By the time that company is raising a series A, they should have these things worked out.
I've always considered the risk-averse investment culture and bureaucracy in Europe to be a major factor.
Concurrently, there is a greater understanding that waterfall engineering is not the best for software. Instead, software is more agile, in that you build test prototypes and have a tightly integrated feedback loop instead of huge project plans that take months to even reach market.
The philosophy is more around testing market hypotheses quickly and iterating quickly.
Another factor is there is a lot of hype around SV that forms a positive feedback loop. Of course investors are not so easy to part with their money but it is inclining towards gambling in some fields flush with capital.
This is not true for all fields in SV though, for example in the biotech and medtech field, getting investment is much harder from my experience, as there are more regulatory factors, higher barrier to startup, longer time periods for outcomes, etc.
But then, as we've seen in the FTX fiasco, some investors really just throw money around without any due diligence.
Perhaps, they know (from business experience) that the VC treadmill is not in their best interests, when everything about that life is considered! :)
Perhaps investors actually benefit from the naïvete (read: not incompetence, just naïvete) of their portfolio companies?
It's a symbiotic relationship, but there's a reason that the road between founder and VC is generally a one-way street.
[1]: There are notable exceptions to this observations. They're worth understanding, too.
> You only need to pick those startups carefully.
This is the "draw the owl" moment. The top comment is saying that they wouldn't pick any startup that didn't have someone to understand basic corporate finance.
Learning to create a successful product is much harder and requires a much rarer set of skills. There’s no course you can take that will give you this ability. Knowing lots of details about accounting and business administration won’t help you unless you can make something that sells.
If you're in the latter situation, then hype is way more important than actual fundamentals.
They need the 100x/1000x outliers in order to return their fund and that means holding on to investments until IPO.
If the guys CalPERS allocated the 0.5% (a few billion) to (the VCs) decided to also not do the risky thing then you haven't got a diversified portfolio.
The point is to put a small amount of your phenomenal wealth into risky bets with outsize returns precisely because you want to capture some of that other risk diversity.
Investors are sophisticated enough to quickly reason about basic margin opportunity, and decide if the company could ever be profitable, even if the founders have no real business experience. The assumption is that by the second round or so, you can refine the estimate of "Could ever be profitable".
More importantly for venture capital, is that there are many profitable businesses in the world that have people with finance expertise. If you just wanted to invest in profitable companies, you wouldn't be doing venture capital. Instead, you're seeking companies that will have massive returns and become profitable some day.
If the founders still don't know how to do finance, but they're making a ton of money, you send them a CFO to tighten that up. Same way you send them names for VP of Sales, or whatever else they need.
Deciding to give up on a company that seems to be generating lots of money, and "just" needs to improve margins is hard. If you tighten too early, you've blunted growth. If you tighten too late, you've thrown away the money. For the last few years, the amount of money sloshing around meant you saw more of the latter. The firms "had" to keep investing their funds, so they were chasing more and more deals on hope. But $10M out of a $1B fund is still no big deal.
tl;dr: the rare thing is rocket ships, not financial sophistication.
[1] https://www.k9ventures.com/blog/2012/05/31/hope-and-numbers/
To be fair, I didn't appreciate how unusual it looked until I helped a friend start their business in Illinois and saw what they dealt with at a bank.
You are correct in your assessment that articles like the one linked here are pretty standard business explainers. The interesting thing for me is that it really is just math and systems so it "should" be interesting but for a lot of folks they don't seem interested and just want to sell product.
So at least part of the venture community has convinced itself that it knows how to "productize" anything, if they just had something to work on. And along comes a person with an idea and hope. The venture capitalist (VC) thinks, "I'll provide the business sense, this person provides the creativity and the elbow work, and we'll split the profits." That can work out spectacularly well for the VC where they invest $X and get back 10 - 100 time $X in wealth. It doesn't always work out, but if it works out enough times, the VC can turn their money into more money faster that way than with say investing in government bonds.
In Silicon Valley this works because of two things, one there was a tradition of providing equity to employees which, when companies grew, put a lot of the wealth generated in the hands of individuals rather than companies. And secondly, California had some pretty good laws on the books about disallowing "non-compete" employment agreements so people who thought they could do the same thing their company was doing, only better, could go out and start a new company doing the same thing without too much risk of getting sued.
Having lived here I can tell you that 20 - 30 year old people are much more willing to invest in something risky than 50 - 60 year old people. So getting that wealth into younger hands adds to the risk tolerance.
To this point: Or maybe I am just poor and don’t get how people with large amounts of cash think. I expect it is a scale thing.
Imagine you have saved enough to pay for all your kids college education and you start your "retirement" fund. And you save money in that until the returns on that fund are actually enough to provide you with the same income, and in the US buy you the same medical coverage, you are currently experiencing working. Now you can "leave your job" and have a lot of free time. (It doesn't mean you can buy a yacht or an airplane and party all the time, just that you're new lifestyle looks like your old lifestyle with the single exception that you don't have to go into work every weekday). Now you end up with a few million $ more for this "third" account. What to do with that? Well a lot of people feel comfortable "gambling" some of that on new ventures because if they lose it, it won't change their life, and if they get a big winner, well it means more things they can try.
So to understand it, you have to imagine that you've got enough savings for all of the life expenses you expect to have going forward, and you have enough savings on top of that such that those savings are providing the equivalent to having a good job (pay and benefits), and now you have savings on top of that.
In the current batch, there are estimates of >100,000 former Google, Apple, Microsoft, and Facebook employees are in that position today. Money did a story on how the density of billionaires in San Francisco was the highest in the world [1] (post Crypto-crash I'm guessing this number went down :-)).
So why do young millionaires and billionaires invest in crazy ideas? Maybe because it is more exciting than having a few million dollars sitting in a bank account doing "nothing"?
[1] https://money.com/san-francisco-billionaire-density-income-i...
So, yeah, there's a level where you know you don't have the money to routinely fly private or buy a super-yacht or buy properties around the world. But you have enough for any expenses you reasonably want/need and may not even want a bunch of the stuff that more money could buy. So you throw some money at interesting things.
a) Yes in some cases engineers with no business experience get funding. But in most cases there is significant due diligence being done on the capabilities of the team.
b) There is plenty of history that engineers with great product sensibilities can learn to run a business and become successfully by augmenting their weaknesses with members of the SLT who are stronger at them.
c) The whole point is for them to deploy their LPs money rather than just letting sit around waiting for the perfect idea/team/market etc combination to arrive on your lap. That simply doesn't happen.
Unregulated markets in a finance-centric economy inevitably drift toward the controlled monopolistic model for this reason. Advocates for unregulated free-markets either don't understand this or are simply being deceptive and are really trying to maximize profits by promoting the growth of monopolies.
Note that if it is a state body that controls all the capital and hence controls economic decisions like infrastructure development, this isn't so different in practice from having a small group of financiers controlling all the capital - in both cases you have a centrally-planned economy controlled by a small cabal that puts their own interests ahead of everyone else's.
One place I worked, their strategy was to chase the “whales” first and get them as customers so we could use them to get other customers. So many problems there that only because apparent to these idiots afterward. First, big companies aren’t idiots. If you have next to nothing to offer, they’ll give you next to nothing in return. And once you have an exploitative contract, good luck renegotiating it once your product has improved.
In this particular industry it was even worse, as we found out. The big companies felt like they were doing people a favor, the medium sized companies were just cheap. Only the little companies were hungry and humble enough to pay good money for good product, but now you have a product that’s been tilted toward the whims of much larger companies, which adds a lot of friction. Plus you’ve done all of your scalability work at the beginning when you are the least experienced with it.
They did end up selling the company at a profit, but they had hoped for early retirement and all they got was comfortable living. I’m not convinced the buyers got a good deal on the terms either.
The salesperson then cares more about commission and less about profit and generates revenue at any cost.
Long story short, when the properties were eventually sold out, I burned my cash flow to buy more of them to other players, at a high price, when they needed money (it would also allow them to play longer)
My logic was that by owning the most properties and by building houses and hotels, I would have the most revenue on the long run. And had the game been endless, I would have won.
However, the chances of someone going on your property isn't even high in this game ! You can sometimes wait for several rounds before this happens.
Unluckily, I stumbled on a rent I couldn't pay, mortgaged some properties. It happened again, and other players would only buy my properties at a price to cover the rent.
And my empire (i had the most properties by far) was on the verge of collapse when I had to run to go to the station.
So yeah, consider the payback period, even in the simplest models of the economy. Monopoly is economy taught to children, yet we adults can overlook its lessons.
The game only has 32 houses. If you get two 3-property monopolies and build four houses on each one, forgoing hotels, you have 24 houses and everyone else is fighting over the remaining 8. If you get max out houses on two 3-property monopolies and a 2-property one, the game is yours regardless of what anyone else has.
I usually did better playing this strategy. Even though winning with houses on park Place is more fun, houses on Mediterranean ave are more certain.
For certain types of companies, revenue is easy. I worked to a company that did mostly consulting, but would also sell you hardware or software licenses, so customers only need to interact with us, and no one else. Technically we could just have given away hardware, and we frequently did sell servers at a lose. That shows up as revenue. As long as you have money or credit to sell expensive stuff at a lose, then revenue is easy.
That's not the main point though. The point is measuring companies on revenue is pretty stupid, without also looking that profitability.
I have seen so many startups over the past few years, with A rounds up to $25 even $50 million where the CEO has zero business experience, they are literally learning by the seat of their pants.. They have gone from some experience as a tech lead for a small team, to the next day to running a large company. Obviously, there will be the odd outlier Zuckerberg type, but many of them are going to be totally out of their depth when the burn rate and path to profit (or even revenue in some cases) start to close in.
2024 will be a bloodbath in the startup world.
When you have that kind of growth and that kind of money, frankly it's different anyhow - riding an explosionn is different than running a company, which is almost always 'operating'.
CEO's are captains of ships with moving parts, experts, probably already a navigator, engineer, maps, standard port-to-port model etc.. In a way CEO's of established companies are 'overseers'.
CEO's of compaanies blowing up is something different, it's not an optimization process it's usually a top-line process, and then maybe crude bottom line net-profit process while keeping enough wood in the fire.
Other than that, nice article!
On the other hand I find building profit one of the most enjoyable and fun things! I've now successfully more than 3 times in a row taken ~$100M revenue and grown it via new top/bottom around 10-15%.
I think it takes a different kind of person to optimize for income than just purely growing revenue.
However, "customer acquisition cost" seems to imply that that customer is now "yours" and he'll keep buying without any more spending from you. That assumption is questionable. Maybe he's just on loan to you, and fickle as all hell. Did Uber "acquire" me just because I used them a few times?
Traditional accounting is "fixed cost" plus "variable cost." You build your factory (fixed cost), and then produce widgets (variable cost). For a long time, you're amortizing the fixed costs, and eventually the price of the widgets is all profit, assuming the factory still runs.
In that method, every customer is a random draw from a raffle, and you have no guarantees that the customer will keep buying. They may, but they may not. You have to keep getting new ones to even keep your base stable.
I’ve confused a few people this ways in conversation lately and I’m not sure what the solution is, but it’s a case of saying, “even the most optimistic scenario is still very bad”.
Keeping someone’s attention is never going to be cheaper than getting it in the first place. The best you can do is spend a maintenance cost to retain them, in which case if enough time passes and enough repeat business happens then the profitability of that customer keeps going up. But you’re going to hit an asymptote that looks like Amdahl’s law, and dictated by those investments.
However, it does nothing for the customer. I refuse to subscribe to anything, as a rule. Deliver some value, and I'll pay for it when I need it. YMMV.
Customer acquisition cost (CAC) is paired with lifetime value (LTV). The length of time you're on "loan" to the company doesn't really matter as long as LTV is higher than CAC.
This model is commonly used for subscription businesses, where assuming each purchase is independent is not really appropriate because they are recurring.
> I have observed that few people understand these nuances and the significant role they play
I've been out of the venture-backed world for a while, so it's an honest question. Few people understanding business basics would certainly explain a lot of recent behavior, but there are other possibilities too.
For example, I could imagine a founder who knew what a real business was, but just said, "In crazy times we'll do crazy things", took the VC money, and mainly shut up about the problems, while quietly trying to mitigate the risks.
Or I could imagine that the OP is literally correct here, that many never bothered to figure this stuff out because it did not matter for the short term, and in fact would interfere with them projecting an SBF-grade aura of extreme confidence.
I've certainly met people in both camps. I'm just wondering if the latter have truly become very common, or even possibly the majority in some circles.
Bootstrapping (funding growth with revenue) isn't the silicon valley way; the silicon valley method is as follows: 1. get funding
2. grow team/build product
3. raise more funding and find product market fit
4. seize control of market / make large top line moneys
5. repeat 3/4 a as necessary.
6. acquisition/IPO, shareholders payout.
Without infusions of external capital it is literally impossible to generate revenue without profit for any period longer than one can sustain their losses. Isn’t it way easier to focus on businesses that do this, that meet a demand people have, and are thus profitable? Instead, investments are made in areas where demand has to be induced via advertising spend, expenses have to be reduced by relying on the ability to “rapidly scale”, and the business has to sap round after round of investor capital at increasingly higher and increasingly more ridiculous valuations with the hopes that it can weather that storm.
When considering the above, it seems to me that we are systematically mis-allocating capital to bad investments. As the saying goes, a bird in the hand is worth two in the bush. You can see people behaving in accordance with this during high-risk periods, e.g. COVID, when capital shifted toward durable goods and physical assets (pre QE infinity). But for some reason, when the risk is not literally right in front of investors, they do not see it. That risk, the integral of which increases over larger periods of time, eats away at the growth rates of companies. I suspect risk would spoil the math that makes a lot of the high-growth companies worth anything, if it were properly accounted for. Not to mention, negative externalities are unknown and thus largely ignored in startups, and thus cannot be accounted for.
But I wouldn’t be generating much profit.
And it looks like that recent profitability is more about AWS than their traditional core business: https://www.visualcapitalist.com/aws-powering-the-internet-a...
