Profits vs Growth

One of the things I’ve always struggled with as an investor in high growth tech companies is the tension between getting profitable vs growing more quickly. It has become a central tenet of tech growth investing (in both the public and private markets) that growth is more valuable than profitability and you can always focus on profits once you have “captured the market.” This leads to behaviors like investing heavily in sales and marketing to increase the growth rates of a business beyond what it can grow at “organically.”

A few months ago, I blogged about a formula I came across at a board meeting a while back that says your year over year growth rate plus your pre-tax operating margins need to be at least forty percent. Meaning you can grow at 100% per year and have operating margins of -60%. Or you can have flat growth and have 40% operating margins. Or you can grow at 20% per year and have 20% operating margins. There is no magic to the forty percent target, but I do like establishing some relationship between acceptable levels of profitability (or losses) and growth. Too many times I have seen companies invest in growth for growth sake without having any constraints or sanity checks on that investment and the losses that result from that investment.

We have worked with/invested in a few super high quality companies over the past decade that did not make this tradeoff. They got profitable early on in the life of their company and then were able to use their profits to reinvest in the business and continue to grow at very high year over year growth rates without having to burn money and raise capital. Indeed.com is probably the best example of this group but we have had a number of them and they are all special companies that I have enormous respect for.

These experiences lead me to question the orthodoxy in the world of technology that says if you are not investing heavily in growth (and losing money), then you are not maximizing the potential value of your business over the long haul. It doesn’t have to be that way. Now maybe you need to have a very special company that has real structural competitive advantages in the marketplace to avoid this tradeoff. Or maybe you just need to be a really sharp and experienced business person to be able to do this (that’s how I would describe Paul and Rony, the founders of Indeed.com, for example).

I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make. It roots out bad investments in people, product, sales, marketing, and elsewhere in the business and helps to maintain a lean and mean highly functioning organization. If you don’t need to make money because there is plenty of capital available to fund your losses and you are “investing in growth”, then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.

I don’t want to come off as a positive cash flow freak. It is our business to invest in companies to allow them to run operating losses in order to get a product in market, grow the business and team, and create value for the founders, management, and shareholders. Most of our portfolio companies lose money and we are used to reading income statements with lots of red on them and staring at runway calculations showing when the money runs out.

But I’m a bit sick and tired of the objective of every operating plan I see is to get the business to a point where it can raise money at a much higher price. That’s nice and it’s how the VC/startup game is played. But at some point I’d prefer to see an operating plan that has the objective of getting to sustainable profitability. And I do mean sustainable.

Because, as I said earlier, some of the very best companies we have worked with at USV got profitable early on in their life and maintained profitability while revenues grew100% year over year for a number of years. It can be done. Maybe the reason that many entrepreneurs don’t think it can be done is nobody is telling them it can. So I’m doing that.

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Comments (Archived):

1. Russell

shazzam!

2. Scott Barnett

Thanks for this. I’ve always loved the phrase “the best type of funding is revenue” – it doesn’t mean you shouldn’t try to raise venture money, but I agree there is way too much focus on valuation and not enough on sustainable revenue and traction. It also means you likely need to move slower than you may like, which takes significant discipline.

3. csertoglu

Timely, Fred.

4. JLM

.One size does NOT fit all.But one set of rules does apply to business.The decision is whether to follow them or to knowingly violate them. Unknowingly violating them is a possibility but not a viable option.In the life of companies, the big issue is the market. What is the market telling you is possible. That is a trick statement because the “market” may mean either the real market of customers giving you money for your product or the market for raising money.The most important thought is what Fred indicated — have a rational reason for whatever you decide to do. (May not have said it that explicitly but that is what I heard.) Know why you are doing what you are doing.Two other practical observations from a guy who was a CEO for 33 years — don’t be afraid to conduct an experiment. Conducting an experiment is an attempt to find out what you know you don’t know.The other observation is that life is not lived at the extremes — you don’t have to go all in on either of the polar opposites. There is a vast middle that you can explore with a hand on the tiller and navigating first one way and then the other.Last point, whatever you decide to do make damn sure your top people know it and why and make sure everybody else knows it.Don’t let a strategic decision ruin the power of alignment because you fail to tell everybody. Tell them way more than 3 times.JLMwww.themusingsofthebigredca…

1. LE

There is a vast middle that you can explore with a hand on the tiller and navigating first one way and then the other100%. However in the world of “online learning” (and AVC.com is part of online learning) people are not likely to buy into that. Because they feel that there are simple rules for business that they can follow that will lead to success. As if it’s math or a programming language or engineering. Or that decisions are as easy as simply complying so that you “pass inspection”. Doesn’t work like that as anyone who has been in business and operated one finds out.Keep in mind that when an investor follows rules or orthodoxy they are spreading bets over many investments. So they can be wrong. When you are running your own ship no such latitude exists. That is a difference that is larger than panamax. [1][1] https://en.wikipedia.org/wi…

1. JLM

Fabulous comment. The margin of safety and the necessity to be right is different for a VC v a real business.The Panama Canal — and now featuring Panamax — is a wonder of the world. The biggest foe to the original building was the mosquito.Between the two attempts — maybe three — more than 25K died — DIED — building it. Can you imagine something like that today?The Chinese will own it within the next 20 years. Only fair since their countrymen built it, no?JLMwww.themusingsofthebigredca…

1. LE

The documentary that I watched on building of the Panama Canal was fascinating. I think it was on PBS. [1] Definitely remember the role of the mosquito.I don’t think any of those big constructions projects could be pulled off today. For one thing labor isn’t what it used to be. Back then human life and so on was not considered valuable and people were not protected like they are today. Think of all of the immigrants (on the canal or building the hoover dam) that were exploited doing construction. Today we live in a world of people wanting everything to be 100% safe and perfect when that is simply not possible.Look at all the manpower, money and effort and money that is going into catching two escaped convicts from that prison in upstate NY! It’s a ridiculous and overblown political circus.[1] Yes it was and it doesn’t get better than this. Clips are on youtube as well. http://www.pbs.org/wgbh/ame…

1. TeddyBeingTeddy

Do you think we could solve the problem of over crowded prisons and expensive manual labor by having convicts build stuff for us? Worked for Rome. I’d give them $0.20/hour, build a bigger faster canal, and just call it The Anal (“c is silent”). Boom. TeddyBeingTeddy for POTUS in 202O.

2. BillMcNeely

I’m always a bit squeamish on prison labor http://www.laborrights.org/…

2. James Ferguson @kWIQly

You know why Cape of Good Hope is so named ?Once the “Cape of Storms” it was a reliable source of water, Vitamin C (scurvy- limeys) and Quinine (Tonic water – malaria cure) – together they make a gin and tonic and upped survival rates by over 80% for the UK – India sea crossing.Entrepreneurs wanted to move stuff by sea (not the Silk Road – echoes of bitcoin ) and the mosquito (malaria) and slice of lime were two sides of that coin. Throwing more funding at the plan without the insight would have been stupid (enter the Dutch who pivoted once they figured that South Africa was an interesting trading proposition) and that was how Britannia came to rule the waves…(temporarily)

1. JLM

.That thing in Suez fucked them, eh?Still love a good G & T — can’t be too careful even today about scurvy, no?JLMwww.themusingsofthebigredca…

2. James Ferguson @kWIQly

It was that that made the connection for me – your mention of Panama – It was to be a hat or a long trench and I went for the trenchStill we’re doing some work with the company that dug the thing – so all the more reason to enjoy a large one !

3. Girish Mehta

Not sure about the scurvy connection to the naming of the Cape of Good Hope. Widely accepted that Barthlomew Dias discovered the Cape of Storms in 1488 but upon the return to Portugal re-named it as Cape of Good Hope upon the suggestion of King John II of Portugal. The “Good Hope” signified the optimism that a sea route to India might now be possible by going around the Cape (the land route was disrupted after the capture of Constantinople (Istanbul) by the Ottoman Empire in 1453).Why the Scurvy argument doesn’t seem right is that Vasco Da Gama who was the first person to actually go around the Cape of Good Hope and reach India in 1498 lost between half to 2/3 of his crew to scurvy during the trip around the Cape of Good Hope. That was a good 10 years after the Cape of Good Hope was named.Now, subsequently it is said that the Dutch toward the end of the 16th century landed at Madagascar and consumed a lot of limes/citrus fruits…but that was ~100 years later…Vasco Da Gama in fact lost a sizeable portion of his crew to scurvy.The generally accepted reason for renaming “Storms” to “Good Hope” in 1488 was that it created optimism that a sea route to India would finally be discovered…which happened 10 years later. Thanks.

4. James Ferguson @kWIQly

Girish – I like your argument, – I concede – I was only repeating received wisdom.I must however object to the truth getting in the way of an otherwise completely good story ! 🙂

5. Girish Mehta

Agreed James – Never let the facts get in the way of a good story !

6. Dave Pinsen

Da Gama got citrus fruit (mainly oranges) on a stop further up the coast in East Africa, but by then, most of the scurvy damage was done, and it’s not clear he understood the connection either. He probably avoided scurvy personally due to the consumption of dried fruit on the voyage, something not everyone had.Really extraordinary what he accomplished, finding a sea route to India from Portugal – it was the longest journey of any type ever undertaken by that point – the 15th century equivalent of a moon landing. Good book on it:

7. Chimpwithcans

http://whc.unesco.org/en/li…

8. sigmaalgebra

Heck yes: With open ocean sailingfor moving goods, no toll roads, toll bridges, castles along the wayto be paid off, etc.

3. Girish Mehta

An enjoyable book on this subject, you might have read it…http://www.amazon.com/The-P…Thanks.

1. JLM

.I have devoured everything that McCullough has ever written.Every subject he touches, his is “the” definitive work. His work on Roosevelt’s youth is a keen insight into who Roosevelt was before he became Teddy.Thanks.This raises my opinion of you immensely — already held in high esteem — and validates mine of myself.Well played.JLMwww.themusingsofthebigredca…

2. Girish Mehta

Thanks :-).McCullough’s latest book came out last month. Haven’t got to it.The late 19th century- early 20th century saw some emphatic physical statements of American achievement – the Brooklyn Bridge, Kitty Hawk, the Panama Canal (all subjects he has written about)You have to wonder what effect this was having on that newly created empire which was established in 1871, and quickly became in some areas the 2nd biggest industrial power in the world. The period of 1871-1914 is a fascinating one. Thanks.

3. JLM

.Great observation.I heard a talk focused on the creation of America from the Civil War to the Second World War that was fascinating standing for the proposition that we struggled internally and then struggled externally and then rewarded ourselves while continuing to perpetuate and struggle with the same shortcomings as a people.Woven through was the role of transportation, tech and money.JLMwww.themusingsofthebigredca…

4. sigmaalgebra

Iron, coal, coke, steel, steam,rails, petroleum, cars, airplanes,radio, Maxwell’s equations, special relativity, general relativity,start of quantum mechanics, chemistry and chemical engineering,mechanical engineering, passengersteam ships, electric power, lotsof cheap lumber, Victorian houses,mass production of textiles, microbetheory, start on the mechanization ofagriculture and associated astoundingincreases in productivity — exciting, fast moving times.

5. ShanaC

I get the feeling the US was an interesting place to be in during that time, especially towards the end

2. Sam

Strategy is choice. Choice is hard. And organizational alignment is the key to making those hard choices stick.I like to joke about executive communications that you should use the advertising framework of reach times frequency. A frequency of nine isn’t a bad rule of thumb for an ad to stick in the consumer’s mind. Five or six might not do it.

5. kidmercury

no doubt. forgoing profits in the name of growth, especially when growth translates to scaling losses (i.e. lose more money the more you “grow”), is an insanely risky strategy. no doubt its preponderance is born of dysfunctional, perpetually bubblicious financial markets and the warped incentives they create.but, while such strategies will end in doom for all, the companies developing a competence in scaling losses will also be able to price many revenue-funded competitors out of the market who are dependent upon cash flow (and thus are vulnerable in price wars).

1. Richard

Are you talking about the Federal Reserve 🙂

6. David Semeria

A lot depends on the vertical. If it’s winner-takes-all then it’s better to focus on growth otherwise your competitors will take your market share, even if you’re profitable.If it’s not a case of kill or be killed then I agree 100% on focusing on profitability.

7. conorop

What’s interesting about starting a tech company in Minnesota is that VC’s are on the opposite side of the pendulum of the coasts – if you don’t have a clear business plan and a handful of paying customers, it is next to impossible to raise cash.In some cases, this (stereotypical) Midwest conservatism forces us to be creative, bootstrap longer, and discover value, but at the same time it can greatly hinder exploration in social or undefined markets. You won’t Snapchat or Instagram coming out of MN any time soon, but we’re growing in healthcare and enterprise tech.All in all, I’m with you Fred – it needs to be a balance.

1. Doug Calahan

Conorop. That’s exactly where we are in Atlanta as well. Because of the dearth of VC money here, all of our tech companies are usually remarkably lean (too lean). And when you look at the $B exits that we’ve had, almost all of them have been self-funded.Fred – the concept of an operating plan to get to another raise at a higher valuation is complete foreign to all of us not in SF, NY, and Boston. It just isn’t an option.

1. Jonathan Liggett

Exactly the same in Philadelphia as well. Outside of SF, NY, and Boston, cash flow reigns b/c there is hardly any 1st round capital available. Plenty of seed money though. Oddly, our most famous fund in Philly, Josh Kopelman’s first round really doesn’t do much business in Philly.

2. William Mougayar

That sounds like later stage VC investing. Seed/angel is different.

1. conorop

I agree! I can count on one hand the firms/individuals that would be considered a true seed/angel.

3. mikenolan99

Conorop – let’s figure out a time/place to meetup – not many of us Minnesota folks prowling AVC!

1. JLM

.Plus everybody in Minnesota is so damn nice.JLMwww.themusingsofthebigredca…

1. mikenolan99

Awe shucks!

2. sigmaalgebra

Especially the girls, lots of blonds!Now if I were X years younger, with my startup working,…! By the way, it is possible tohave 90% of the students aboveaverage!

1. HatchMarfa

And people wonder why women in tech don’t get taken seriously. Sigmaalgebra, I suggest you check your comments and think about your audience before posting.

2. sigmaalgebra

Ah, there’s nothing wrong withblonds or “Gentlemen PreferBlonds” or girls being pretty.If they can also do technology, so much the better.For women in technology or to be taken seriously in general,there are issues: One of themstarts right in the crib where thegirls are interested in people andthe boys, things. Without a lotof effort to change things, thatdifference continues so that thegirls/women tend to be much lessinterested in technology.In a narrow sense, just the techitself, the girls can be fine. Butthe situation gets more complicatedwhen consider ‘social context’,girls wanting to ‘fit in’, and otherinterests of girls, joining groupsof girls for, say, gossip, or findinga husband and being a mommy.My wife was an example — terrificat essentially everything includingtechnology. Valedictorian, SummaCum Laude, PBK, Woodrow Wilson,Ph.D. in essentially mathematicalsociology. In writing artificial intelligence (AI) software, she made the fastest progress our AI groupever saw.But there were also other issuesclosely related to being female.Basically Mother Nature was therelong before feminism and has someconstraints that are not easy tosee but are surprisingly effective.There are at least two ways to address these constraints: (1) Believe that they don’t exist,invest years, lose your investment,slowly figure out more about theconstraints, and be sadder butwiser and have lost some years,and maybe more. (2) Take myword for it that there are strongconstraints and that, first-cut, simple approach, just follow tradition, even if don’t understandjust why. Mostly you won’t beable to beat Mother Nature, andfrom women Mother Nature wantsmotherhood, not software engineering.By far, by a very wide margin, therisky approach is to take thefeminists seriously.

3. HatchMarfa

This doesn’t even merit a response. However, I do plan to share this on social media as yet another example that some people in tech just haven’t gotten the memo yet.

4. sigmaalgebra

By now you have responded twiceto my posthttp://avc.com/2015/06/prof…In your responses, you have saidnothing at all direct orrational to anything I wrote; Ihave written nothing about youpersonally; but, twice, you haveaimed remarks at me personally.Not good: What you are doing isarguing a very weak position –no rational content, justpersonal slights.So, apparently you have norational content to contribute.But, maybe you do: If so, benot shy and, instead, cough upwhat you have. Write it down,and send it. That’s what yourkeyboard and this blog are for.The odds of your being, orknowing anyone, better than mywife at technology are epsilonabove zip, zilch, and zero. Hertalent between her ears was offthe tops of the charts amongvery bright, accomplishedpeople. E.g., two of her profswere President, AmericanSociological Association. So, Iknow first hand that women cando technology.But, also as I learned from mywife, I also know some thingsabout women, also from someexcellent sources. E.g., thereis in E. Fromm, ‘The Art ofLoving’, the remark “Men andwomen deserve equal respect aspersons but are not the same.”Darned right they are not thesame.Why do women gossip? Gossip forhuman females is not a smallthing — it’s one of the biggestthings.Why? One answer is also in E.Fromm as a special case of hiscentral point about people. Formore, read Deborah Tannen,You Just Don’t Understand:Women and Men inConversation. Of course, if you actually arewell informed on this subject,then you know Tannen’sbackground, a professor atGeorgetown. She’s darnedserious, in particular aboutwomen and how they differ frommen.Yes, there’s a lot of text inthe public media about womenbeing equal, just thesame, not just in respectbut in essentially every wayother than some obvious anatomy,and Fromm addressed the originof this thinking: He wrote thatWestern Civilization got thatattitude from the FrenchRevolution where any differencewas seen as a threat ofinjustice. The attitude ismisinformed and harmful to manywomen and families.Well, we’re not talkinginjustice; instead we’re talkingwhat’s real and actual: Net,human males and females just arenot the same, and if you insistthat they are then you will haveone heck of a rock to push up avery long, tall hill. You willnot be successful because MotherNature was there long before youwere, along with her buddyDarwin.Technology? I know what theheck I’m talking about: I holda Ph.D. in Engineering, fromsome work in applied math, fromJohns Hopkins. Not easy to get.I’ve published peer-reviewedoriginal research in appliedmath, mathematical statistics,computer science, and artificialintelligence. My currentproject just had me get somesoftware running, software with18,515 programming languagestatements.About one women who was justterrific in technology, again,from my wife, I know what theheck I’m talking about.About some of Mother Nature’sconstraints on humanfemales, again, from my wife,her sisters, her mother, andmore, I have some rock solid,very telling examples. Netthose females all hadintellectual talent beyondbelief but most definitely werenot males — not even close –but were different. I didn’tsay better or worse but onlydifferent.Heck, one of my nieces from mywife’s family, without herparents even knowing what shewas doing, graduated from a verylarge, very competitive highschool first in her class. Incollege, right PBK. Okay, shewent to Harvard Law and thenstarted at Cravath Swain. Shedidn’t much like that so got anMD and now is a practicingphysician. So, we’re talkingValedictorian, PBK, Harvard Law,Cravath Swain, and MD –brilliant. She’s also drop deadgorgeous. But she’s still verymuch a female, not a male.Heck, I’ll make it a littleeasier for you to understand intwo points:(1) That niece in high school,as Valedictorian, totally blewaway, knocked into the nickelseats, all, 100%, of the harddriving, aggressive, knock’mdead boys around. With PBK incollege, essentially the same.In Harvard Law, to get toCravath Swain, third suchperformance in a row.(2) My wife, while in college,wanted to learn some Europeanhistory but didn’t need thecredits for her Bachelor’sdegree and didn’t want to haveto work hard to protect herrecord. So she audited a coursein European history. The profwanted audits also to take thetests, so my wife did that.But, since she was justauditing, she didn’t try.Well, it was a lecture hallcourse with 300 students.Presto. Bingo. Guess who, noteven trying, led the class?Right: At the end the profcontacted her and explained thatshe had made the highest scorein the class and would havegotten an A. Not even trying.Blew away everyone else in theclass.You are lucky you were not in aclass with her — history,trigonometry, statistics,organic chemistry, developmentalanatomy, etc. — because strongevidence is that the best youcould have done was to come in adistant second.Distant? She was so far aheadin the trig class I taught thatshe could have taken a 0 oneverything after the midterm,including the final exam, stillcome in second in the class, andstill made an A. Of course, asit was, she totally blew awayeveryone else in the class.Fire away. Load up your BettyFriedan, or whatever, mortarshells and take your best shots.By the way, there’s someevidence that really BettyFriedan was a Communist saboteurout to weaken the US by makingUS women unhappy being a wifeand mother with the high USstandard of living. She wasastoundingly successful and,net, one of the most destructivepersons in history.Summary: Can some women bebright, brilliant, accomplished,totally knock the boys into thenickel seats, including in theSTEM fields and business? Yes.Are those women really just likemen? Essentially never. Forwork in the STEM fields andbusiness, do those women havesome constraints, vianature and/or nurture, that, onaverage and in nearly all cases,strongly affect what they do?Yes.Are men and women just the sameexcept for the simplestanatomical differences? Nope,on average and in nearly allcases, not a chance, not evenclose.Why are women different? Goodguess: That’s what MotherNature and Darwin want forreproductive advantage.Am I arguing that the feministsare mostly seriously misinformedand destructive? Yes.Where did the destructive ideascome from? Likely heavily fromthe media that always wants astory, e.g., surroundingfeminism and women’sequality. Why does themedia do this? Because theywant controversy, attention,eyeballs, and ad revenue.Doesn’t this hurt thecredibility of the media? No,the media has no significantcredibility.Apparently you are upset by whatI wrote; in that case, likelythe media has gotten you up onyour hind legs all excited justthe way the media wants in orderto get your eyeballs and theirad revenue.A danger is, if you have sisters ordaughters, you can ruin, yes, definitelyruin, their lives encouraging themto chase that feminist stuff.E.g., the feminist stuff was one of themain things that killed my wife. I jokenot. This is serious stuff. Thisfeminist stuff can ruin lives and familiesand kill people — as in dead.Long term, there’s no problem here:Darwin will handle it. Then all womenvulnerable to the feminist nonsense willbe weak, sick, or dead limbs on the treeand, then, gone, out of the gene pool.But in the meanwhile, feminism will kill alot of girls and women who otherwise couldhave had some really good lives. Feminismis a gigantic trail of tears leading tothe final resolution of the grave.I’m outraged: I don’t like to seekittens, puppies, girls, or women hurt,and the feminists are hurting girls andwomen by the tens of millions.And there are a lot of blonds inMinnesota. No joke.

5. HatchMarfa

Your comments state that women in tech should not be taken seriously and are simply “less interested” in technology. Can’t wait to show this to Marissa Mayer and Sheryl Sandberg.”For women in technology or to be taken seriously in general,there are issues: One of themstarts right in the crib where thegirls are interested in people andthe boys, things. Without a lotof effort to change things, thatdifference continues so that thegirls/women tend to be much lessinterested in technology.”

6. HatchMarfa

I wonder if Fred and Joanne Wilson are reading this. They have backed many successful women entrepreneurs, women who are, in fact, very interested in technology, in building product and creating businesses.

7. sigmaalgebra

You found no contradiction orinconsistency in what I wrote.E.g., you just need to payattention to my qualification Without a lot ofeffort to change things,For Marissa Mayer and SherylSandberg, (1) now they are bothin general management, and (2)there is little evidence thatthey have much in technicalqualifications.And for changing things, both inthe past were under a lot ofpressure to do so, Mayer atGoogle early on and working withPage, Brin, and Schmidt andSandberg working for Summers.More generally, women who try todo such things will likely beweak, sick, or dead limbs on thetree in which case Darwin willhave something severe to sayabout their contributions to thegene pool.Understanding men, women, andhow they differ, especially fortechnology and business, is abig subject. Net, on averageand in nearly all cases, the menand women are very different.

8. AW

Hey, check it out internet people! This guy has a wife, clearly he knows what he’s talking about! We should all respect his hard work on this discussion board- not for the sake of progress or the merit of his values, but simply because he put in so much time and effort to publicly display his ignorance in this way online. Hats off to you sir, for finding a place to vent and inappropriately redirect your feelings of inadequacy at members of a minority. May I suggest you get bent, and/or seek some sort of counseling services?

9. sigmaalgebra

You attacked me personally andotherwise said nothing clear, definite, or of substance andcertainly nothing at all supported.

10. Waylon Flinn

The science of gender bias is actually more complex than popular culture generally appreciates.We can all be better informed about the facts. Interesting reading in the scientific literature: Rudman and Goodwin, “Gender Differences in Automatic In-Group Bias” and Eagly and Mladinic, “Are women evaluated more favorably than men?”. Always more to learn!

3. PhilipSugar

You know the phrase “MN nice”. It means to be nice to someone’s face while turning around and stabbing them in the back

2. PhilipSugar

I get there so often I feel like a resident

4. BillMcNeely

Check out Minnesota based Vugo/Viewswagen

5. James Ferguson @kWIQly

Try Switzerland for financial conservatism – but when proven they are strong (not talking the banking industry 🙂

6. Real People Dating

Growing up in small town MN and now living on the upper east side after having gone through my previous startups acquisition, I will tell you there is a radical difference between MN and NYC lol.That being said, the costs for starting in MN are WAY lower than anything in NYC. Get a product built, get some early traction and then look to raise money (*if necessary*) in NYC/Boston/Cali. Unless you are looking for under $20,000 funding wise, a company should already have a clear business plan and paying customers. MN doesn’t suffer from the startup hype we have in NYC/Cali, which is actually refreshing…Additionally, there are some pretty good investment firms in the cities – I know a couple of them personally and they are always look for solid young companies to fund.

1. ShanaC

Favorite difference?

7. kayar raghavan

You make sense, conorop.

8. markmay

I conceptually like the 40% framework, a lot but… Of course not all businesses have the same long term margin potential so there must be a variation that takes this into account. Adding to my todo list

9. Michael Liu

Damodaran has an interesting post around the value of growth.”it is not growth that you should be paying a premium for but “quality growth”, with quality defined as the excess return you generate over and above the cost of capital…If you accept the proposition that growth creates a trade off of lower cash flows today for higher ones in the future, you have the three ingredients that determine the value of growth. The first is the level of growth, with higher growth rates in the future generating higher earnings over time. The second is how long these high growth rates can be sustained before the company becomes too big to keep growing (at least at rates higher than that of the economy). The third and most critical is the return on capital you generate on new investments”.Source: http://aswathdamodaran.blog…

10. JimHirshfield

Nice post. I’ll choose to read this as a positive sign coming out of a recent board meeting you had. 😉

11. Joe Marchese

A key point can sharpen focus: ‘maybe you need to have a very special company that has real structural competitive advantages in the marketplace to avoid this tradeoff. ‘ Not every company can achieve this, but the degree to which it can is a major driver of sustainable exponential growth.

12. William Mougayar

Well, every deal, every company, every situation is different.It’s good to be able to “flirt” with profitability sometimes to prove that the model “can” be profitable. But sometimes, the flip side can also occur- i.e. the company has revenues and profits and they think that’s it, and they forget to re-fund their growth.Even the best public/large companies that are profitable re-invest part of their gross profits in growth. Between them and startup growth the difference is just a relative one.

1. LE

Well, every deal, every company, every situation is different.Exactly. I simply don’t see how it’s possible to come up with a few simple rules or guidelines. As if you are planning for a vacation and say “I only want to go to a place that is warm”. Business is nuance and each and every situation and company and complexity will matter.Business is about decision making. It is not medicine and it’s not about following rules that may apply in different situations.

13. LE

then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.Agree. Otoh having to watch every penny is an unnecessary constraint and overhead that drains people and quite frankly will usually result in making poor choices. “penny wise, pound foolish”. Because it’s to easy to get positive reinforcement from not spending money. [1][1] I am sure that you know many people (in business or otherwise) who continue to be cheap way past the point which they need to be. Thinking frugality is some great virtue that will get them to heaven or makes them a better person.

14. Jordan Thaeler

Fred, isn’t that in conflict with the way VC funds operate? Most VCs require the 20X returns to justify the risk they take… or don’t take. If you want companies to be profitable at every stage of growth how can you get that 20X return without owning 99.9% of the company? Are you saying that VC should become a lower market growth equity PE and be transparent about it?

1. Richard

Really? Never forget the value of “G” in the DCF.

2. fredwilson

we made about a 100x return on the single round of primary capital that Indeed raised. and we owned less than 20% of the business. something like 15% i believe.

1. Jake Baker

A few thoughts and some simple (probably wrong) math:1) Indeed.com estimated at ~$1b exit (http://www.businessinsider….2) 15% stake worth ~$150m implies $1.5m initial investment3) 2004 USV fund was $125m of commitments, so Indeed.com returned whole fund and then some4) Exit in 2012 with investment in 2005 implies ~93% IRR5) Interesting to go back and read original announcement post: https://www.usv.com/blog/in…All in all – WHOA. Not a bad deal!!

2. ShanaC

smart guys you invested in

3. Michael Liu

Fred never implied that the companies need to be profitable, only that they should optimize for profitability as opposed to future funding.

15. Richard

Really surprising how many startups operate at a loss without any idea of where the break even landing is. I get it for conpanies like Twitter but conpanies in the sharing economy don’t exactly operate in unchartered waters.

16. Twain Twain

Tying it in with yesterday’s post on ‘Does it tell a story?’, startup teams could do this to examine where the growth vs profit trade-offs and inflection points are.This is an example (not my model).

17. Robert

This reminds me of an interview with Joi Ito that was posted on this blog (http://avc.com/2014/06/vide…. Joi Ito takes the approach that revenue will figure itself out when you grow and says “The traditional obsession with the so called business model […] is a short sighted focus”.In stark contrast to David Heinemeier Hansson who is very critical of growth without profitability (I wrote a post about it a while back http://blog.robertsj.com/tw….I guess it depends on the business you are trying to build, also if you are still figuring out profit-market fit or just copying a business model that already found this.

18. pointsnfigures

Yup. In the Midwest, there have been tremendous constraints on capital raising. It’s not like the Valley, or even NYC where there is more money available. (Just because it’s available doesn’t mean you can raise it. But, it’s easier to set up a meeting in a coffee shop than get on a plane and fly to a meeting in a coffee shop) That has forced companies in the Midwest to think about revenue early, very early. People won’t invest without a path to revenue.

19. JamesHRH

The thing that stand out – didn’t those very best companies make a mistake in taking on VC investment (assuming that working with USV is an obvious answer, so we will have to talk theoretically here).

1. fredwilson

maybe. a few of them didn’t need it

20. PhilipSugar

Yes, yes, yes. I love this post.There is a thought, that double sales people, double sales!!! Heck why double lets quadruple. But that is not always the case.It can be true but many times not.South Park did the best spoof on it with the Underpants Gnomes.

1. pointsnfigures

When ever I meet a startup, I want to know the sales strategy. I want to know who the target market is, and how long the sales cycle is. My experience is that sales cycles are typically a LOT longer than startups estimate, and that screws with the math around lifetime value of customers and customer acquisition costs.

1. LE

The time that someone says it takes to sell their product or service really is meaningless unless they have actual data to back up what has happened in the past. Without that any estimate is going to be way off. It only differs in how off the estimate is.Even if someone happened to say “takes 3 weeks typically” that couldn’t possibly be valid. Why? If you know anything about selling you know that there are times of the year that people simply don’t make decisions. Holiday times for example. Or seasonality as another. Or various levels of decision makers that can nix a project and/or delay it because of their schedule and whether meetings and agreement are needed.There is also a great difference between selling to a qualified lead that contacted you vs. selling to someone who hadn’t yet thought about your product at all and might not even want to be bothered with even taking a sales appointment. And a million other little details. Even what appears to be a qualified lead might just be kicking tires (as the saying goes). Look at your own behavior how many inquiries do you make vs. how many times do you actually purchase what you have “requested literature about” (as used to happen in the past).

21. Bob Vance

“I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make. It roots out bad investments in people, product, sales, marketing, and elsewhere in the business and helps to maintain a lean and mean highly functioning organization. If you don’t need to make money because there is plenty of capital available to fund your losses and you are “investing in growth”, then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.”So very true.

22. Anna1984

Clayton Christenson talks about this problem being prevelant in big corporations seeking to launch startups internally. They throw a lot of money at these incubator business units, removing any urgency to achieve profitability. When the incubator business does poorly, the parent company keeps investing in “growth”, effectively creating a bigger problem.

1. CJ

Heh, totally watching this unfold in the company I work for at the moment. So weird, it’s as if no one there has ever read The Lean Startup before. Instead they’ve thrown a ton of cash down a hole with no chance to recover any of it.

23. Pranay Srinivasan

I like the way Amazon operates – They could be profitable every year, but they choose to re-invest every cent they have into infrastructure, operating costs, team, and new developments. This keeps them agile, ahead of the market and prepares the ground for future growth.More than sales and marketing, I think infrastructure esp in physical world businesses will be the key differentiating factor aside from the network effects a distributed and globally powerful network bring with them.VC Investment that goes into preparing markets, and scaling across physical barriers like distance and space would possibly justify investments before reaping their rewards.Because the only reason I took VC was because I had to invest in infra that didnt justify current cash flows but was a bet on the future (with visibility of course).Thanks,Pranay

24. BillMcNeely

Down here in Dallas the money folks are very conservative coming our of real estate, oil and gas. They like B2B plays (Tech Wildcatters )preferably with (lots) of revenue and customers

25. kevando

Translation: Raising money at a higher price isn’t as likely as it used to be..

26. Steven Kane

You know, from many years of conversations, that I agree with this. But – right or wrong, appropriate or bubblicious – haven’t most (maybe close to all) the returns in VC over the last, say, decade, come from exits of companies that never achieved real positive cash flows?

1. fredwilson

yeah. but i am celebrating that ones that did today

1. Steven Kane

amen brotherstill. it took me many years to grok that the role of VC is *not* to create successful companies (though that certainly happens.) rather, the role of VC is to fund the industry’s/nation’s/world’s R&D. which may or may not result in conventional P&L results, but which, over the longer term, result in more/better/more readily available creature comforts, and increases in productivity and efficacy… and, ultimately, profitsof course, that lofty rhetoric still is not justification for the obscene fees! 😉

1. dan_malven

Totally agree that most of VC is an outsourced R&D function. Back in the 50’s and 60’s, big corporations all did their own R&D. The rise of the venture industry in the 70’s and 80’s was really just another piece of the great outsourcing migration, similar to executive recruiting, IT, etc. Occasionally, VC is about business building, but it’s definitely the exception not the norm. And a lot of people (investors and operators) get mixed up when they’re not fully cognizant of which game they’re really playing.

2. ShanaC

🙂

2. ShanaC

That’s, interesting

27. TeddyBeingTeddy

Top 5 AVC post ever. I’m wallowing up with tears of joy. Profit does matter afterall? So many people look to you and learn from your blog. For young bucks to hear about a word called “profit” and for someone like you to tell them it matters… game changer. Thank you.

28. James Ferguson @kWIQly

Early positive margin shows many risk factors are manageable – Organic positive margin growth (especially on top of a bootstrap) indicates:1) MVP (Viable !!!)2) Some understanding of a commercial market (Not-Negligible)3) Some team competence (useful)4) Controlled technical risk (doable)5) Almost certainly market insight and vision (because such spaces are uncommon)A) If a margin = 40% is proven, growth DOES makes sense (organic or funded).B) If growth = 40% is proven (organic or funded) IT SAYS NOTHING for eventual margin.All else being equal A beats BA) plus funded growth = happinessB) plus more funding = more B)Happiness in a big market <—- Pig in cloverThat’s an objective worth pursuing

29. Salt Shaker

Would a re-think of growth vs. profit by VC’s lead to a higher % of exits? Obviously, the current orthodoxy and investment strat is working for many a VC but could even a marginal re-balance lead to more success stories (and frankly more reasonable investments and valuations)?

30. James Ferguson @kWIQly

Another trade off is the “pull the plug” outcome.Given a profitable core – funding is not part of the survival plan – and that makes sense especially in frothy markets.

31. Richard Kain

What are some examples of a profitable startup that didn’t spend enough and got outfoxed by some growth-at-all-costs venture funded firm? Just looking for the real world examples of the cautionary hypothetical that justifies this Get Big Fast 2.0 mentality. Even industries that have big network effects?The video game industry is replete with self-funded successes though most are quiet about their numbers. (Storm8’s CEO did write about this yesterday: http://techcrunch.com/2015/… and the now publicly traded King.com took minimal capital to get to their scale.) Should Zynga have aimed for profitability instead of scale?Amazon is of course the re-investor par excellence. But the account of how close they were to running out of funding (in Brad Stone’s “The Everything Store” among other places) is harrowing. Obviously they created a ton of value but competitively, they’ve only pushed out only other non-profitable retailers with less access to capital. Walmart did $2.3b in net income in first full year of Amazon’s operations (1995)…and $16b last year – one might ask just how impacted have they really been by Amazon?Even when there is a clear invest-now mandate it seems very hard for companies to culturally switch gears to profitability. Instead the capital allocation habits continue and they overshoot with increasingly indiscriminate, costly growth initiatives.

32. Saikiran Yerram

Reminds me of the Silicon Valley HBO episode (Sand Hill Shuffle), where the ex-CEO Goolybib was surprised to hear that he could have taken less money because nobody told him he can.So I am glad you posted this.

33. Cookie Marenco

Thank you! I was beginning to think there was something wrong with making a profit! Your formulas are much appreciated.

34. Frank Denbow

Self-funded companies don’t have the option 🙂 40% metric is a helpful one, thanks!

35. Sam

There is a corollary here with corporate ventures. Many of the most ambitious startups within a corporate environment are not allowed to have the initial negative profit / low profit runway required to scale up, and they are killed prematurely. But the ones that survive and achieve escape velocity are virtually guaranteed to deliver returns accretive to the corporate parent’s profitability. That level of profitability is in their DNA from the start.

36. Val Tsanev

“I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make. It roots out bad investments in people, product, sales, marketing, and elsewhere in the business and helps to maintain a lean and mean highly functioning organization. If you don’t need to make money because there is plenty of capital available to fund your losses and you are “investing in growth”, then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.”This paragraph should be emailed to every stakeholder in the startup community including founders, VCs, angel investors etc., then maybe the “irrational exuberance” ,the phrase Alan Greenspan coined, will end.

37. Timothy

@FredThe irony to this post is that all of USV major exits have been to companies running at a loss.Geocities, Tumblr, Twitter, Zynga, etc.

38. vruz

The reason “many entrepreneurs” do this is many dealers give away the first dose for free.

39. @DisruptiveDave

This is the part we all tend to forget when discussing this pretty hot topic: “I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make.”It’s a red flag that (usually) only those with some experience can see before it’s too late, especially when you’re dealing with young entrepreneurs who haven’t had to balance budgets and forecast and manage P/L, and build cultures.

40. gary macgregor

exceedingly well said Mr. Wilson.

41. Nick P

Good article. The Silicon Valley mentality of huge, profitless companies being worth so much always left me puzzled. Most of my encounters in business world have the people with money saying “Show us value,” while preferring the investment keep providing it. I think the incentives of the VC’s and market reinforce the trend.I’d like to see some tech VC’s focused on funding companies aiming to provide good products and services over the long-term that actually make a profit. Especially those displacing the big IT companies’ various solutions.

42. Jonathan Sherry

Late to the party here, but thanks for writing about this Fred.We’ve grown CB Insights through revenue and despite that have managed to maintain a serious clip of growth. It just means we’ve been judicious in how we spend the money to ensure that growth.My co-founder, Anand, talks about this quite a bit in his Mixergy interview with Andrew Warner. If you have some time on your evening commute, highly recommend tuning in: http://mixergy.com/intervie…

43. Matt A. Myers

Investing in the wrong kind of growth is an artificial crutch.

44. Stephen Voris

Maybe I’m just channeling @kidmercury here, but does anyone else see a parallel with government(s)?Separately, though, this tradeoff between the short-term (profit) and the long-term (growth) shows up everywhere – and you have to survive the short term to get to the long term (see gaming term: ‘zerg rush’). Arguably this is one of the reasons behind income gaps that widen over generations – those with less have to devote more, percentagewise, to survival, and thus have less to devote to (financial) growth.

45. sigmaalgebra

Broadly, there’s a big flaw in theanalysis:CEO: Our potential market is huge, nohumongous, no, astronomically jumbo — wecan own the universe and everything in it.We just need funds to expand to meet thisfantastic opportunity.Skeptic: You have fantastic demand, youmean now?CEO: The desperate customers are nearlybeating the doors down, rushing to stufftheir money into our hands.Skeptic: Desperate you say?CEO: Beyond desperate. The stories Icould tell you ….Skeptic: Well, if for a while you raiseyour prices then you will get more revenueat your current level of delivering yourproduct/service but still have plenty ofcustomers ready to pay your higher prices.E.g., if at your current prices you have300 eager customers for each 100 units youcan provide, then raise your prices untilyou are selling only to the 100 carriagetrade, Chablis-Brie, high roller, cost noobject, Beamer 7 Series, yacht club set(get a brand name with high prestige) andthe other 200 save their money.There’s even a chance that, for each 100units you can provide, your higher priceswill increase the number of customerseager to by from 300 to 600. Call that anice problem to have.The extra revenue you get will be justwhat you need to increase capacity toserve more customers. Then you can loweryour prices to get those extra customers.So, there is a demand curve, andwhat you should do is to increase yourprices to a market clearing level,that is, so that amount the customers wantto buy is just the maximum amount you canprovide now. Then the extra earnings willgive you the cash you need to growcapacity, lower prices, serve morecustomers, grab the market, establish yourbrand name, have economies of scale for abarrier to entry, etc. and be on your way,as you said, to owning the universe andeverything in it.Or, in short, if the business is reallythat non-stop, never-quit, all-go, toinfinity and beyond, with currentcustomers thrilled, with donut scalpersselling your donuts in front of your storefor three times what you have beencharging, then you should be able to raiseyour prices — as is standard with ashortage such as you have — andwith the higher prices and resultinghigher earnings letting you increasecapacity.E.g., if your business is a Web site, thensay that users need to register, and onlyregistered users are allowed in. Have awaiting list, first come, first served,for more registered users, and e-mail themwhen you have more capacity and accepttheir registration application.Tell your advertisers that you have themembers of the Long Island Ferrari OwnersClub, the NY Yacht Club, the BoD of MoMA,the BoD of Lincoln Center, the AllianceCôte-d’Or, the HBS Alumni Association,and the New England Beamer Owners Club allsigned up (the members, along witheveryone with season tickets to LincolnCenter, get priority registrations!) andare raising your ad rates.This is complicated?

46. ShanaC

Will the fed rate change all of this?

47. sigmaalgebra

Actually, if have much data to talkabout an answer at all, then the issueis each, say, month decide how muchto spend on growth.Then with solid data, have a deterministicdynamic programming problem. AnExcel spreadsheet is a good way toformulate the problem, say, one columnfor each month and one row for eachvariable and some unknown decisioncells for the decisions to be made.If don’t want to trust in a deterministicproblem but accept that will have someexogenous random variables andhave even a first cut on the distributions,then have a stochastic dynamic programmingproblem.Really, again, if have enough data totalk very seriously at all about whatto do, then very much should attackthe problem with either deterministicor stochastic dynamic programming.These two are the discrete time, usually non-linear versions of optimalcontrol.It should be done. I’ve done suchthings before — they don’t have tobe too difficult.

48. Gregory Magarshak

It can be done. We’ve done it. But at the expense of growth. We’ve sort of been the beneficiaries of having received a lot of “we love you but you’re too early” from VCs. As a result we built out a viable business and got revenues, and can now focus on viral growth.Having said that, my advice to entrepreneurs would be to give up more of your company early on, and accomplish more things at once. The only reason we didn’t do that with Qbix is because we’re really passionate about our long-term vision and plan to be doing this 5-10 years from now. We want to be for people’s social lives what Google is for their information.

49. Michael Brady

Great article as always Fred! You are the most balanced writer on the tech scene around AND you are a VC. Wow!The one thing I think is missing for your piece is the economic cycle. I think you have to tilt / adjust your analysis and ratios depending on where we are in the economic cycle. It was fine two or three years ago to be going gang-busters for growth with interest rates as zero and money freely available. We are now at a stage where interest rates are just about to start going up and money supply will be restricted. They will affect private funding dramatically in the next year or so.The focus at this stage in the cycle now has to become a profit. If it does not and companies keep chasing growth then they will burn cash and be in a difficult funding position when they realize that money is not longer freely available. Some companies (and plenty of unicorns) are going to find this out the hard way unfortunately but sounds like you will have your portfolio companies well warned…………

50. Zolicon

Profits verses People.

51. dineshn72

I suspect this is largely a function of the market environment. When capital is available cheap (as is the case today), focus is more on growth vs profitability; whereas during the times of scarcity of capital everyone is laser focused on becoming cash flow positive…

52. Max Win

It is next to impossible to raise money for tech startups here in Myanmar. I am currently thinking about opening a life style business (like a taxi company or a fancy restaurant) and use that revenue to support my tech startup which is not going to make any money soon. Bootstrapping seems to be the only option for now.

53. Jim Tousignant

Great post Fred…too few entrepreneurs focus on profitability

54. Ron Valderrama

As someone starting a company in Dallas, I can’t afford to play the leaky bucket growth game. Investors here are not as willing to take a chance on a company with no revenue (or plan for revenue. You are 100% correct that it forces a team to be much more scrappy and analyze every penny being spent on growth.

55. Platformula1

Wilson is being polite here in the way he is framing the issue. There is an even bigger problem than ‘Profits vs Growth’.There is a strong attempt within the larger VC community to actually redefine the meaning of the word ‘profit’ based on ‘subscription economy’ exceptionalism–i.e. that SaaS or ‘as a service’ businesses should NOT be measured on GAAP accounting principles.FYI, my piece from a year ago titled “Software is Eating the Income Statement” which pushes back on Andreessen Horowitz attempt to do just that. Since then other VCs have also taken up this banner of SaaS or subscription economy exceptionalism. Link below.https://medium.com/@Platfor…

56. Grace Hopper

I love this blog post!!!!!!!!!!I hope my use of many exclamation points properly communicates my enthusiasm :)I run a company that is growing more than 200% year over year with millions of dollars in revenue and is profitable with nearly 70% gross margins. For more than 18 months in a row now, we have operated cash flow positive every single month.What I appreciate about this post is that I feel like the tech community acts as if there are two options:(1) raise tons of money and burn through it on your way to your IPO (which happens before profitability, mind you) or (2) have a middling lifestyle business.I understand that not all profitable businesses are VC fundable, or will grow into the next big thing, but I think the continuum of companies is much more diverse than most startup entrepreneurs are wiling to acknowledge and enormous value can be created all along that continuum.Or put another way, amazing, HUGE companies are built in a myriad of ways and at the end of the day, fundamentally sound economics are…fundamentally sound.

57. Dan Woods

Here is some sober thinking from Mike Tuchen of Talend along the same lines. Tuchen says companies that raise a bunch of money often become extremely sloppy in execution. http://www.forbes.com/sites…

58. christopolis

growth=bribing people with free stuff to help keep the story going

59. Joerg Stimmer

If one does have the backup by investorsand can focus on growth for a longer period it sees a good idea, especially inB2C. Our SaaS company is purely in the B2B market where sales cycles are long.In addition, my experience is that being in the market for a certain period (afew years) and truly claiming to be profitable was a key asset when talking tonew customers and an important stimulator for growth (we now work on, afterbeing in business for several year). This might be a specific experience of astart up originating from Germany.

60. apurva

The growth chasing tendency of entrepreneurs that you complain about has majorly been created and fueled by the valuation strategies of venture capital industry.I do not see any bootstrapped businesses fueled by revenue and not venture capital adopt a reckless growth mindset. This is IMHO probably the biggest reason some entrepreneurs avoid venture capital.

61. Nick Lashinsky

I think it makes sense to earmark money to burn when you’re running experiments to look for a product market fit – plus, who the hell knows what profitability will look like? But when it comes to pouring fuel in to a business for growth, if the goal is to build a sustainable b2b business, I would think you’d really want to be at least be chasing profitability. And I think Fred is talking about growth rounds: B/C, etc..You know, I’ve now worked in both extremes, and I’ve seen how the financial discipline from building organically grown businesses can provide for very helpful, refreshing business instincts that startup teams out here in SF highly value: When you’re working to build a profitable business, you think about how to be better at sales, a lot. Sales also happens to be a critical tool for finding product/market fit.After the crash of 2008 I was in NY focusing on maintaining profitable, organic growth working for a privately owned energy services company. The owner, a former wall-street guy, has built to the company from around ~30 when I joined in 2010 to around ~350 employees today – growing in a highly financially disciplined manner with each leader held accountable for their own regional or functional profit centers. For example, when I opened the NYC office, I wasn’t able to hire another sales person until I could sell enough to support both of our salaries – and the same went for the operations team. This model when done well, can foster healthy competition, financial stewardship, great salesmanship + creativity! While anyone can blow money, this kind of discipline provides an awesome training ground for business leaders that I think Silicon Valley would benefit tremendously from seeing more of.

62. geeknews

Maybe your should look at what RawVoice is doing. VC’s did not even give us a chance and all the companies that they invested in our space in are gone.. Millions burned.. But we are still here. We had to be smart, we had to watch expenses and we are still growing rapidly.Would I take VC money now.. No.I also know that we would be in the graveyard had we had the chance to take money in the beginning. Our goal continues to be to not have a lifestyle company but being profitable for 10 years is still quite satisfying.

63. Chris Johnson

@fredwilson:disqus I’m curious why more VCs don’t take more of a portfolio approach here, focusing some of their investments in a given fund on startups that have achieved breakeven (and therefore are presumably less risky) and the rest on the negative-cash-flow moonshots (which naturally must be more risky). Private equity firms do the equivalent (i.e. consider allocating some capital to presumably lower risk companies that should generate a baseline return for the fund and the rest to riskier plays). Is this ever part of your equation? If it is for many VCs, it certainly doesn’t get much airtime.

64. Lili Balfour

Agree with that last sentence — entrepreneurs look to those who came before them for guidance. And if those who came before them didn’t focus on profit, they assume they don’t have to either.When we hit a down cycle and the funding runs low, which I believe is coming in the next 18 months, those who focused on profitability will be better positioned to attract new capital (if needed).

65. Rainer Dechet

good to read … many thanks

66. Ash Patel

Angels, incubators and VCs should force their portfolio’s founders to study balance sheets. I’ve spoken with quite a few founders wanting to be profitable, but not doing the right math. Scary.

67. Ludwig

I was wondering how you can apply this rule to a company that has no revenue at all yet, e.g. a company that is offering an app with a future subscription model (that’s not been activated yet) to focus on user growth for now?

1. Lili Balfour

I would focus on user growth and benchmark it against similar companies.

68. The Heasman

Different markets have different appetites.I have no experience, but I really can’t see VCs in London chasing Unicorns the way people in the Valley are.

69. Natwar M

Couldn’t agree more, a few days back I read this article (http://blog.hubstaff.com/sa… which touches same point (profitability) but from a really different side..what do you think? – Natwar

70. Jeffrey Lim

Most of the startup in Asia put profit above all. Of course market share is equally important

71. Chris Jagers

Of course every business/vertical is different, but there is still a clear take-away here. I like ALWAYS talking about growth and profitability in terms of each other. They are two levers that operate in tandem, and it makes no sense to discuss one without the other.When VC or aquirers ask about revenue, the answer should always be: “Revenue is X because Profitability is Y.”

72. Dave Pinsen

It was an image, which Disqus doesn’t let us edit after posting, but I’ll try attaching it to this comment too. In case it doesn’t work, here’s a link to the author’s page on the book: http://www.nigelcliff.com/?…

Negative Gross Margins

There’s been a lot of talk coming out of silicon valley lately about fast growing companies with high valuations that are going to face problems in the coming year(s).

Bill Gurley said this recently:

“I do think you’ll see some dead unicorns this year”

Mike Moritz said this recently:

“There are a considerable number of unicorns that will become extinct.”

But how is this going to happen?

The most likely scenario is the thing that has been driving growth (and valuations) for these companies ultimately comes home  to roost. And that is negative gross margins.

We have seen a tremendous number of high growth companies raising money this year with negative gross margins. Which means they sell something for less than it costs them to make it.

It can be an “on-demand” service provider that subsidizes the cost of the workers on its platform so that the service seems like it costs less than it actually does. Why would an on-demand startup take this approach? To build demand for the service, of course. The idea is get users hooked on a home cleaning service, a ridesharing service, a food delivery service, or a gym roaming service by bringing it to market at a price point that is highly attractive and then, once the users are truly hooked, take the price up.

It can be a service provided to startups, like the ability to ship via an API, or the ability to process payments via an API, or the ability to pay your employees or give them benefits. All of these examples have a real cost component to them. They are not pure software. And there are providers in the market who are not passing through the true cost, in effect subsidizing the cost of the service, to gain market share. This results in fast growth but negative gross margins. Again, the companies that are doing this are hoping that once they get to scale and users are “locked in”, they can raise prices.

There are other examples out there of companies with negative gross margins, but these two categories are where we’ve seen a lot of this kind of behavior.

The thing that is wrong with this strategy is that taking prices up, or using your volume to drive costs down, in order to get to positive gross margins is a lot harder than most people think. If there are other startups competing with you and offering a similar service, you aren’t going to be able to take prices up without losing customers to a similar competitor, unless your service truly has “lock in.” And most don’t. Using volume to drive costs down can work, but if there are similar services out there, the provider who is being asked to take a cut by you might just move their supply over to another competitor offering a higher price.

The bottom line is the primary way this strategy works is if you obtain a monopoly position in your market and you are the only game in town for your customers and suppliers. But given the massive amount of startup capital that is out there and the endless number of entrepreneurs starting businesses similar to each other these days, I think it will be hard for most companies to achieve monopoly position (which is somewhat in conflict with what I wrote here the other day).

Yes, there will be a few that succeed with this strategy. Getting a huge lead on your competitors, raising a ton of money to operate a scorched earth strategy and force your competitors out of the market, will work for some. But not nearly as many as the capital markets seem to think.

And so most of the companies out there who are growing like weeds using a negative gross margin strategy are going to find that the capital markets will ultimately lose patience with this strategy and force them to get to positive gross margins, which will in turn cut into growth and what we will be left with is a ton of flatlined zero gross margin businesses carrying billion dollar plus valuations. And that is what Gurley and Moritz see when they look out into next year and the year beyond. They aren’t alone.

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Comments (Archived):

1. awaldstein

Bingo.This is endemic to startups in tech and very much true in the artisanal food world as well.What it creates is a race towards the bottom that invariably is a loss for everyone.Same counter logic that impacts thinking about sales. There are companies that evaluate the upside of a sale by revenue. Then there are companies with smarts who evaluate the effect of a sale by what happens as the baseline uptick after it.Great topic and welcome back!

1. Richard

Always felt that for food retailers gross margins are a poor metric for any one single product.

1. awaldstein

True but your really need to have it under control because invariably if you don’t your other cost lines will simply swallow the model and spit it out.

2. Realist50

That is generally correct.Going back many years, I know that Wal-Mart places a lot of emphasis on “basket” information looking at what products are commonly purchased together. That’s basically assessing the total gross profit margin % (and dollars) from a customer visit. That can be valuable information to decide to discount and advertise a popular (or high dollar) product to drive store traffic, or just in deciding what to stock.. I assume that other retailers look at similar metrics.There’s also the separate, but related, question of thinking about gross profit dollars in terms of shelf space. After all, a store only has so much room, and so a retailer wants to make sure that a product deserves its space. So looking at gross profit dollars per linear foot of shelf space per month or year is a useful exercise. Think through the math of that – there are various combinations of selling price of an item, gross margin percent, and rate of inventory turns that can all end up at the same place even if the particular components are very different.

2. Vasudev Ram

> and very much true in the artisanal food world as well.What, negative gross margins is, there as well?

2. jason wright

i wonder which companies this analysis could be successfully applied to?predictions please.it seems to work for drug dealers. that’s a “lock in” market.p.s. you wrote this in NYC or Paris?

3. William Mougayar

It would be interesting to name names. Otherwise everybody is looking at each other, and thinking: Moi? Maybe start an Endangered Unicorn list?

1. jason wright

shall we speculate?

1. William Mougayar

go ahead…

1. jason wright

i don’t think Gurley is referencing Uber.

1. fredwilson

Well I’d like to see their gross margins

2. kidmercury

the believers will say they are profitable in big metropolitan areas, and are exploring the boundary of the minimum urban density required for it to work (i.e. works in nyc and chicago, does it work in nashville….). plus the whole “we’ll push costs down by over 50% once the robot cars kick in” strategy.

3. Richard

Talk about a back of the envelope analysis! D – on this one

4. jason wright

is Lyft taking a different approach?

5. Richard

As an investor in sidecar, dont you have a pretty good idea of the costs per 100000 users to operate?

6. Alex Dunsdon

Would be fascinating

2. kidmercury

here’s the list of unicorns: https://www.cbinsights.com/…here’s my very cursory take on who won’t be making it (or will have to get acquired or undergo some radical restructuring):SpaceX (although potential for government funding to make this one last)DropboxSpotifyStripeDomo TechnologiesBlue ApronInstacartSnapchatprobably others too, though i’m not very familiar with a lot of them.

1. Chimpwithcans

Spotify model seems to be Soundcloud + exponentially higher costs (back catalogue and artist maintenance). No hardware advantage ala Apple Music. Easily replicable (see Tidal, Qobuz, Deezer, Rhapsody, Pandora etc etc.) In short – spot on with Spotify.

1. jason wright

i read that Deezer is spending 75% of revenues on rights holders.

2. Chimpwithcans

Tesla? Not yet profitable I believe….diesel emissions scandal may push some big players into the battery market?

1. kidmercury

tesla is not on the cbinsights list, presumably because they are a publicly traded company. i do think publicly traded companies can keep the “no profit” philosophy going much longer, because they are tapping into a much larger pool of capital.

2. Chimpwithcans

aaaah i forgot to click on that link….and of course we are talking private valuations – my bad, got excited.

3. pointsnfigures

Groupon

4. pointsnfigures

Cost of the car will push them to gas. Scandal was with VW which isn’t BMW, Mercedes, or Audi.

5. James Ferguson @kWIQly

Audi is VW Owned – I guess the smell spreads

6. Chimpwithcans

I believe it is Audi.

7. ShanaC

is public. their unicorn status fluctuates day to day in the market

3. jason wright

Dropbox – i wonder how many users have upgraded to the paid services (as a % of total users)? the 2GB free limit is not much.

1. kidmercury

i would imagine their enterprise solutions are more of an opportunity, though i believe box has a better position there. also, box IPO’d at around 1.7bn valuation. dropbox’s last round was 10bn……

2. Mike O'Horo

I’ve had the paid version for a few years now, but with Google bumping up the limit on its free Drive account, it’s starting to look like I can spread my storage between the two and drop (pun intended) back to the 2gb free acct on Dropbox.

3. jason wright

i’ll be spreading too. your move Dropbox.

4. Eric

2 GB isn’t much, but Dropbox’s problem is that competitors are giving away all the storage and typical users need for free. I imagine that bumping up against 2 GB in dropbox is more likely to inspire people to use Google Drive (which offers 15 GB and unlimited storage for photos) than it is to inspire them to pay for Dropbox.They’re dealing with this with an enterprise push, but they’re way behind Box in that arena and Box ain’t exactly worth $10 billion.

5. jason wright

i agree.

6. Adam Lipman

Dropbox and Box both are struggling to find a differentiated product. The features and functions they offer in addition to “dumb cloud storage” have not been sufficiently compelling. So here’s the thing, Google doesn’t rely on it for revenue and can get something out of it (more lock in to their ecosystem and data on you) and the cost is nominal to them. How do you compete with that? They better find that killer feature or they will be commoditized out of business.

4. ShanaC

snapchat shouldn’t be on the list, they are part of facebook now

5. Rob Larson

Theranos.Agree with you on Blue Apron and Stripe

2. Girish Mehta

Interesting – Can a mythical creature become an endangered species ? Schrodinger’s cat lives in the startup world !

1. James Ferguson @kWIQly

But how can you be sure – As soon as you open the box the myth collapses into a reality.Some people prefer the optionality of staying ignorant !

1. Girish Mehta

Yup, that was part of the analogy – “delaying opening the box” is equivalent to “staying private longer” :-). Which is what is happening.Of course Schrodinger is rumored to have said later that he wished he never met the cat.

1. James Ferguson @kWIQly

very nice metaphor – another issue is whether Schroedinger or Pandora filled the box !

2. Girish Mehta

Nice.

2. Vasudev Ram

I once made a pun apropos of something, involving Heisenberg [1] and Pauli’s principles [2], but now I’m not sure what it was … :)[1] https://en.wikipedia.org/wi…https://en.wikipedia.org/wi…

3. fredwilson

I’m not doing that. Those that are doing this sort of thing know who they are. Plus I don’t like shitting on our portfolio companies and the portfolio companies of others. But let’s be clear. We are all guilty. I am. Gurley is. Moritz is

1. LE

God I hate to always fucking say this again as it even annoys me but “you can only be as honest as your competition”. That is the driving force in why things like this happen. (I guess I could switch to “hard to be a saint when you are just a boy on the street” I guess.)

1. Sam

This is just flat out wrong. You choose where you play. And you choose how you play the game. There are plenty who can make a damn fine return (and then some) playing the game at a high standard of integrity despite what passes for acceptable business conduct around them.

1. LE

How long have you been in business for if I may ask?

2. Sam

I’m in my mid-40s. I’ve worked for multiple companies in multiple industries. I had a friend early in my career counsel me that, “You don’t want to go into investment banking, Sam. It’s not a fit for you. The asshole quotient is way too high.” (Apologies to the bankers out there. I know some fine human beings in the industry, in fact.) You make your choices. I’m living proof that you don’t have to choose “least common denominator” business conduct. You just don’t.

3. LE

True however you also said this:I had a friend early in my career counsel me that, “You don’t want to go into investment banking, Sam. It’s not a fit for you. The asshole quotient is way too high.” So the question is what would happen if you had chosen that career (because of the lack of your friends advice)? Easy to say “I would have left” but you know it’s entirely possible that once the ship sailed (perhaps you got married, kids and needed the money because of a marriage or divorce) you might have stayed in the business, hence the saying that I have. The saying doesn’t mean that in some cases you can’t choose a different profession. However my point is simply that all of the facts “assholes” are not apparent to everyone at the start. There is no consumers report (or even Tripadvisor or Amazon reviews) that clearly lay this out. Or at least in a way that a young person (with no experience) would take it seriously.The classic example I give is really an old style car repair shop. Given that because of the hidden nature of how car repairs used to be there is a bit of cheating going on. So if you are the honest shop (and have less revenue) in an industry dominated by cheaters it’s a bit hard to be the honest one. Others differ with me on this but I’ve seen it in enough businesses to know that it exists. Look, even Fred say “I’m guilty of this myself”.By the way my saying is really more relevant to someone in a business than an employee. The reason is as an employee you can more easily get up and leave. But once the car repair shop is open (or the lighting distributor) you aren’t going to just shut down and start a new business. You will play the game, make sense?

4. Sam

I understand your point of view, but I think people tend to underestimate the amount of choice they have. There is always a choice. The employee / owner distinction may change the nature of the consequences of your choice, but you still have a choice. Sell that car repair shop to someone who wants to be in that industry. Why not? Life short.And you are absolutely correct about the lack of a consumer reports. I was lucky to have a friend who knew me, knew that industry, and very clearly told me “not a fit.”

2. William Mougayar

Agreed on that aspect, given there is blame to go around. But startups never want to stop believing that everything is possible. The minute you start to inject reality and spreadsheets into their journey, it takes away the thrill of the risk and their swinging for the fences moments. However, reality is necessary at the right time. Too early it kills, and too late it kills too.

3. pointsnfigures

Never tell another guy his dog can’t hunt

4. Mike Bestvina

Wow, impressive to see an investor admitting their portfolio isn’t perfect. Appreciate your candor.Honest question – if you have a company that you’re “guilty” of, why did you invest in the first place? Are you simply following what the rest of the market values? (no shame in admitting that)

4. Richard

margins alone dont tell the story ….CAC (customer acquisition costs), retention period (opposite of churn), ARPU (average revenue per user) and LTV (lifetime value)

1. Adam Lipman

agreed and the CAC for a lot of these companies is super high. If you look at sales and marketing cost for many of them, they eclipse revenue by a large margin. This is of course attached to the cost of supporting the desired (user) growth curve. LTV is an interesting one as for most of the Unicorns this is quite subjective (assumptions can change this figure by orders of magnitude).

2. William Mougayar

true; they are a reflection / outcome of these other ones you mentioned.

4. csertoglu

Negative gross margins are also sometimes difficult to recognise. We see many startups come up with creative management reporting formats to disguise their true gross margin levels. For the inexperienced investor, these tricks may be tough to spot.

1. awaldstein

Startups are easy to analyze. The trick is that their value at an early stage has almost nothing to do the balance sheet.

1. William Mougayar

“value at an early stage has almost nothing to do the balance sheet.” Pretty damn true. you could even remove the word “almost”.

1. awaldstein

yup–that is why people like you with strong operational experience can make great investors.understanding this truly comes from on the ground experience.

1. boteman

That sounds more sensible. I almost did a spit-take when I read that last paragraph mentioning zero gross margins from “billion dollar valuations”. That makes one wonder who is assessing these valuations if they are so far off the mark, then? Believable?? Poppycock??

2. William Mougayar

true, but if you inject reality and spreadsheets too early into the journey, it may kill the entrepreneurial free spirit that “everything is possible”. That said, injecting reality too late can also be detrimental.

2. sigmaalgebra

My guess, that maybe fits the data fairly well, was that the LPs write the basic rules, and they are (for information technology; biotech seems different) (A) traction significant and growing rapidly and (B) addressing a large market. It appears that nothing else much matters.

2. fredwilson

Yupppp

5. Dave Pinsen

But given the massive amount of startup capital that is out there and the endless number of entrepreneurs starting businesses similar to each other these days, I think it will be hard for most companies to achieve monopoly positionWhy should they be allowed to maintain a monopoly position? Whatever happened to antitrust laws?

1. Michael Elling

Video is eating the web. Not software. What controls video? Sports. Address the sports monopolies and we very rapidly move to a highly fluid video on demand environment that in turn necessitates a complete rethink of the core and edge networks (and storage and processing, etc…).As an industry analyst I wrote a post in 1998 that the govt shouldn’t go after MSFT, but rather afford more competition in the last mile. MSFT’s monopoly developed because of the relative (in)efficiency of processing at the core vs the edge. Well with the advent of the iPhone MSFT’s monopoly controls evaporated. And that really wasn’t do to govt action (in fact just the opposite). We now have new monopolies that are led by content, not processing.

6. William Mougayar

I would add that this analysis applies equally (if not more) to some sub-unicorn startups, especially in the $150-$500M valuation range.These companies have most certainly raised B rounds (and some C), and their valuations got ahead of their operational soundness. And there are a lot more of them than at the unicorn levels.

7. Tom Labus

When and if they go public, they’ll get pounded by the market.

1. fredwilson

Yup. Sqaure is a great company with a product I love to use every day. We’ve discussed how much I love it here at AVC. They have 29% gross margins. So not negative. But we will see how well street likes those numbers soon

1. sigmaalgebra

Naw, everything will be okay if just follow one old rule left over from year 2000: Never be between an equity investor and the door when the lock up period is over!

2. jason wright

as a consumer? coffee shops?and you have a lot of Square stock?

8. Seenator

I think Sam Altman also referred to as Unit Economics on his take & over valuation:http://blog.samaltman.com/u…Commentators are looking hard for what’s wrong with startups in Silicon Valley. First they talked about valuations being too high. Then they talked about valuations not really meaning anything. Then they talked about companies staying private too long. Then they talked about burn rates.But something does feel off, though it’s been hard to precisely identify.I think the answer is unit economics. One of the jokes that came out of the 2000 bubble was “we lose a little money on every customer, but we make it up on volume”. This was then out of fashion for a long time as Google and Facebook hit their stride.There are now more businesses than I ever remember before that struggle to explain how their unit economics are ever going to make sense. It usually requires an explanation on the order of infinite retention (“yes, our sales and marketing costs are really high and our annual profit margins per user are thin, but we’re going to keep the customer forever”), a massive reduction in costs (“we’re going to replace all our human labor with robots”), a claim that eventually the company can stop buying users (“we acquire users for more than they’re worth for now just to get the flywheel spinning”), or something even less plausible.This is particularly common in startups that don’t pass the Peter Thiel monopoly test—these startups seem to have to spend every available dollar on user acquisition, and if they raise prices, customers defect to a similar service.

1. fredwilson

Yupppp

9. Chimpwithcans

Great post! It is the flip-side to what you wrote the other day – not in conflict, I believe.

10. Josh Goldberg

Great post. I often see early stage pitches where folks are trying to disrupt a traditional way of addressing a problem with a solution that is great for the customer. But when you think about it, you wonder how can they ever make money doing it.Some things haven’t been successfully disrupted because of lack of imagination. Some because the inherent cost to do so is too expensive it can’t be done (yet).

11. Andrey Shpak

But what about costs going down over time with scale / experience / technology innovations? So a negative margin now may mean a positive margin in two years (depending on competitive situation of course).

1. fredwilson

Can’t do that with people.

1. pointsnfigures

people get more efficient and better at their jobs over time though. So, you conceivably should get more production out of the same salary. Hard to measure and hard to count on.

1. Stephen Voris

I’m pretty sure that’s what “raises” are supposed to reflect.Whether or not they actually reflect that, or scale at the same rate as the person’s productivity, is a different question (to which the answer is quite frequently “no”).

2. Andrey Shpak

Well, yes and no. People (a) learn, (b) develop better and more efficient processes, and (c) can use different and better software. Over time more processing power allows for more powerful software, which may provide productivity benefits.

2. Realist50

That can sometimes happen, but the company needs a clear explanation of how and why that will occur.For example, if I have a factory capable of making 2 million widgets per day, but I’m currently only making 1 million, I’m underutilized and almost certainly incurring higher cost per widget as a result. It’s possible to come up with a pretty good cost model of what my cost per widget would be if I instead ran near capacity. COGS are always some mixture of purely variable costs, semi-variable costs (e.g., step function type of costs), and fixed costs.The thing is that a lot of so-called “sharing economy” companies will discount the price of a service below the purely variable cost of what a third-party driver or worker is being paid to provide the service. There isn’t any efficiency in the world that can make up for that – the company needs to charge the customer more and/or pay the supplier less. So, as Fred says in his post, correcting that requires making pricing changes, sometimes drastic ones. That’s generally pretty difficult to do without driving off your customers or suppliers.

12. Salt Shaker

So, where does the blame lie, with entrepreneurs who lack operational experience and a sound biz model or the investors who fundamentally turn a blind eye and roll the dice and pray? Seems like there’s an awful lot of “fools gold” out there with fools on both sides of the table anchored to lofty valuations.The criteria for investing will certainly change when/if capital becomes more difficult/expensive to secure, while scale shouldn’t always be viewed as the senior criterion for success. High margin, low volume is perhaps a better starting point and biz model.

1. LIAD

does there have to be blame at all?it’s a high risk, high reward strategy. people ponying up the cash and those pumping the plan understand the game they’re playing and are happy to go for gold. at least initially.

1. Salt Shaker

But Is that really a sustainable strategy? Money is currently cheap, I get that. But the tides will change, it’s inevitable, particularly when they’ll be many “crash and burn” data points. I believe many, not all, should and will be reevaluating their investment strategies.

1. LE

Musical chairs some people will end up seated and some will not.

2. fredwilson

The blame belongs on everyone.

1. LE

What I said in a longer winded way. Add in of course blogs and the media.

2. karen_e

Also let us ponder the ill will. As a consumer I can sniff out when I’m being treated like so much cattle to “lock in.”

1. JimHirshfield

“…let us ponder…”I just did. Felt great. We should all ponder for a few minutes every morning. Yoga for the brain.

1. Girish Mehta

Would I need a yoga mat for that ? Pondering the imponderable…

2. JimHirshfield

Only if you ponder on the road.

3. Anne Libby

I kind of count on you to punder.

4. JimHirshfield

Brilliant!

5. Pranay Srinivasan

pondering while I encash a $10 coupon for a free meal i just ordered on my app. pondering also while i uninstall that app to install a new app where I just got another free meal for $10.

3. Chimpwithcans

Yes, clearly the model is marketable. Plenty negative gross margin cos. to invest it it seems.

3. LE

The blame is the collective experience and environment. You have not only entrepreneurs (in some cases) who lack any operational experience (and have never run any business) but you also have investors who perhaps have never run any business. Or maybe have only run a business that is an internet or tech business (in other words not a traditional company). [1] As a result the only schooling that they have (if you want to call it that) is how these types of businesses operate. They’ve seen some of the success and some failure but are driven by the successes mostly. (After all look how Amazon has survived despite constant losses over the years).When you think about it it makes more sense than it doesn’t.[1] And by virtue of the fact that they are now an investor won very big at whatever they did to get to that place.

4. christopolis

because of monetary policy the blame lands on the US government and me and you for not stopping it. Malinvestment is an inevitable outcome of printing money to fix problems.

5. iggyfanlo

Just like cheap mortgages of 2006-07… partly the government for low rates (subsidized pricing), partly on the investors for stretching for bad yield, partly on the bankers for “packaging” and structuring credit (sleight of hand) and partly on the homeowner for buying too much house

6. Alex Dunsdon

Everyone. It is the institutionalised culture. We are all subconsciously influenced by it. Till we’re not.

13. Douglas Crets

I think fear that your product won’t sell is what leads people to take this negative gross margins strategy, and at the same time, they don’t invest in good marketing strategies. They get behind the ball before the rack is lifted.

14. JimHirshfield

Stick to making picks and shovels, kids. The unit economics always work out.

15. Jabez Boyd

I’d argue not unicorns alone…big and small.

16. LIAD

If rich VCs want to subsidize my elite on-demand, servitude-bubble inducing lifestyle…Oh, but wait.1/VCs are backed by Pension/Saving Funds financed by Main St.2/On-demand economy workforce comprised of low/middle income earnersIf low/middle income earners want to subsidize my elite on-demand, servitude-bubble inducing lifestyle…#oh

1. Richard

On demand is just the midern equivalent of a part time job. The on demand economy makes a lot of sense for a lot of people

1. ShanaC

for how long

2. Realist50

I agree with that to a point.I do wonder if Uber and Lyft’s attractiveness to drivers will wane over the years once drivers have been with them long enough to get a sense just how little money they are making after taking into account full vehicle costs – not just gasoline, but also depreciation, maintenance, etc. As a proxy for that all-in cost, look at the IRS mileage rate of 57.5 cents per mile.I strongly suspect that a lot of Uber and Lyft drivers are currently thinking about their costs just in terms of gasoline, but that may change over time.

17. James Ferguson @kWIQly

Spot onCorollary – In such an environment there is no incentive to develop a profitable business model – It is ‘better’ to be better at raising funds.That the markets are obviously inefficient is clear -Less obvious is that a winner would emerge absent VCSo all the VC money thrown at growth (rather than investment into process, efficiency, R&D etc) is at a meta-level a zero sum game.This also suggests that a “serial fund raiser” that most beloved Wunderkind of VC may simply be adept at playing this game well – It is very different than adding net value to the economy, and such a funded growth streak will come to an end.Funding market share is a bit like advertising – better for society if nobody plays, better if entrepreneurs win on merit -OK it isn’t going to happen, but if a VC can find a team who could win on merit and back their proposition they are relatively much better off under any scenario. Ergo fund companies with a viable business model !If lean is good for a startup and you only hit the gas post PMFVC lean equivalent is to fund once business model is proven

18. Neima

At the end of the day, its simple – startups need to create products that people appreciate and are willing to spend their money on. So, why are there so many high valuation companies out there who aren’t doing this? Why are VCs investing in them?VERY frustrating!

19. Chimpwithcans

Negative gross margins. What a stupid concept on which to base a company. Surely that should be step one – ask yourself what is a product/service you can actually create/do for someone, and sell to a customer for a profit. it can even be 1 cent profit, but there has to be a profit! Then refine. It’s hard to tell a rosy future to investors, even harder when you are in the red.

20. LIAD

‘negative gross margins’ – clever business speak that takes the sting out of the situation. reframes it. turns it into something praiseworthy.”we are proud of our industry leading negative gross margins. the team are to be congratulated on their wonderful achievement”Negative gross margins is one way of saying it. Another is losing money on every sale.

1. sigmaalgebra

Gotta get you a gig as press secretary at the White House!

1. LIAD

lol. no thanks. look where the last one ended up. trolling on medium!

1. Salt Shaker

Carney made a bad situation worse. As Amazon’s lofty (and likely pricey) hired gun, he was clearly embarrassed and felt blindsided. You’d think that wouldn’t happen to someone w/ his PR experience and credentials.

1. LE

Bad? Worse? Care to speculate on the dent that Amazon’s sales will take? Ok so it’s a bit of the Streisand effect. More attention. But Carney’s audience is perhaps not Amazon’s customers but someone else. Give that some thought. If something doesn’t make sense often there is something that you don’t know or haven’t considered. [1]Anyone stopping buying from Amazon as a result of what they have read? [2] I haven’t. They are a great source for what I need.[1] Every single expert and pundit, almost without exception, got Trump wrong. They didn’t understand the game he was playing.[2] Did football take a hit as a result of any negative press? People are willing to look the other way if they are addicted to something.

2. Salt Shaker

If what you’re hypothesizing is true, and I’m not doubting you, then why should Carney respond at all? Plain and simple, ego.

3. LE

Nope. Not with Carney. The strategy may be wrong (I mean it’s possible) but you can trust that it was well thought out and fleshed out. Not every plan works. But it wasn’t for ego I am pretty sure of that.

4. Salt Shaker

Then why post on Medium as a personal response rather than handle as a corporate rebuttal?

5. Amar

I had the same thought. The response that made sense to me was – “Amazon is doing this to keep its internal morale high”. Yes, a memo might be enough but for the thousands still employed there it sends a positive message to see their workplace defended in public.That said, it felt like a complete waste of time to me as an outsider. It did not change my mind on the topic. It made it murkier than it was and confirmed that there smoke even though no one can point to the actual fire.

6. LE

To step out of the “I am a tool” box that he would be in if he handled it as a corporate rebuttal perhaps. Once again, from someone like that, for something like that, things are well thought out. This is not to say that mistakes aren’t made. Only that there is a method to the “madness”. In what I do it’s the way way. Everything is well calculated out. And often bizarre and “truth is stranger than fiction” to those who don’t know my motives. Nothing is left to chance. (Wish I could give examples but unfortunately, I can’t.)

7. sigmaalgebra

Here’s a candidate reason Amazon responded via Carney: (1) I have zip, zilch, and zero respect for the honor of the mainstream media (MSM) and less than that for the NYT. (2) The MSM are interested in eyeballs for ads and then ad revenue. The editorial content is smelly bait for the ad hook. (3) The MSM uses whatever techniques, from formula fiction, grab’m by the heart, the gut, below the belt, scare’m with scandal, danger, threats, etc. (4) The MSM like to start a story, maybe just made up, keep writing about it more and more, try to get other MSM outlets to form a gang of bullies and pile on, and maybe, out of just thin air, convince a lot of people that the made up story was true. (5) One of the NYT story themes is evil capitalistic big business.So, for Amazon, they have to be alert to the possibility that the NYT will just use Amazon as raw material for such stories, just make stuff up, distort, lie, mislead, whatever, to make Amazon look evil, to up the paranoid anxiety level of NYT readers, and just keep feeding off Amazon, on and on, as long at the NYT can keep getting eyeballs.Such an NYT attack could seriously hurt Amazon. So, Amazon has to be ready to defend themselves and, really, to fight back, e.g., to undercut the credibility of the NYT in front of the target NYT audience. Gotta teach the NYT a lesson; gotta make them hurt; gotta cost the NYT readers, eyeballs, and ad revenue; gotta make the NYT not do that again, at least not to Amazon. Amazon has some ways to fight back, e.g., with what ads they run, with what media they sell,E.g., Amazon could produce a movie to hang out any and all NYT dirty laundry they could find, infer, suggest, hint, report from rumor, etc., heavily promote the movie, offer it for download at a low price, etc.It used to be “Don’t get into a public argument with someone who buys ink by the barrel.” Well, now, don’t pick a fight with a company that is one of the biggest players on the Internet.I’m concluding that more generally it’s best not to be a public figure unless really have to be and, then, to be ready to pay for high end legal efforts as part of fighting back. Else, the MSM might just decide to eat alive such a person or company, like rats on a prisoner in chains.In particular, I’m concluding that long ago, six months, maybe six years, Trump saw that as soon as he announced for POTUS the MSM would be awash in rats, hyenas, jackals, snakes, sharks, etc. out to create a story, a theme, a gang of MSM bullies, piling piling on, running nonsense, nasty stories nonstop until Trump withdrew from the race. So, right away Trump fought back: He pushed back hard against Kelly, Ailes, Fox, etc. More than once he had to tell Fox that he would not appear on their shows. He made it clear that, to interview him and, thus, get the eyeballs and ad revenue, have to be fair. So, finally, now he has the MSM mostly calmed down, maybe even intimidated. I can’t think of any politician who ever did anything like that before. The MSM would have loved to have eaten Trump alive. Well, they didn’t get to. And their many predictions that Trump would quit have shown some of how bad the MSM really is.If I have to appear before the MSM, then maybe I will bring a 3 ring binder about three inches thick with index tabs and full of details where the MSM did dirty stuff, got stuff badly wrong, was obviously biased, etc. E.g., if interviewed by the NYT, as soon as the first question was asked, I’d turn to the binder and say, “So, this question is from the once revered, now highly self-esteemed, NYT that (A) messed up with …, (B) got it totally wrong with …, (C) over and over ran propaganda on …, etc. That’s the source of your question. Okay, now that we have that source clearly in mind ….” Just treat the MSM and the NYT as rabid skunks — get too close and will come away smelling bad or might not come away at all. Just keep that in mind — rabid skunks. Over again: Rabid skunks.The MSM is one of the worst bottlenecks to progress in the US.Why? I want information about government, the economy, foreign affairs, etc. The MSM gets a grade of F — never even a D-. Why? They fail even standard high school term paper writing standards of providing references. A high school term paper written without references gets a grade of F. So should all of the content from the MSM and NYT. All of it. Grade of F.Give references, and still the grade will be F because of a long list of other failings. E.g., the MSM is unable to report a percentage meaningfully. E.g., they are willing to say, “Earnings were up 5.4%”. Meaningless nonsense. A percentage change is between two numbers and an interval of time, and the MSM absolutely refuse to report the details on the two numbers or the interval of time. Grade of F.That the MSM get a grade of F goes way back: E.g., there is a 1930s Andy Hardy movie that made fun of newspapers, asserted that the credibility and accuracy are just laughably bad — and no doubt the movie audience agreed.The situation goes on and on this way, The MSM is really, at best, essentially only light entertainment. The problem is, voting citizens are not getting the information they need and lots of people and organizations are hurt by the rabid skunks.Maybe Amazon should do a movie, All the News Unfit to Print, with a sequel It Can’t Get Any Worse Than the NYT.The good news is that the Internet is well on the way to solving this problem. E.g., there is the WaPo: They used to regard themselves as the last word about anything within 100 miles of the Washington Monument. And maybe much the same for other major newspapers, TV channels, etc. But, to heck with DC, NY, Boston, LA, etc. All those MSM players are now just Web sites and have to compete with the world — no more geographical barrier to entry. No more living off just the home town audience.And, the idea of one news source is also on the way out: Instead, there stands to be fantastic splintering into niches so that each reader can get what they want for their own interests. Some readers will want something like a scandal rag with three headed goats and aliens born to women on earth; others will want the deepest and most solid material anyone can write; and nearly any such interest will have media specialized for that interest.NYT? RIP. It’s a beautiful new day!

8. Douglas Crets

If I may insert my two cents.. because Bezos told him to.

9. Douglas Crets

It would happen to someone who doesn’t have to fight a very docile press. In my opinion, Jay Carney didn’t earn his presidential chops managing the press. He earned it answering questions and redirecting queries and comments. The “press” is not at all invested socially in asking questions and writing the real stories. It’s a paper mill.

2. fredwilson

A scene for Silicon Valley TV show!

1. Rob Underwood

Reminds me of a anecdote I heard when I was consulting from a client. A large NEM (Network Equipment Manufacturer) implemented a new service management system. The highlight of the system was that customers could now self-create service tickets — tickets that would initiate the break-fix triage and escalation process.The “go-live” of the system was widely celebrated organization-wide when in the first month it was live the system resulted in a tripling of the number of service tickets created since there was no friction of a CSR between a customer and a ticket. The only problem? The actual service delivery organization itself had no way to respond to triple the volume AND many/most of the new tickets were issues that could have and should have been resolved without service engineer intervention. The celebrated new system, with proud headlines organization-wide about the tripling of service tickets, broke (temporarily) the entire services management group of this NEM.

1. CJ

This is my space. 🙂 Most companies get sold that the tool is the answer, that it’s magic and that it will fix all ailments. That’s BS. The tool will expose you quicker than an emperor with new dress. ESPECIALLY because technology change is easier than people change and is often used as a substitute. And that’s exactly what happened here, they had these issues before but their customers had no way to make that known. Now they know. :-)They also misjudged the internal demand to remove interaction with their group. They were attempting to reduce friction for themselves and never thought through the use-case from the customer’s end. Services organizations often have an unjustifiably high opinion of themselves. Finally, they implemented Self-Service without Self-Help. Knowledge has to be implemented right alongside Self-Service. However this team wasn’t trying to reduce friction for the CSR – so they never considered the customer’s point of view. So they didn’t anticipate the increased demand, they never knew that demand existed. But again, now they know. :-)I bet I can even tell you the name of the tool they used: ServiceNow.

2. Bostonian128

Russ Hanneman: Do you know what ROI stands for, Radio on the Internet, and do you know how to get rich? Negative Gross Margins!

3. steveobd

I think we know someone who can make that happen 😉

3. iggyfanlo

This is a variant of the “buying revenue” days of 2000

4. jason wright

TechMeme liked it.

21. sigmaalgebra

Ah, Fred, you are missing the importance of the old business strategy: Of course we lose money on each sale, but we’ll make it up on the volume! :-)It’s beyond me why any serious money would be invested in a startup that wants to sell a dollar for 75 cents on the hope and prayer that the hooked customers will later be willing to pay, say, $1.25.Hope and prayers; gee.If can sell “Hope and change”, then maybe can also sell hope and prayers?Instead, I have to suspect some other rationalizations.Then reading on I see: raising a ton of money to operate a scorched earth strategy and force your competitors out of the market, Good, at least one rationalization.Maybe another rationalization: To get into a market, raise a lot of equity cash, e.g., from traditional private equity, do a traditional roll-up in the market, that is, buy out competitors, and then, with a really strong market position, say, a near monopoly, raise prices. Maybe.Another rationalization: Get a lot of publicity about being a unicorn, that is, worth $1+ billion, and hope (that word again) that this publicity will increase the exit price in some M&A, acquihire, or IPO. zero gross margin businesses carrying billion dollar plus valuations. I agree except for the stuff about the “billion dollar plus valuations” which sounds like funny numbers to me. I have to suspect that look at the deal terms and find some version of “heads I win, tails you lose” or “heads and both the investor and entrepreneur win a lot; tails the investor wins a little.”So, what are the terms, senior preferred stock with a 3X liquidation preference and a full ratchet anti-dilution clause or some such?I’m reminded of the joke yesterday, let’s see:To have valuation of $1 billion, naw, let’s be generous, $10 billion, sell, let’s see,10 * 10**9 * x / 100 = 1000orx = 100 * 1000 / ( 10 * 10**9 )= 1 * 10**(-5)%of the company for $1000. So, the investment was $1000 and the valuation is $10 billion. Easy!Also this stuff about negative margins confirms my reaction reading Samuelson’s college text on economics: It seemed that his description of the Fed was solid, but I couldn’t find anything else in the book to pass even the sniff test or the giggle test. In particular, the supply and demand curves didn’t consider suppliers deliberately selling at a loss! But, actually, there have long been simple cases, e.g., a grocery store selling a loss leader.Also one of the biggies was transistors: They started out going for some dollars each. Then the number sold went through the roof so that, by any of the supply-demand curve analysis, so should have the price, say, to thousands of dollars for each transistor. Nope: Instead now we can buy some electronic device with some tens of millions of transistors, maybe a billion transistors, for ballpark $150.Result: Selling more units of something can reduce the price per unit, from simple economy of scale, or, as for transistors, great progress in making them, that progress paid for by the initial high margins.Once it was suggested that I take a course in economics. I went to the class, on time, sat in the front, paid careful attention, said nothing, took good notes, and when the class ended and all the other students had left asked the prof what he was assuming about his supply and demand curves — monotone, continuous, uniformly continuous, differentiable, continuously differentiable, Lipschitz continuous, convex, quasi-convex, pseudo-convex, Riemann integrable (there are examples of functions differentiable but whose derivative is not Riemann integrable), measurable, or what? Gee, these definitions are important in mathematical economics, e.g., a famous paper by Arrow, Hurwicz, and Uzawa deep into the Kuhn-Tucker conditions where such definitions and more are crucial. Uh, I was pretty good with some of the fine details of the Kuhn-Tucker conditions!Later the same day I got a call to contact my major prof, and he announced “You are out of the economics class”.Although that was not my intention, fine with me!Gee, I must have terrified that econ prof! Poor guy! If he is going to use some math, then maybe first he should go learn some!Considering how the real economy sometimes works, e.g., negative margins, I’m glad I didn’t waste my time with that econ prof’s half baked, trivial nonsense.Later a friend told me about his dry cleaning business: He went to a town about the right size, not too big or too small, with no Mafia role, bought a dry cleaning store, used a less expensive approach to dry cleaning, lowered his prices, got the business, went to the nearest competitive store about the time it had lost too much money, bought out that store, did this a few times, then had a geographical area with a local monopoly, e.g., was next to a large lake which, of course, cut out about half of the potential competition and number of stores he would have to buy to get his monopoly, raised his prices, did well, got a nice yacht, etc. So, he did a small version of a roll up. I didn’t see that in Samuelson or that econ lecture!

1. Jim Ritchie

Ha, good story.As a math and computer science major myself I can relate to not understanding the “pseudo science and math” that economic theory is built upon. Most of it is a lot of baloney. The fact there is a Nobel Prize for economics is even more laughable.

1. sigmaalgebra

Yes, I was a math major. Computer science? Taught it at Georgetown and Ohio State. Took it? Essentially no! I was, uh, self-taught in computer science! Taught it, used it, did research in it, published some of the research? Yes. Took a course in it? Essentially no!At Ohio State, we very much needed better computing. In the first faculty meeting after I’d arrived on campus, I stood and shot my mouth off and then was asked to go shopping. The longest sitting CIO in US higher education opposed me, bitterly. IBM’s super salesman Buck Rodgers came calling, twice. The local IBM branch office worked hard for the business, selling to everyone relevant on campus but me and tried to insult me. I had something in mind I’d used and managed when I was a grad student. Net: IBM 0. Me 1. The CIO? Ohio State got a new one, and I served on the selection committee. I was made Chair of the business school computer committee. So, I beat the CIO and the super salesman! The site did well for years.We got the secretaries terminals and printers. So, at home, as time sharing, before a test, I’d type in the test and use the access control list (ACL) features of the OS (which borrowed some from Multics) and then deposit the test in one of the secretary’s directories (with an ACL for write only!) for her to print out and hand to reproduction and have my tests ready to go by class time! Worked great!For that paper by Arrow, Hurwicz, and Uzawa, sure, the first two won Nobel prizes in econ. As a grad student studying the Kuhn-Tucker conditions, I saw a question about constraint qualifications and saw no solution in the library; none of my profs saw a solution; so I got a reading course to get a solution. I did, in about two weeks. Fast reading course! It was also the last credit I needed for a Master’s.In part I discovered and showed that, for the set of real numbers R, a positive integer n, and a closed subset C of R^n, there exists a functionf: R^n –> Rthat is strictly positive on C, 0 otherwise, and infinitely differentiable. That’s comparable with the Whitney extension theorem — I assumed a little less than Whitney and got a little less. But Whitney assumed a little too much for my application of my theorem to solve my problem.So, sure, for interesting closed sets, consider some bizarre ones: In R, (A) a Cantor set, (B) a Cantor set of positive measure, in R^2 (C) the Mandelbrot set, (D) a sample path of 2D Brownian motion. So, an infinitely differentiable function can have a bizarre level set. So, a set can be a level set of an infinitely differentiable function if and only if that set is closed. Curious. As we know from Mandelbrot, a lake is a good candidate for a fractal. So, a mountain range can have a surface that is infinitely differentiable but, still, have lakes that are fractals, say, a Brownian motion stream (low flow rate!) feeding a Mandelbrot lake! That result polished my halo in the department!How to prove it? Intuitive outline: If C = R^n, then there’s nothing to prove. Else pick countable dense set, x(i), i = 1, 2, …, in R^n – C. For each i, find the distance (which has to exist, e.g., from just compactness) r(i) from x(i) to C. Look in Rudin’s Principles for the little exercise of a g: R –> R 0 on (-infinity, 0], strictly positive otherwise, and infinitely differentiable — sure, the function makes crucial use of the exponential. Then for each i, consider the circle in R^n with x(i) as center and radius r(i) and use that Rudin exercise to define the function on rays from x(i) to the boundary so that on the circle get an infinitely differentiable mountain (in R^(n + 1)) positive at x(i) and going to 0 on the boundary of the circle. Then add up the mountains in a convergent, smooth way. Done.So, to solve my problem, and apply my little theorem, I cooked up a bizarre closed set, in R^2, rays from the origin where there is one ray for each positive rational less than 1, for positive integers p and q, p/q in lowest terms, where the length of the ray is 1/q and the angle of the ray is p radians. So, get a bizarre spiny urchin! Near the origin gets to be a busy place! Easily enough the urchin is closed!When I went to publish, I discovered the Arrow, et al. paper and that they had stated but not solved a problem close to the one I’d solved. Well, my work also solved their problem! Ah, the Nobel committee hasn’t called me yet! And, poor Uzawa, I suspect he hasn’t gotten his prize yet, either!A useless paper? Oh, no! It was applied math! How? It was the last I needed for my Master’s! Also with such research and the polish on my halo, my path to my Ph.D. was much easier, especially since by then I already had a manuscript with the core research!We shouldn’t laugh at pure math: Eventually the last laugh might be for the pure mathematician! E.g., one paper I published in anomaly detection is, intuitively, like declaring any point in a lake an anomaly, and the technique can approximate, as closely as we please, fractal lakes. So, the work is for detecting the onerous, bitterly challenging zero day problems in server farms and networks. The technique comes with a knob can turn to select false alarm rate in small steps over a wide range and, then, get that rate essentially exactly in practice (false alarm rate, usually too high, is a @JLM “barbed wire enema” for system management staffs). Also the technique has some good results on detection rate.The technique is a little like pouring water into Fred’shttps://scontent-lga3-1.cdn…and adjusting the false alarm rate, and the detection rate, by how much water pour in.

1. Michael Elling

As a former student of the dismal science I would agree. And there is very little good economic theory and modeling particularly around network effect (as it confounds classic economic theory). A simple example:1 actor has 1m subs. 10 other actors have 10k subs each, or 100k in total. With bill and keep there is a simple flat connection pipe that sends no price signals or (dis)incentives, other than traffic between these actors. The net effect is linear growth between the 11 actors.However, with terminating settlements that are relatively higher for the 10 smaller actors and relatively lower for the large player, we will see geometric growth across all 1.1m subs. The smaller players relatively higher costs are evened out by the settlements and the resulting traffic growth. And the larger player will end up with absolutely larger growth. I’ve looked for economic papers on this rather simple math and can’t find any. Every analysis focuses on artificially high costs and inefficient redistribution that doesn’t take into account marginal demand.Settlements need to reflect economic reality clearing supply and demand ex ante. Settlements have had a dirty connotation since they were first imposed by the US in 1913 and again in 1934 when the US govt failed to mandate interconnection at layers 1 and 2 and protected inefficient investment by cloaking it under “universal service funding”.But with today’s mobility, video-on-demand and 2-way video markets, and looming internet of things, competitive markets can indeed provide universal service if interconnection is mandated and the regulators “shepherd and guide” balanced settlements through the right sort of analytical framework.

1. sigmaalgebra

If I can get a more clear description, with more definitions, of what you are discussing, I’ll see if a math description pops into my mind.Of course, likely the reason Arrow, et al. were interested in the Kuhn-Tucker conditions is that they were trying to say how some part of an economy worked by assuming that the players in that economy were doing some optimization.The Kuhn-Tucker conditions, then, are for optimization. Usually they are necessary conditions for optimality. So, looking for an optimal solution, look only where the Kuhn-Tucker conditions hold. With some more assumptions, convexity and related weaker assumptions, can also have that the Kuhn-Tucker conditions (KTC) sufficient for optimality. That is, if find a point that satisfies the KTC, then know that that point is optimal.The KTC are a fancy case of Lagrange multipliers.Intuitively, KTC necessity says that if wandering in a cave and looking for the bottom and put down a marble, to be at the bottom it is necessary that the marble not roll. For this to happen, the slope of the floor and the location of the walls have to be to keep the marble from rolling. To make the KTC true, the constraints, e.g., the walls, have to be reasonably nice mathematically. For nice there are conditions, a rather long list. Just need any one of the conditions on the list. Some of the conditions are easy to verify and others, more difficult.Some questions in economics also want to see saddle points, and there are theorems, e.g., Sion, about those, too.The closest I came to math for network effects was likely the time I saved FedEx with a little calculus for revenue projections for the BoD: From the airplane capacity, we knew the maximum daily revenue b. For time t and revenue y(t) at time t, assume that growth is due to the network effect of current customers communicating with potential customers, e.g., by sending them a package via FedEx. Then the growth rate in revenue per day should be directly proportional to the product of (A) number of current customers talking and (B) the number of potential customers listening. So, for some constant of proportionality the growth rate, say, dollars per day d/dt y(t) = y'(t), that is, the calculus first derivative, should satisfyy'(t) = k y(t) ( b – y(t) )Of course we also know y(0), that is, the current revenue.So, sure, with just freshman calculus, no course in differential equations needed, there is a closed form solution, right, in terms of exponentials. The solutons are lazy S curves that start at y(0), rise, and are asymptotic to b from below.That solution may be the logistic curve.So, if consider FedEx as being an example of a network effect, then that little equation is one simple model of its growth. .

22. Richard Lee

Will this cycle take much longer to play out? cheap debt, massive capital raising w expensive equity, so more cash on the b/s for the ‘unicorns’. also, maybe more m&a for the ‘haves’.

23. James Ferguson @kWIQly

Roger L Martine writes: (Fixing the Game)“A pervasive emphasis on the expectations market,” writes Martin, “has reduced shareholder value, created misplaced and ill-advised incentives, generated inauthenticity in our executives, and introduced parasitic market players. The moral authority of business diminishes with each passing year, as customers, employees, and average citizens grow increasingly appalled by the behavior of business and the seeming greed of its leaders. At the same time, the period between market meltdowns is shrinking, Capital markets—and the whole of the American capitalist system—hang in the balance.”Is this not exactly what Fred is talking about – Chasing expectations rather than value

24. Rob Underwood

While I understand there are operational differences between what’s described in the post and freemium (basic product for free, better product for significant positive gross margin, together averaging out to a respectable organizational positive gross margin), I wonder from a practical, investing standpoint what the difference is between the negative gross margin scenario described above and what I’m seeing happen a lot especially in EdTech, namely the “free now”/”premium later” (often much later) strategy of giving away a free product for years with expectations that you’ll add paid product later (or, worse I think from a customer perspective, start charging for the previously free product). This isn’t quite the same as the pricing and volume strategies described above, but it seems fraught with the same or similar risks. I shake my head sometimes thinking about companies that have “hooked” schools, especially principals, with “free”, at the prospect that they’ll go back and start asking for money. I think that’s a tough road.

25. Elizabeth Dorsey

Isn’t it the role of the VC to have a very high level of industry expertise in the areas he/she invest in? Wouldn’t that be the assumption of the pension funds? The one that they could pass along to their own client base: low-income workers? That the VC has the industry knowledge and financial analysis acumen to do a present value analysis of revenue growth? Or are the products or services wildly innovative and impossible to analyze? And, oops, there are negative gross margins?

1. jason wright

you would naturally thing so, and there’s also the issue of the herding mentality.

26. pointsnfigures

Unit economics. Look at this extremely hard in seed. If the unit economics don’t work, the business can’t work. There are learning curve effects that can help the business change it’s costs over time as you indicate, but there is no guarantee.

1. Tom Labus

But if you’re getting a ton of cash from “late stage investors” economic reality gets tossed out the window. And it’s not your cash either

1. pointsnfigures

Yup. Interesting how the face of late stage investors has changed in the last 8 years. I think a lot of it has to do with the Federal Reserve 0% interest rate policy. The funds are chasing yield and trying to get an edge. Since VC is an inefficient market, they think they can beat the market by assuming risk in a late stage valuation. Public equity markets are efficient, and it’s harder to win.

27. Jeff Robinson

Herd mentality – Now most Tech/Startup VC’s blogging about the fact that there is a “bubble”. Industry/valuations need a good washout.

28. christopolis

and once these big spenders stop advertising the problem extends out to more and more services.

29. beidaren

Isn’t this similar to Amazon’s strategy? Amazon has near zero margin. It keeps getting into new caregories in order to create the illusion of “growth”, like a ponzi. At some point the music will stop.

1. Richard

Ha!

30. Jan Sessenhausen

Another amazing and also scary trend in this context is vouchers. We see a lot of companies using vouchers (e.g. x$ on purchase, 25% off, 1 for 2 etc) both for customer acquisition as well as retention / activation. They are great to drive growth and show some (fake) traction, however they can be really misleading. At the same time companies fool themselves into believing all will be fine (positive gross margins) once consumers start buying without vouchers.What we also see more and more is both companies and customers getting hooked on these vouchers and only using the services. Customers develop a totally different price perspective and only order when they have access to discounts, companies not wanting to stop the practice since this would stop growth.The argument I hear again and again is to use vouchers to “let the customer experience the service”, but in most cases this is fools gold since this experience is most often not much different to that of the next competitor and the consumer just chooses whoever is giving the best discounts that moment…

1. JLM

.Pricing theory and customer acquisition cost are legitimate manageable aspects of any business. You argue for the reality of the situation — sometimes the customer experience as a “tryer” is not that good.Still, these are perfectly legitimate methods of creating tryers which is the ultimate goal of the marketing department.If the tryers are not “wowed” then that is another problem. It’s called customer retention and it impacts the long term value of the customer.In the end it is CTA v LTV.JLMwww.themusingsofthebigredca…

31. Sam

If I had to assess a business’s viability on only one financial metric, hands down it would be gross margin. Show me the trailing history in $ and %. Show me the forward projection in terms of $ and %. And now tell me why those projections make sense.What’s above or below the gross margin line can be managed. But gross margin is critical because it goes to the heart of the value you provide to your market, the variable cost to deliver that value, and the competitive dynamics in your industry. Trouble often shows up first in the gross margin line.And this applies to practically every company in every industry.Negative gross margin today? You better have a damn good story to go with your forward projections.

32. portfoliologic

Anyone have thoughts about a clever way to short potential unicorn demise via some sort of public equity strategy?

1. Richard Kain

A commercial REIT that focuses on San Francisco would be very exposed. I don’t think there is an equivalent to SL Green which focuses on New York City properties, and in general the liquid ones are pretty diversified. Kilroy Realty is I think exclusively on the west coast and has made big moves in SF (Dropbox’s office space at 333 Brannan for example. http://www.kilroyrealty.com….

33. Ben Kinnard

Is there a textbook example that all these startups can point to and say “Well X managed to raise prices and become profitable after initial negative margins”Seems even the big boys can struggle to make money sometimes (Amazon apparently still doesn’t have pricing power after nearly 20 years, Netflix and Tesla still losing millions), so who are all these startups hoping to emulate?

1. Realist50

PayPal is the one I can think of that bled a lot of cash, including promotions way back offering people money to sign up for accounts, and then turned into a really profitable business. Not sure it was strictly speaking “raising prices”, but it was somewhat similar.I agree with your implication that Amazon simply seems to be a not terribly profitable business model. I have no idea how someone justifies that company having a market cap of $260 billion.

2. Michael Elling

Netflix losing money?

34. JLM

.One of my favorite things in the whole world is Mexican street corn — spicy corn grilled in its husk by vendors over a charcoal (gas, ugh) grill.They have been doing this and selling it for a long time.Beer and street corn is damn good. YOU would love it. Promise.These street vendors could teach this lesson at Harvard. It is pretty freakin’ basic.No Mexican street vendor is thinking — “Shit, I lose money on every single ear of corn but what the Hell, I’ll make it up on goodwill and volume.”The Wisdom of the Street Corn Vendor?He also did not invent sex.JLMwww.themusingsofthebigredca…

1. William Mougayar

Agreed, but suppose that vendor is selling their corns for $1, and making 20 cents of profit, but a new street vendor startup figures something new with the same taste and quality, and can sell them for 75 cents and make 25 cents of profits, then what does the first vendor do?

1. JLM

.Therein lies the problem — a lack of basic realism.How can someone who knows their costs have a competitor who is able to beat their COGS by that margin?In your example, the NET margin is 25% ($0.20/$0.80) while the competitor is making a margin twice as large — 50% ($0.25/$0.50).Not realistic.I used the Mexican street corn vendor as an example because the COGS is so simple to figure out.JLMwww.themusingsofthebigredca…

35. Timothy

Fred – long time listener, first time caller. I am an outsider looking at this Silicon Valley crazy world because I am in the process of building a Startup now. I’m glad to see that common sense business practices are being discussed as no one wants the rug pulled out of the VC world like in 2000 because dot.coms had no business cases, but simply hype. I am working on a B2C property management SaaS product, and know the consumer will pay whatever you offer them. Some of my competitors are giving away the farm with Freemium, but the incumbent marketplace is charging $136 per property (National Avg). I understand you need traction, but consumers aren’t stupid and will pay for value e.g. Apple. I think there is a follow-the-leader mindset over the last 5-10 years with Facebook and Twitter gaining users, then figuring our revenue (Twitter still TBD). We need to Keep It Simple Stupid. Assess the marketplace, charge a fair value, and spend accordingly on marketing . . .stop worryingabout 1.5Billion users. Thoughts?

1. JLM

.The real equation is simply customer acquisition costs — CTA v LTV (cost to acquire v long term value) — and it does use pricing theory as part of the lure of growing a business.Freemium is a legitimate — did not say “good” — tool in the toolbox.The “basics” require looking at the income statement from gross revenue through COGS to NOI to earnings. You have to construct your income statement even if you have no idea of the numbers. It’s just a model. Model it.When the numbers go negative somewhere along the way, you (as the founder) have to have a strategy to reverse that sign.This has been around since men were founding dirt companies.JLMwww.themusingsofthebigredca…

36. Jason

See ya Postmates, it’s been real. Guess I’ll have to figure out another way to get a $27 burrito.

1. JLM

.Move to Texas, burritos much more reasonable here. A million Californians have done just that. It IS the burritos, I guess.JLMwww.themusingsofthebigredca…

1. Girish Mehta

And – In splendid irony and specially for you JLM – the only chain with Burrito in its name in Bangalore is a startup called “California Burrito” !I frequent one of their outlets…good, but not the same as Austin.http://yourstory.com/2014/0…

1. Amar

Tacodeli sets the standard ;-). Note: some may say that it is Torchy’s nonetheless it is an embarrassment of riches.note: i know i am switching conversation to tacos away from burritos. It is easier to hide your lack of skill inside a burrito, much harder to do that in a taco.

37. Naman Kumar

Fundamentally, that makes sense and it’s an age old principle that competing on price is a race to the bottom unless you make up for it in volume, which implies winner takes all.But what about optimizing the business for niche markets or differentiations that, by themselves, would seem insignificant as differentiators? Like Lyft differentiates from Uber on customer service (I think), Hipmuk differentiates from Kayak etc in UI…probably a lot more examples that you know better than me…

38. Val Tsanev

Also switching costs between unicorns and alternatives are close to zero. For example switching from Uber to Lyft is a 1 minute process delete Uber app and download Lyft app, it is that simple, same holds true for all other on demand services with competitors in the app store.

1. Ben Kinnard

there’s not even a reason you need to delete the first app, just have two on the phone, or there are probably apps that aggregate all car hailing services and don’t have to deal with any other costs (what Yipit did with daily deals in 2011)

1. Val Tsanev

Yes you are right Ben, I presented the most time involved case scenario and even then would not take more than a minute

2. jason wright

Google is but one click away from being disintermediated, but it’s not happening to any great degree.

1. Val Tsanev

Don’t think comparison is relevant! Google has c.70% marketshare in the online search business, Uber is nowhere near that in the overall transportation/ride sharing business. Once Uber gets to that market share, if it ever does, I highly doubt it, the switching costs will be immense the way they are now with Google, so don’t think Google is only one click away from being disintermediated, no company with c.70% market share in any industry is just a click away from being disintermediated.

1. Realist50

The barriers to entry for a competitive search engine are much higher than for an on-demand taxi app. The former takes a large technology infrastructure, but the latter does not. That’s particularly the case because an on-demand taxi app doesn’t have to come in and try to compete with Uber in every market. It’s very conceivable just to do so in 1 or 2 cities, especially initially.

39. iggyfanlo

It’s funny… many VCs, including A16Z, have been stating that this time (contrast with 2000 bubble) is different because it’s real revenue, but if it’s negative gross margins, then it really isn’t different… It rarely is different

40. BillMcNeely

The on demand business is tough. It’s hard to do it on 20 points. Your 20% goes quickly. 3% for processing credit cards, 5% for insurance etc.40 points is more realistic but then you get push back from the consumers.

1. Richard

20 points works for distributors

1. BillMcNeely

Its not working for Uber http://www.businessinsider….

1. Richard

Ill take a look, but … Gross Margins may not be the right metric. Utilization rate per car per hour is a much better indicator of total profits .

1. BillMcNeely

ahhh. That’s a good one.

41. William Mougayar

This all makes sense, but there’s a contrarian warning here about the actual profit margins that are being targeted for viability.The conventional wisdom is that higher margins are better, but if you are an established player, that is a vulnerability, because startups will arrive and attack your high margins because they can survive on smaller margins. And that is actually Amazon’s ace card. Amazon’s profit margins are so low, you can hardly go under them, yet Amazon continues to outperform the market.

42. Jan Schultink

What cost is variable, what is fixed cost? Some cost that look “fixed” can actually be pretty variable with volume and should hit the gross margin.

43. Govind Kabra

Can you talk about %utilization going up? Can you talk about these services having two cost components– fixed cost and variable cost? The fixed cost simply need to be spread out over whatever is the usage. If no one goes to the gym at 11am, gym needs to recover that hour’s fixed cost from those who show up at 12pm. If utilization goes up, everyone’s share of fixed cost goes down.

44. Marcus Foster

Spot on, I think, for all the companies that don’t create unique IP to provide their service. But companies that do a lot of science and engineering can raise the barriers to entry significantly and put themselves into a stronger position to control pricing.

45. Arlo Gilbert

Brilliant article as always and there are some nuggets in there that have my head spinning.Take for example your reference to “the ability to process payments via an API” and a negative gross margin. I don’t know what Stripes margins are but they have to either be razor thin or negative and given that Stripe powers such a massive number of the new economy startups, if they were to raise prices, what would the result of that be? Would lots of other low margin businesses who are only able to survive because other low margin businesses existed suddenly become negative margin businesses?Could something like a Stripe raising prices have a domino effect? Great article.

46. anshublog

Great post. I think there needs to be more thought given on where dominant strategy works (or could work) and were it does not.- Flipkart & dozens of Indian startups: India is yet to have its first Amazon, first E*Trade, first Priceline. Therefore investing large amounts of capital in negative margin business to acquire “first time” users can work. Even there, more capital is going to render this strategy harder to follow over time.- SaaS: When you compare your CRM app valuation to Salesforce, remember that Salesforce essentially had no real competition for many years. They are 10 to 20x bigger than any other CRM related cloud startup out there. This is rare. Yet, if you are in a new market spending more can help. In SaaS, I have not yet met any negative gross margin startups except “people powered SaaS” startups.- Products with subscription revenue: If you are selling a conference room device for negative gross margins but have a somewhat clear way to make it up in subscription revenue, then this can be viable. Risky but doable.- Marketplaces: If you are able to genuinely create a marketplace of buyers and sellers with strong network effects, selling at a loss in the beginning is defensible strategy. Marketplaces are hard to build but winners can have huge impact.- Networks: LinkedIn, Facebook, WhatsApp. All negative gross margin since they had no revenue. In these cases, it was somewhat clear that you can make money but still negative gross margin for many years initially.

47. Stephen Voris

I’m reminded of the difference between static and dynamic rock climbing: with static techniques, you can hold position indefinitely (i.e.: you have positive gross margins); with dynamic techniques, you use unstable holds – briefly – to reach higher or further than you otherwise could… necessarily giving up your stable holds in the process.Hopefully you’ve got another set of stable holds you’re aiming for – or, put another way, hopefully those holds you’re aiming for are stable.

48. Andrew Ghobrial

In other words:Relative ease of obtaining capital = more startups eager to pursue monopoly status.Barriers to entry are increasingly lower = maintaining that monopoly is incredibly hard/unlikely.Even marketplaces with strong network effects aren’t immune to this, as any newcomer that makes it seamless for a seller to list on their platform while remaining on the incumbents in the meantime is a threat.Would you say that Amazon falls under this?

49. quan

“Postmates” comes to mind. I see their spam at my college daily for free food delivery. Completely unsustainable.

50. Julien

One question comes to mind: are “merged” unicorns the next thing? They clearly have a bargaining power issue if they can’t raise prices at the risk of losing customers to a competitor or shrink costs at the risk of losing a supplier… then, the solution is to *be* their own competitors. This will of course have a strong (negative) impact on valuations but at least they may survive?To me this looks like a pretty solid prisoner’s dilemma:- if you’re the first unicorn (in your market) to go under, you lose everything- if you’re the last unicorn to stay alive, you win all there is to win- if you’re able to merge with the competitors, your chances of not losing are significantly better… and if you execution is flawless, the market size may not shrink.

51. Tonomics

That’s not the whole story.The life of these companies rely on one relationship: native gross margins X rising interest rates expectation.A company with native gross margin needs certain ‘escape velocity’ to turn things around with rising interest rates (or high expectation thereof), as there’s pressure for exits and occasional outflow of capital in PE.However, if interest rates stay at zero and, even bolder, the Fed launches QE4, many unicorns will survive and become great companies in the next years.

52. Tomoko Hud

A scene of a TV show

53. Ian McHenry

@fred – what big companies have successfully either increased prices or cut costs to gain positive gross margins? Seems Amazon is doing this as people don’t really comparison shop anymore, allowing Amazon to increase prices. Any others?

54. Amit Reaganswami

So I will be the crazy one and say what needs to be said…A lot of startups which try the negative gross margin strategy do so after experimenting with paid customer acquisition strategies and seeing the cost. So crazy hypothetical example is : I can acquire one order at 1000$ selling something with a GM of 100$ or I can bring the cost down and GM to 0$ and CAC drops to 400$. or GM of -100$ and CAC drops to 100$. Loss goes down from 900$ to 200$, even with negative GM. During the early days, the numbers are that bad !Eventually the idea is to get better CAC numbers in place and also to use the sampling of the product at negative GM’s to hope to make it over time. This is why recurring revenue is valued above all else. There is a path to recovering the loss that was made with the negative GM.Negative GM causes its own virality and you can argue that its a bad customer cohort you are acquiring but thats not always the case.Big money only chases the winners, so the negative GM participants know that they ether win or go home. And after acquiring big money the winners double down on the negative GM to “grow” the market.Eventually companies close negative GM after the “brand” is established and they become the quasi monopoly. By that time, efficiencies are also discovered, but not enough not to raise prices. As prices rise sales fall and there is a lot of pain. But if the startup survives, it becomes “it”I think Amazon did this with ruthless efficiency during its road to a quasi monopoly…

55. Adam Lavine

Negative gross margins aren’t made up in volume either!

56. avifreedman

It can be a little tricky as a SaaS company, at way pre-Unicorn valuation, where the ops and support costs of minimum table stakes vs 0-1 or 2m ARR shows 0 or slightly negative margin, and you just need to scale a bit to get to 50% then 75% then keep optimizing to 80%+.I would assume that the growth SaaS companies wind up on that curve, crossing towards the 75%+ somewhere around 10m ARR, but the data is hard to get as we see just pre-IPO, which is scaled much further.Curious if any AVC readers have any data on when it should be clear re scaling into +GM from 0-1m ARR

57. Realist50

On a related note, these sorts of considerations are what I find it extremely unlikely that Uber will ever justify its massive valuation.For on-demand ride services *, I predict a future where services like Uber or Lyft are ubiquitous but low-margin businesses. I don’t see the barriers to entry in this business as being all that high, especially because a competitor can logically choose to compete only in 1 or 2 markets. The way to gain market share is clear – come in charging lower prices while also cutting the percent commission to provide higher fees to drivers. I can foresee a future where third-party aggregator apps tie in to multiple on-demand ride service apps to compare both pricing and availability.For an industry that looks similar to this one in a lot of ways, see another transportation industry – airlines. It’s a ubiquitous industry used by millions of travelers every day, but one that struggles to remain consistently profitable.* I hate the term “ridesharing” being used to describe paying a stranger to drive you. It’s a nonsensical euphemism that doesn’t actually describe the core service that Uber and Lyft provide.

58. Jeff Lunsford

Companies are long to die/hard to kill. Instead of dead unicorns, what we are actually going to have, starting next year, is a bunch of Zombie Mules – zombies because you can’t kill them and mules because their excess capital will allow them to live a long time under harsh conditions but they won’t be able to reproduce or grow. Tweeted six months ago: https://twitter.com/lunk18/…

59. Betty Greenwald

Here is why this advice is useless.1. As you admit. It will work for some businesses and wont work for others. We dont know which is which? Do you?2. Fred doesnt name names. He hints at which ones he means. Come on Fred… make a call on which unicorns will go under? Your buddy BIll Gurley did. He named names. Mike Moritz did not name names. Not impressed.3. This is written to support your portfolio companies. I guess they are getting hurt by a low cost provider.4. This is written so you can acquire equity in startups at lower prices. Scare tactics.lastly, as with all VC posts…. I am sick of VCs speaking without releasing their ROI’s. How do we know which of you is good and which suck? I guess this could get complicated because Fred made money investing in Tumblr but that is only because Yahoo was dumb enough to buy it.I do think you are smart Fred but I dont think you have any idea whats gonna work any more than any of us do. I wouldnt have bet on almost all of the winning internet companies. I am amazed at all the things people do that I never thought they would.I never would have bet on Airbnb, Uber, Facebook, Linkedin, etc…

60. Bloviator

History repeats.

61. Ari Isaacs

Beyond bad indicators, there is a ton of money left on the table.The first services in a space would be pretty unique and effectively a monopoly at the point of consumption. If they would just keep prices high they would have great and lasting profits from a subset of the market and set a high price point for the entire space. They could leverage this capital to grow in many directions.Rather than capitalize on huge gross margins and first mover advantage, these companies choose the easiest path of growth and choose to loose money in the name of growth for so long that by the time they want to turn into profit they have a host of second and third movers further under-pricing them and a near perfect market space that bars them from making significant profits

62. alexanderjarvis

“We lose money on every sale, but make it up on volume”

63. awaldstein

Perfect.Go to your local whole foods and look at any category section.What you are seeing is a constant stream of red ink where success is defined by margin loss.The value of a brand has never been stronger. The know how of how to build one and a community around it never so under the radar.

64. awaldstein

Dunno.I’ve made my career being the one person in tech companies whose job was to do just that.I never asked why they needed me, only focused on being the best at it.Still do. And the phone keeps ringing.Going to think about your questions. Your analogy above is already bookmarked into my next post about The Race to the Bottom.Thanks!

65. LIAD

flawed today may become profitable and at scale tomorrow.#just #saying

66. fredwilson

I don’t do well on the road Charlie. I like to blog every day but doing it when I travel is not optimal for me. Sorry for the lack of good stuff lately

67. tgodin

and with regard to Groupon, I think that it made a few investors some serious dollars. there’s a difference between a great investment and a great business.

68. LE

Building customer dependency on low prices, then jacking prices up is effectively bait and switch. If that’s the plan, it approaches fraud.Not bait and switch. Bait and switch is understood to be when you advertise one product without any intention of selling that product and instead push a different higher profit product. Didn’t look it up in the dictionary either. It’s what it is. Or car dealer advertises a low lease price on a car that isn’t actually available. (Not called bait and switch though).Building customer dependency then “raising” prices (“jacking up is pejorative and isn’t correct they won’t be able to “jack up” prices in the way that you seem to be thinking) is fine.Is common in many businesses to offer a low price or a loss leader to get a customer, then when the customer likes your service or product to raise prices. So first quote on job give a lower than market price. Next job or down the road (when they like you) you give a higher price. If they are happy they stay. If they are not they leave. Nothing wrong with that. Are there twists of this that could be wrong or fraud? Of course the details matter. But the general principle is fine.

69. Girish Mehta

1. Unicorns are mythical. Private company valuations are also partly mythical. WSJ is reporting that 11 VC backed companies that IPO’d after start of 2014 are trading at value below their last private raise. There are more visible examples of companies trading below their IPO end of day price.2. Am reminded of a situation in Singapore several years back when the business was considering if to do a very attractive “mail in rebate”. Such rebates incorporate the premise of “breakage” – viz. a non-trivial number of customers will not actually redeem the rebate after purchasing the product, and allow the rebate to expire. People who have worked on such programs will tell you that breakage can be quite high. If that happens, you get the benefit of the revenue without the margin hit. My point was straightforward – The rebate is very attractive. Assuming the customer will not redeem such an attractive rebate implicitly assumes the customer is either lazy or stupid. I do not want to rollout any program on the premise that the customer is lazy or stupid.Right now, in India there is massive amounts of discounting… deep negative margins driving growth funded by VC dollars. The money is flowing from VC pockets into consumer’s pockets. This is going to be interesting to watch play out. The Indian consumer is showing little loyalty, and is demonstrating a willingness to switch to whoever gives the best deal. I would not assume any consumer lock in when prices get raised…but you can still play for Last Man Standing.4. “…Because we can turn profitable the day we choose to, but right now we choose not to” — This statement is an output from a spreadsheet exercise, but its very difficult to execute to operationally. Having said that, its not as if the investors in India don’t recognize this…they are smart people who do this for a living. In India – these investments are happening because India is the Last Frontier. The game in China has been played. There is also some path dependency to their investments now. Its a High risk – High reward game, which is starting to acquire the contours of a ‘Big Bet’. People do win Big Bets…sometimes.

70. pointsnfigures

Who knew factoring could be a business?

71. William Mougayar

Agreed. There’s a difference between investing in growth to sacrifice margins temporarily, with a sound business model vs. shaving margin to grow artificially when the business profitability model has not been proven yet.

72. kidmercury

regarding #4, it’s not a bad investment in monetary terms. the early stage investors will probably still have made a great return. the late stage investors are hoping they can get to IPO in time. if they can, it may also be a great return. such is life with fed funds rate below 1%, which has been the case for the past 7 years in the US and most of the rest of the world. manipulation of rates results in counterproductive speculation (i.e. bubbles, meaningless flipping) and a subsidy to the financial class at the expense of lower classes (expressed by higher financial asset prices and higher real estate prices).

73. TeddyBeingTeddy

Isn’t a company with negative GPM substantially similar to a Ponzi scheme? Creatively justify it however you want, but selling $2 in exchange for receiving $1 isn’t sustainable…even if they manage to trick a few VCs along the way.

74. PhilipSugar

You know who wrote a great post on this: Paul Graham: Are you default dead or alive: http://www.paulgraham.com/a…The problem with negative gross margins is you cannot grow your way to profitability. The more you sell the more you lose.So you can try and jack up prices.But here is the really big problem:Nobody that tries that strategy is lean.By definition. If you were you would never try this.So what happens??? Somebody who really is lean comes in and steals your air.

75. JamesHRH

1999 – eyeballs are more important than revenue2015 – revenues are more important than margins.Rrrrrriiiiiiiiiigggggggghhhhhhhhtttttttt.

76. LIAD

it can. fred lays out 2 ways of it happening

77. awaldstein

arnold@waldstein.com

78. sigmaalgebra

You are so mean to HomeJoy! Of course, during that series HomeJoy looked like a disaster, but you don’t understand! :-)! They were girls, and the idea in that series of lectures was to treat the girls like little sisters and show that girls, too, could contribute to the series. And the girl who did the lecture was so enthusiastic, hopeful, committed, optimistic! It’s like having a lot of fresh flowers at a classical music concert: The flowers are really nice and look really good during the concert but by the next day are already starting to look ready for compost pile! Then to generalize from an Indiana Jones movie, need fresh batch of flowers!

79. Richard

Homejoy was so poorly run. The problem wasnt the margins it was the founders

80. LE

Nobody is going to raise prices by 50% in that time period. Nobody is going to raise prices by 50% in 5 years either. The increases would in theory be subtle and nominal. People are not schmucks. Must fly under radar at all times.One of the things that surprised me in tech when I first got into it was that prices dropped. In other businesses that I was in they predictably went up. But not in a hyper way, just in a “here is the new contract price way”. Tech could lower prices because demand keeps going up. In traditional business that doesn’t happen you have inflation and your costs going up so you have to either get more customers or raise your prices. Plus you have to give employees raises every year.Back when my dad started in business in the 60’s he would print prices in his catalog. Then when inflation started he didn’t put prices in the catalog he printed a separate “price list”. That way as his prices went up he could change what he charged customers. I remember that to this day.

81. JimHirshfield

Good point. But I guess there’s always another layer to the onion. Who are the picks and shovels providers to Twilio and Stripe…and their competitors?

82. pointsnfigures

If you want to switch your search engine it’s pretty painless and easy. Heck, there are still some search engines left over from the 90’s you can use. Want to help Yahoo? Use them for search.

83. pointsnfigures

Groupon still there. One thing they have is the largest email list in the world. Next recession, people will turn to them. Remember, they started in 2006 as The Point, pivoted to Groupon in 2007. Recession hit big time and that actually drove adoption and growth.

84. awaldstein

Nothing older than an old email list built for a different reason at a different time.

85. JLM

.Good trade v good/bad investment has been around for a long, long, long time.JLMwww.themusingsofthebigredca…

86. Sam

If by “the game in China has been played” you’re referring to the real economy, I have to disagree. They will continue to have business cycle expansions and contractions, and the sector mix of their economy will change, but they are still very much on a multi-decade expansion. All of the elements of a competitive market economy are there, incomes are rising, and the Communist government eventually will get around to strengthening the rule of law underpinning economic activity. (Apologies if I misunderstood your comment, but I see China very much as continuing on its long term growth path, if maybe now at a healthy single digit pace.)

87. Ari Isaacs

“WSJ is reporting that 11 VC backed companies that IPO’d after start of 2014 are trading at value below their last private raise.”This statement assumes company prices are always supposed to go up; I find that a disturbing underlying assumption we tend to have about tech companies. It holds true for seed rounds where if the company doesn’t go bust, fall apart, or pivot to death its going to go up, but by the time a company is being traded in the public market it’s price should reflect it’s true value, which can go up or down.If anything, 11 out of a #shitload of companies indicates under-pricing at the first day of trade.

88. Girish Mehta

Nope, I was referring to VC investments in startups (in response to Charlie’s comment in #4 on “who is investing in this stuff ?). VCs are making massive investments in India startups in negative margin businesses — where the equivalent businesses in China have been staked out.

89. ShanaC

Why

90. josephcohen

Agreed! Great post @fredwilson:disqus – thanks for dropping knowledge. Keep it coming.

91. iggyfanlo

But the negative gross margins were just pushed onto their merchant customers (via AR financing) almost like loan sharking… it did make some folks money by fooling some of the people some of the time

92. jason wright

do you drink whiskey and rye?

93. Richard

I don’t follow?

94. JLM

.Bullshit meter going off a little.A company is either making a gross margin or not. If they can’t hang a positive number at the gross margin level (gross revenue – COGS), then the rest of the income statement is bleeding red.They are not making money.If someone wants to look at the business and “value” it, that has nothing to do with the company’s performance and is totally about the quality/value of the opportunity.Not the same thing.JLMwww.themusingsofthebigredca…

95. JLM

.You’re doing fine plus we all go drool over the GG’s pics when you’re traveling. Don’t be so hard on yourself.JLMwww.themusingsofthebigredca…

96. fredwilson

if i’m not going to be hard on myself, who will be?answer: my wife 🙂

97. iggyfanlo

I think we’re in violent agreement on negative gross margins… GRPN never really had a sustainable business… saw an opportunity to finance small merchants who were dying for cash… not sustainable… even though I think GRPN had positive gross margin… just not sustainable business model

98. awaldstein

If you work in any business where the customer has a choice of buying the same product somewhere else–which is almost all products–then this strategy died when the web was born.Good one but kinda a dinosaur from a different time.

99. JLM

.Not together. I drink Deep Eddy Vodka ruby red.JLMwww.themusingsofthebigredca…

100. laurie kalmanson

i can still remember

101. JLM

.I know not another person who blogs as consistently as you. A few headfakes? Just fine by me.JLMwww.themusingsofthebigredca…

102. LE

I will be glad to be hard on you. I’m already worried about you getting soft with all of these trips that you take. Why? Because I know how important what you do is to you and I know you need to keep your focus or you will slowly fade to irrelevance. And you won’t be happy with that. (Yeah, I know “thanks!”.) Ditto for Joanne.People are much to easy on you. Me personally? I don’t want to hear any whining at all. I’m kind of partly kidding of course. Only partly. But on the other hand you didn’t get to where you are today by being a wimp and making excuses. And Joanne is a ball buster for sure 24×7.

103. Adnan Aziz

Just as long as you didn’t drive your chevy to the levy afterwards… @jasonpwright:disqus

104. JLM

.Enough Deep Eddy ruby red and that Chevy will drive itself. Why I love it. Of course, one day it may be the way that I die, no?JLMwww.themusingsofthebigredca…

105. TeddyBeingTeddy

Investing in growth should sacrifice operating margin, but not gross margin.

106. TeddyBeingTeddy

That’s the Ponzi scheme strategy.

107. William Mougayar

“should” = yes. assuming the model is right.

108. ShanaC

you can’t get leaner at some point – people have to eat. Wheat have a cost. So does fuel. So does a house. So does heating a house.There is a base minimum at some point with human labor.Unless you have no human labor. Then you create a new problem – no human labor, no customers

109. LE

Part of the problem is people who don’t know about business reading about strategies or embarking on them and not understanding the nuances of what to do, when. Lack of experience and long term perspective.If it only were that simple (and luckily it’s not).Unfortunately it would be great if one could just read what they need to know and know what to do from reading. But you know as well as I do that one hat does not fit all business situation. But by reading things that is what people think.It’s obvious that there are cases where using negative gross margins could be a strategy that would work. If it didn’t work in some particular cases we wouldn’t be talking about it. In other words “losing money”.So for example maybe Amazon can get away with it but the local wholesale distributor (competing with them) can’t.Impossible for “the newly hatched” to know enough to know (seat of the pants) when to go down that road or not.

110. LE

Don’t want to pick apart what Graham said (he obviously is very successful) however this type of thing kind of urks me:Airbnb waited 4 months after raising money at the end of Y Combinator before they hired their first employee. In the meantime the founders were terribly overworked. But they were overworked evolving Airbnb into the astonishingly successful organism it is now.Just because things worked out for airbnb doesn’t mean this was the rightthing to do or that others should do this as well. This is like the”companies don’t need a corporate jet it’s lavish”. The type of thingthat journalists always throw out when a company goes south. They talkabout the “lavish spending” as if they didn’t have that everything wouldbe fine. It wouldn’t.The company that I worked for in SiliconValley pissed away money for sure. But they failed because they didn’thave good products. If they had good products non of that would have mattered on a macro level.My dad used to criticize the money that I spent on my business (buying new work tables for example healways bought used) but it all worked out because we did well enough topay for the tables (and other things).. If I had failed he would havesaid “see that is why”. Not the case.

111. ShanaC

what of these type of business have that?

112. PhilipSugar

Good to see you.You misunderstand my point I think :-)The only people that try this strategy are flush with cash. You have to be.

113. LE

Those that supply those pick axes could quite well collapse after their customers collapse.Man selling pick axes sees demand and is drunk with success. Next thing you know he takes on a lease for additional store space. Buys additional tables, chairs and other fixed expenses. More pencils. Next thing you know demand dries up but he is left on the hook for all of those added expenses.This is a common problem in even brick and mortar businesses. Take no risk get no gain. Take the risk and the environment changes and you are up shits creek.Look, back in the 80’s I bought a really expensive machine because, in part, I had a big customer that was giving me a great deal of work. A few weeks after delivery the customer decided to do the work in house and the employee that was supposed to run the machine left to start her own business. And I still had the payments to make on the machine. It all worked out, but it could have easily gone the other way.The thing about business is you don’t know all of the “near misses” that happen each and every day. Like with plane accidents. You only know the cases where there is a crash. So yes, for sure, the potential is there I can attest to that (from more than my experience).

114. LE

Disagree. People are slow moving like ships. They don’t switch as easily as you seem to be implying that they do. Have you ever dealt with small businesses purchasing items for their business and/or purchasing agents? I have. Once you are in it’s fairly difficult to get unseated because your price is a bit higher. Of course a 50% increase would make them bolt nobody is arguing that.On consumers, go see how quickly people switch from Amazon to another vendor for a product “just to save a bit of money”. People also greatly value convenience and certainty and when they are busy they don’t want to have to re-invent the wheel.

115. LE

I don’t either but then again I haven’t looked. And that’s the thing. We are all “customers” of this blog. And if you’ve ever operated a service business you would know that you are only as good as the last value that you provided. People have short memories. And they will fork to a new service if it no longer provides value.You are an important part of this blog as well. I enjoy reading things that you say. Even if you mention Austin and Tacos a bit to much. (It’s like a “tick”).

116. PhilipSugar

Amazon has positive gross margins but negative operating margins. Same sometimes as Walmart. That is actually a moat. It is the scorched earth Fred talks about.The difference is a bunch of tech companies, where you lose money on each sale and hope to make it up on volume.

117. LE

Who really knows? A huge company with a bit of opaqueness and potentially financial engineering to make things a certain way. Quite easy to make numbers say what you want or in order to tell the story. Not saying you aren’t right, but I am a bit more skeptical and it’s not like companies haven’t done a version of book cooking in the past.

118. JLM

.Need to get your ass down to the ATX and fill you up with tacos and see WTF you say then, pardner.Back at you. I enjoy your voice — because you actually know how the cow eats the cabbage.JLMwww.themusingsofthebigredca…

119. Lawrence Brass

Reading you guys is a top quality experience, everyone. Now I understand what does Fred mean when he mentions the avc community in his talks. I have really enjoyed these weeks reading the blog on a daily basis, very addictive, so thank you.You are not customers, you work here.(you may continue kissing)

120. LE

Need to get your ass down to the ATXI might do that. Perhaps if you would share with me why you went awol from this blog for such a long period of time before returning. I have my theories on the reason for this of course.

121. JLM

.Never complain. Never explain.JLMwww.themusingsofthebigredca…

122. Amar

Please announce it if you decide to make that trip 🙂 I would love to sponsor your beer + tacos in ATX as well. This forum and you people have been the most enjoyable classroom i have had in years now.

123. Sam

Turns out I misinterpreted Girish’s comment, so my comment above isn’t really relevant to this thread anymore. But if you’re interested in my off-topic comment (why I am positive on China’s long term economic prospects), it’s sort of how I integrate all the elements of what I read about China and what I am observing directly. I work for a US-based global company with significant operations in China (over 1000 of our own employees in the subsidiary there) and travel to the region at least a couple times a year. Chinese people work hard. They are generally well-educated. The economy is very much market-driven and entrepreneurial. If you look at economic data trends (GDP/capita, e.g.), it is a country in the midst of a remarkable multi-decade expansion. You read a lot in the press lately about how the economy is slowing down, export-driven manufacturing is exposed to oil, and many companies are moving manufacturing back to the western hemisphere because cheap labor and location (Mexico) is better to serve the US market. That’s all true. But it takes away from the underlying momentum that will continue in China. The sectors may change (a little less manufacturing, a little more personal consumption), but the long term trajectory is positive. The country has plenty of work to do to correct its horrible environmental problems around air and water, and the rule of law is still nowhere near what it needs to be (outright fraud is tolerated if not expected in many business relationships), but those are squarely on the radar of the Communist party and will change. So I see the long term growth path in China very much continuing. My two cents.

124. LE

A cousin to that saying is “time to stop learning and start doing”. Relates to back in the days of business books at Barnes & Noble (not just “career students” people staying in school for degrees although it applies) where the tendency is to buy yet another book on sales, management or whatever instead of actually trying to implement a plan of action.

125. LE

What’s your opinion of the new Canadian power couple? My wife (who is younger than I am) doesn’t know of his father or Maggie his mother. Maybe the cartoonist. They are a good looking couple for sure. Amazing how in politics where a good name and a nice smile can get you to be the leader of a country, eh?

126. LE

Same for godaddy. At least with Comcast (or Verizon Fios) there is fine print that says “bend over and grease up a year from now”.

127. LE

Printing, painting, plumbing, carpentry any thing where jobs tend to change and are done by estimates. There are others those are just off the top.

128. WorruB

If you’re not making gross margins then you’ll never find out if you have a good product. If I sell $100 bills for $95 a piece I can sell a ton. I ask all my customers, they love my product, recommend it to all of their friends.Obviously this is an absurd case, but if you’re not selling to anybody for a gross profit or at least have a clear path to bringing down your internal product costs.The businesses this seems toughest for are businesses with good margins but high customer acquisition costs. Paypal was famously paying $20 per customer directly (not including marketing) to acquire each customer and then recovering that in LTV (hopefully). That formula involves a lot of assumptions, but at the very least they had some piece of the business that had gross margins.

129. PhilipSugar

Could be but if you look at how Amazon shits on their warehouse workers as an indicator I somehow think they manage to positive gross margin.

130. LE

Which made me wonder “why haven’t they unionized then?”.And I found this:http://www.thewire.com/busi…

131. ShanaC

thanks. I was curious

132. ShanaC

I’m around. Things, they are. Got a bunch of things to think about and do

133. ShanaC

And yes, you have to be flush with cash – going leaner isn’t an option because of exactly what I said, there is no where to go unless you think people can’t eat and houses don’t exist

134. William Mougayar

Well, he has worked very hard at it in the past 4 years, at rebuilding his party that was almost decimated in the last 2 elections, and brought it back to life vigorously. He’ll do well, and the country is energized. I’d be more worried about the Blue Jays at this moment 😉