The business covered here is fictional, but I would not be surprised if several real companies have experienced this seemingly paradoxical problem. Can too much access to scalable hardware on demand be dangerous? (see my previous post on how on demand computing creates good and bad leverage)
Let’s take a look:
A company spends $5 (using CPC ads) to acquire a customer that generates $60/yr in revenue, but requires $50/yr in on-demand computing expenses (using something like Amazon Web Services…AWS).
In case 1: The company acquires 100,000 customers, generating an operating profit of $500,000 in year 1, and $1 million in year 2. Yay for leverage! Assuming this startup has 5 people, the management expenses might be $500k/year, so the company breaks even in year 1 and earns $500k profit in year 2…this company is sustainable or can easily raise more money.
In case 2: The company also acquires 100,000 customers, starts charging $60/yr, but in month 6 an external factor drives the price point down to $40/year (let’s say, Google entered the space). In this second case, the company would lose $250k in the first 6 months (because of the 1-time customer acquisition cost), and then start losing massive amounts of money (because the service is no longer profitable). Their balance sheet is clean (no debt), but the fact that the company has to service their acquired customers means that they are essentially locked into a long-term liability…without the cash to cover it. Of course the service could be turned off, but if that happens, consider the startup dead. As a customer, would you try other products if a new company just “turned off” a product that you were using? I don’t think so! Assuming they do the right thing and keep the service running…now this startup needs to either try to get bought or raise more money…anyone want to invest in a company without a profitable user base burning through $120,000/month in cash?
Here is the financial summary of case 2:
Month 0: -$500k in customer acquisition costs
Months 1-6: $3 million in revenue - $2.5 million in computing expenses - $250k in salaries (and related expenses)
Total cash flow (months 0-6): -$250k
Months 7-12: $2 million in revenue - $2.5 million in computing expenses - $250k in salaries (and related expenses)
Total cash flow (months 7-12): -$750k
In year 1, this company has burned through $1 million, and now has a monthly burn rate of $125,000. Even IF the employees were willing to work for free to get the company back on track, they couldn’t. They now need $83,333 every month just to pay their on-demand computing services. Setbacks like loss of pricing power occur ALL THE TIME, a good entrepreneur can react, find a new strategy and build on prior successes…but not if they are saddled in “off the balance sheet” debt!
In case 2, it seems easy enough to not view their on-demand service as true “leverage”, but in case 2 the company pushed itself to the limit, and got hammered by downward pricing on their product. Perhaps in a situation where traditional hardware was purchased and deployed, the company would have grown more slowly while focusing on customers with a higher profit margin (to increase the ROI on the computing assets that they purchased). Imagine if they spent $500k right off the bat on servers and pre-paid hosting. This company would then have a VERY low burn rate when times got tough…giving them substantial negotiating power when raising new capital. Of course, there is a HUGE assumption that the company would be able to adapt and find a new revenue stream, but iteration and responding to competitive forces is part of what entrepreneurs and startups are really expected to do.
At least startups should UNDERSTAND how on-demand computing and subscription services impacts their risk/reward profile
Companies using on-demand services should regularly build models to understand how leveraged they truly are. I studied corporate finance, and to me it seems like choosing to use on-demand services requires looking at a lot of the same “pros” and “cons” that a company would consider when looking at debt vs. equity financing…not surprisingly in our economy that has mastered the concept of boom & bust, I haven’t seen much coverage of the “cons”.