Meritocracy Consulting Blog

Recently, I met with Kent Goldman from First Round capital at an office hours event in Santa Monica.  Kent as been on the entrepreneur and investor side of a lot of really great internet deals.  Additionally, I have heard nothing but good things about their firm and want to commend their VERY entrepreneur friendly networking event that they hosted.  Kent and I spoke about many interesting ideas (some mine, some general tech stuff), and as I wrote my thank you email, I came across an interesting post of his about a concept he is calling Capital Alchemy, or how to convert traditionally fixed costs into variable costs.

I encourage everyone to check out his original post, but essentially he highlights the growing trend of leveraging on-demand services and on-demand computing to grow your company with less capital.  By no means is his post meant to be an exhaustive resource, but he does point out the benefits of this new trend.  For investors, there really are few downsides, but for entrepreneurs and business owners, I wanted to discuss some potentially negative aspects of variable priced “subscription services” or the increasing reliance on “pay as you go” services as you try to grow your business.

When fixed costs turn into variable costs, the obvious benefits are flexibility and the ability to grow with less capital. The standing argument (not just from Kent) goes that any cost that can be turned into a variable cost…should be.  I mostly agree, but as with all subscription services, this strategy creates de-facto “off the balance sheet” leverage…a lot of it.

If this strategy creates “off the balance sheet” leverage, who is at risk?

With debt, someone must secure it (or at least they are supposed to), typically with cash, business equity or traditional assets (like a building, servers, etc…).  On-demand or “pay-as-you-go” computing creates hidden leverage that is essentially secured by the business owner’s personal equity in their business…and unknowingly the customers assume an unknown risk (that the service is more likely to be shut down unexpectedly).   For businesses that do nothing but grow, leverage is great, but the volatility of startups increases substantially as a result of this new strategy (capital alchemy).  Even though the mythical entrepreneur loves risk and volatility, I’ve found that most actual entrepreneurs are extremely risk-averse.  Because there is so much business risk in a startup that entrepreneurs must tolerate, financial risk (namely debt) is something entrepreneurs are usually not too excited about.

In addition to on-demand computing being very similar to debt financing…there is a misconception that on-demand computing does not have a price premium. On-demand computing is similar to using a credit card or factoring your receivables.  For people without money or access to less expensive debt,  sometimes those “financing techniques” are the only options…for each you pay a hefty premium.  As the size of the startup grows, on-demand computing becomes increasingly expensive (since cheaper alternatives start to emerge…like building and managing a small server cluster), PLUS there is the hidden leverage factor that I will demonstrate in a follow up post (read how amazon web services caused a bankruptcy).

My primary point is that startups should UNDERSTAND how on-demand computing and subscription services impact 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”.