Meritocracy Consulting Blog

Apple is experiencing standout success as a company that tries to do it all…don’t be fooled, vertically integrated companies rarely succeed.

What are some up and coming companies that are doing well by staying focused?

• Twitter – open to the point of ridicule…they are already competing nicely with Facebook and critiques should realize that their success should also be measured and credited in comparison to all of the less open competitors that did not even get off the ground
• Wordpress – largest blogging platform…beating Google and other large players in this space
• Tesla – if they successfully implement the software API that they have talked about (things like dashboards created by 3rd party companies, acceleration/speed limits on new drivers…lame, but of interest to parents, and even self driving cars…could emerge as viable new businesses)
• Blippy – how have credit card companies, Amazon and paypal not realized this opportunity? Props to Amazon and ebay if they partner instead of competing with this company.
• Bedrock - new advertising product, turning the controls of Google’s debatable ad monopoly on their head

While these companies are small, they each are great examples as they are solving a narrow set of challenges in a space with near limitless growth potential.  I look forward to watching them evolve, and HOPE that they stay independent.

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”.

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”.