20 ms·

Unit Economics

372 points by _sentient 11y ago

moistgorilla 11y ago
I was nodding my head in agreement until I got to this line > where you make more than you spend on each user, and it gets better not worse as you get bigger, you may not look like some of hottest companies of today, but you’ll look a lot like Google and Facebook. Wouldn't Facebook be an example of a company with bad unit economics?
- pbreit 11y ago
  Considering Facebook is a website with zero marginal costs and zero acquisition costs, no. It makes way more $$ than it spends, especially marginally/per-unit.
  - jegutman 11y ago
    Yea, and why not just look at the actual history of FB where they were quite easily able to pay for server costs at an early point with ads. It's possible they hit a point where they were losing money, but 100% at any point past the very beginning if they wanted they could've invested less and been a profitable business. Possibly not a business that would've existed for the long run and it might have opened the door for a competitor, but they could have drawn down money out of the business they had built. Many of the companies people complain about actually couldn't do that because they don't have any ability to raise their prices without losing all of their customers.
- steego 11y ago
  You're accounting for Facebook's and Google's business model all wrong. The end users aren't the customer. Advertisers are the customers. Think of Facebook and Google more like giant hydro-generation plants that have to continually work to divert the flow of attention of its users to its customers. Like any hydro-generation plant, you want to capture a monopoly from this recurring source of income so you can dictate premium prices from your customers.
  - LAMike 11y ago
    A+ analogy
  - nostrademons 11y ago
    They also have basically zero user-acquisition costs, on both the user and advertiser side. CAC (customer acquisition cost) is usually the largest variable cost for most businesses. Things like server costs, electricity, etc. are tiny in comparison. Cut CAC and your margins skyrocket. Indeed, the reason why Google & Facebook are profitable is because they're a very effective way of cutting CAC for other businesses. Their revenue is another businesses's marketing spending, and yet they're still better than the alternatives for driving customer conversions.
  - eggie 11y ago
    To see these systems like massive hydro-generation plants, you first have to assume that human attention for advertising is an infinitely-renewable resource. Revenue is certainly increasing rapidly in recent years: http://www.iab.net/about_the_iab/recent_press_releases/press_release_archive/press_release/pr-061115 http://www.iab.net/about_the_iab/recent_press_releases/press.... Maybe there is no ceiling in sight.
- eggie 11y ago
  Unlike the others replying to you, I tend to agree. At least, I am dubious that they will "keep customers forever", which seems to be a key part of good unit economics. Things change, sometimes very fast.
deleted 11y ago
[deleted]
pbreit 11y ago
I've gotta think one category he's talking about are the delivery services. I still have not seen a decent articulation of the end-to-end economics. But they can't be terrific. I know, for example, that Sidecar pays drivers up to $20 for a single delivery and just can't see how this is viable outside of rare exceptions. At least Instacart prices the item being delivered (and I suspect never gives you the yellow ticket price which pretty much every Safeway item gets nowadays).
- exelius 11y ago
  I agree; delivery services will only make sense with autonomous delivery (which I suspect is the long-term plan for all of them - Uber included). But realistically, the R&D required there is crazy if you're trying to be first to market - Amazon and Uber are investing billions in this, and they're the competition. Once drones or autonomous cars become widespread, this business becomes a commodity and anyone without a legacy business they have to migrate will be at an advantage. So I have no idea why these companies are getting funded other than it's a problem that's simple enough for a really smart university student to tackle.
  - _sentient 11y ago
    Uber is profitable in many of its mature markets. This is while charging less than half what you would pay a legacy taxi service, while paying drivers more than they would make at the same. This is the direct byproduct of strong network effects on both the supply/demand side, paired with operational excellence on their part. Self driving cars would bring the marginal cost down even further, but they have built a stunningly good business with or without a quantum leap in automation. The same probably isn't true for many other Uber-for-X companies, particularly those with underwater unit economics.
    - exelius 11y ago
      Yeah; Uber had a unique opportunity because the taxi business was stuck in the 20th century and had a bad case of regulatory capture as a result. That said, in Uber's more "mature" markets you're starting to see a lot of the problems that caused the taxi business to regulate in the first place: too many drivers, no way to guarantee steady revenue as a driver, etc.
cm2012 11y ago
As a side note, unless you have a secret sauce (something unique to your company, like better proprietary data, lower operating costs, etc.) all acquisition channels will decline in effectiveness over time, making it harder to make unit costs work. This is generally known as audience fatigue.
ececconi 11y ago
The one product that I use and pay for that is so good that I recommend to all of my friends is Spotify. I'm so surprised how few of my friends actually pay for it though. They're willing to put up with ads and reduced quality for just $10 a month. Other services I found so good that I recommend to all of my friends but do not pay for because my data needs are very small are dropbox and evernote. I bet some of my friends wonder why I wouldn't spend such a small amount of cash for their usefulness. Getting people to pay for digital services is hard.
- jobu 11y ago
  > They're willing to put up with ads and reduced quality for just $10 a month. I see two reasons for this: 1) Free is huge. Most people are willing to put up with a lot of bullshit for free. 2) Netflix. We pay $7.99/mo for essentially infinite TV on multiple devices, but $9.99 only gets me audio on one device at a time. It seems like a worse deal, so why would I pay?
  - martian 11y ago
    Also: never underestimate laziness. Typing in a credit card takes work. Re: Netflix/Spotify price differences. The relative size of the libraries (vs all content in the domain) is something to keep in mind. Netflix gives users access to some videos, but Spotify gives users access to almost all songs [1]. [1] Can't find precise estimates for sizes of libraries, so apologies for the argument from anecdotal evidence.
    - ghaff 11y ago
      OTOH, $120/yr for music is, depending on your assumptions and how you measure, actually pretty high compared to what people have historically spent on recorded music. [1] I know I've been on the fence about paying for a subscription given that I already have a big library of most of the music I care about. It's not so much that I'm too lazy to subscribe but I'm very slow to sign up for services that are going to hit my credit card every month. Netflix video streaming is close to worthless for movies. But combined with DVDs it's pretty good. [1] http://recode.net/2014/03/18/the-price-of-music/ http://recode.net/2014/03/18/the-price-of-music/
ykumar6 11y ago
The exception may be for companies that have clearly recognized network effects. In this case, your product may not be valuable without a lot of users, customers or cars .. You need to spend to get to critical mass, but I'm sure it's important to articulate a plan on why your business becomes profitable from that point onwards. Too often, there isn't a tipping point or that tipping point is very hard to reach and companies never become profitable
minimaxir 11y ago
Let's extrapolate the argument to the second order. Mobile gaming, for example, has bad Unit Economics. Games like Candy Crush Saga and Game of War spend absurd amounts of money in acquisition. ...which is Facebook and Twitter's primary revenue stream. There is a possibility of a domino effect.
- sjg007 11y ago
  Hmm.. I think they have whales that drive revenue.
- highCs 11y ago
  > Games like Candy Crush Saga and Game of War spend absurd amounts of money in acquisition. I think this is wrong. These games have strong invite-friend mechanisms and have high retention. That's why they are popular in the first place. No source at hand though.
  - minimaxir 11y ago
    That's how it used to be years ago. The economics have changed; due to the increased competition in that marketplace and the extreme aversion of users to paying for things, freemium games must use social engineering to survive. Whales only play one game at a time.
    - highCs 11y ago
      I see, that's interesting.
    - corysama 11y ago
      Yep. "A service launching this week will tell you that Machine Zone is currently spending somewhere around $12 per user with AdColony, InMobi, and Unity Ads, up to $20 per user with Vungle, and between $2 and $30 per user with Chartboost." http://venturebeat.com/2015/08/12/this-service-tells-you-what-supercell-machine-zone-and-other-big-publishers-spend-on-user-acquisition/ http://venturebeat.com/2015/08/12/this-service-tells-you-wha... GoW has very low retention. Users who stick around in GoW are the kind of people who like to spend a lot of money to feel empowered. But, finding and keeping those people is very expensive because it involves churning through a whole lot of users who aren't like that.
eldavido 11y ago
@sama: right on with this. SV $ metrics are always measured in revenue growth, not free cashflow, margin, etc. Measuring revenue works fine for high-margin businesses, which software has been for a long time. Now that we're using VC to finance resource-intensive SaaS companies (e.g. analytics) and even cleaning/home care/service companies, there's a need for collectively higher financial sophistication. Revenue growth is a good proxy when you're selling zero-marginal cost products; not so when you're selling 95 cents of cost for $1.
- kansface 11y ago
  It seems like VCs ought to be more sophisticated than to naively apply the model for SaaS to low margin consumer facing products, but I don't know enough - this really could be the case. Similarly, I have no understanding of all the money that flows into the space (from the outside). The margins are low (to non-existent) and the space is brutally punishing. Screw up a persons laundry, food order, or plain just take too long and you have to give away a year's worth of margins to keep the customer. Delivery as a service is a commodity - who cares who delivers your food or does your laundry? At the same time, the cost of switching between providers is as close to zero as it gets (they are doing home delivery after all!). In the parallel universe that is SF, VCs subsidized (thanks!) the industry to the tune of making it comparable (or actually cheaper) in price for me to pay someone to pick up my laundry, wash and fold it, and return it, to doing it myself at a coin operated laundromat. Whenever the service I used raised prices to stop hemorrhaging money, I simply switched to their latest VC funded competitor.
  - S4M 11y ago
    I think you explained very well why HomeJoy failed this summer.
- Pxtl 11y ago
  Well, a "per-user" cost growth-model might work. That is, your business follows the Uber model of geeks on top and "contractors" at the bottom. You can ignore everything other than the contractors with the assumption that you'll outgrow them or optimize them into negligible levels, but you accept he contractor cost in your big "growth curve" pitch.
highCs 11y ago
Advise for game developers: that's why you should not do clones or games which looked different but are actually clones - like not-so-innovative 2d platformers. If you think about an innovation for your next game, think about it twice, will it drive sells, really?
exelius 11y ago
Low margin businesses are all the rage because all the large, high-margin opportunities are either gone or have such huge barriers to entry that startups have to raise a half billion dollars before making an honest attempt. At least that's what I see. Not that we shouldn't chase the expensive ones, but I don't know that VC is the right framework for that.
- nostrademons 11y ago
  Maybe the solution to that is to go after small, high-margin opportunities, ideally growing ones. http://paulgraham.com/startupideas.html http://paulgraham.com/startupideas.html
  - exelius 11y ago
    This is currently the model that most big consulting companies use: find a thousand niches and fill them all with people. I have a feeling that if you enter these markets as a startup, you'll find they're not really as high margin as they look, and that the margin will get eaten up by integrators anyway (integration work doesn't scale exponentially and causes your costs/outputs to lag your pipeline). Anyway it's not a bad idea; just not one I feel is especially well suited to the VC investment model.
    - ghaff 11y ago
      It's also the model for a lot of business software that caters to some specialist requirement, industry vertical, etc. Just look at the huge partner ecosystem of Salesforce for example. Something like 160,000 people attended Dreamforce. Some of that is large software firms and in-house end-user development of course, but a lot of it is small ISVs with niche add-ons.
    - nostrademons 11y ago
      I think the idea is to pick niches that are small now but will become big in the future. Build the only programming language available for the Altair and you have a high-margin monopoly on a market of a few thousand machines. Build the only operating system for every IBM PC and clone, and you have a high-margin monopoly on a market of hundreds of millions of machines. That's behind the common SV wisdom of "catch a wave", "ride a trend that's larger than yourself", "find markets, don't try to create them", etc. The pitfall is that it requires some degree of future-prediction, and predicting the future is left as an exercise to the entrepreneur. The guy who built the first programming language for the Altair is the richest man in the world; the guy who built the first programming language for the Alto [1] has largely been forgotten by history. [1] https://en.wikipedia.org/wiki/Xerox_Alto https://en.wikipedia.org/wiki/Xerox_Alto
beat 11y ago
Moving matter rather than information is inherently expensive. A lot of the current darlings are about moving matter around. Their best bet is to achieve monopolistic dominance by being radically more cost-efficient than the old-school industries they disrupt, but it's still expensive.
martian 11y ago
The number of companies that have bad unit economics is, I agree, substantially higher than it should be. But I'm not sure this explains the bubblegum expansion of valuations and rounds we're seeing today. There are many thoughtful comments on the perceived bubble from people all over the industry. I'm not qualified to say one way or the other, but I did enjoy Mark Cuban's recent post on the matter. [1] My company, Thumbtack, got a lot of this right early on. Years ago we doubled down on getting the unit economics right. So right that we were (IIRC) profitable for a month or two before taking a big VC round. Not sure how many other companies can say that. But at the end of the day, if the bubble is a bubble and it pops, knowing that we would survive and be able to make a profit is hugely satisfying. My advice to any young startup is figure out how to make money early on. It's the rare Google/Facebook that can blow up and use the platform to sell ads. Most startups will not do this, but many can still make good money doing important things that people will pay for. [1] http://qz.com/356620/mark-cuban-is-absolutely-convinced-we-are-in-tech-bubble-and-its-worse-than-the-last-one/ http://qz.com/356620/mark-cuban-is-absolutely-convinced-we-a...
LAMike 11y ago
Is Sam talking about Fanduel and DraftKings?
- powera 11y ago
  Those two certainly apply IMO, they both have The Next Zynga written all over them. Any investment where you have to spend the money buying every ad on TV has a red-flag that the valuation isn't nearly what people claim it is. Actually, Zynga itself is another one (though it's a public company). I don't see any evidence Zynga will ever be a profitable company, and it has no valuable assets, so I think it's fair value is pretty close to $0.
  - vinceguidry 11y ago
    TV ads can be quite price-effective if you have the right strategy, are catering to a broad enough market, and have a good pro. Fantasy football has such broad market appeal that pretty much any ad buy is going to reach a significant number of people that play it.
shubhamjain 11y ago
I don't get why we always cite Google, Facebook, WhatsApp, Instagram as an example of companies that have shown the way. While, those companies are great in their work and business, they didn't really start with an aim of providing value but as just-another-side-project. Why do we ignore the thousands of online businesses that might not be raking in billions but are successful by every measure? A reason why I look forward to products like Bare-metrics, and AeroFS. The problem I see with seeing these companies as an example is that most people think around the ideas that they feel good about. It is disappointing that so many people are just driving towards building another photo sharing app or a low margin business.
- worik 11y ago
  Exactly. It is silly to aim for billions. Aim for making a living by providing a service that some people will pay for. Small percentage of people paying a small fee multiplied by the Internet. The maths works. As more and more people realise that "free" means "costs are hidden" more and more people will start paying small fees for what once was free. It will never be a high percentage, but high enough
- mbesto 11y ago
  Google and Facebook are cited because they generate an ungodly amount of cashflow/profit and have manage to do it in a smaller timeline than their equally financially regarded counterparts (Google took 15 years to reach that of the revenue that took Coca Cola took 100+ years to reach). I'm curious as to why you consider Baremetrics a success and by what measures? No offense to the guys at Baremetrics (they're product is well executed and I reference their SaaS metrics constantly), but their financial performance is not great [0] given their funding raise and valuation [1]. They're losing more customers than they gain, they're presumably cashflow negative (for a team of 6 engineers at competitive salaries, you're looking at $750k/year cost) and their ARPU/LTV numbers are really low (in relation to their low number of customers). Right now they're getting 10x on revenues, which is crazy high. [0] - https://demo.baremetrics.com/?start_date=2013-11-13&end_date=2015-09-20 https://demo.baremetrics.com/?start_date=2013-11-13&end_date... [1] - https://angel.co/baremetrics https://angel.co/baremetrics
applecore 11y ago
In today's environment, it's better to be one of the "hot" companies with presumably poor unit economics. Otherwise, your competition will out-market and out-sell you every month simply by spending more money.
- vinceguidry 11y ago
  If you can achieve profitability, then you could presumably wait for your competitors' business models to fail and then rake it in when all their customers have to migrate. They pay all the costs to build up your customer base then go away.
  - deleted 11y ago
    [deleted]
  - nemothekid 11y ago
    >then you could presumably wait for your competitors' business models to fail Isn't that essentially playing the market? You might be waiting until the bubble bursts - which puts you in the same position as everyone else trying to short this bubble thats supposed to pop any day now. And even if you are profitable now, the effects of a bubble doesn't mean you will be profitable afterwards.
    - vinceguidry 11y ago
      The market is not a company. If you're playing anyone, it's your competitors. Understanding your competitors is much easier than understanding the market. Actually running a business in the space makes you much more familiar with the unit economics of it. If the market fails, that is, if people decide they no longer wants the service you're both offering, then you're both hosed. If you feel there's a bubble, that is, if you feel that demand for a product / service is going to eventually collapse, then the rational response is to get out of that market, assuming your position is liquid enough to do that, and invest in asset classes that will do well if and when the market collapses. You don't start taking short positions unless you have specific reason to believe a specific company isn't looking good. Otherwise volatility could cause you to lose a lot of money in a very short period of time. Also, you can't short a whole market, you can only bet against it.
aliston 11y ago
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. The first 3 are essentially the same thing and the 4th is related.
roymurdock 11y ago
Kept waiting for him to drop the phrases "network effect" and "economies of scale" but it never happened. AKA burn to acquire users until you're so big that you can throw your weight around to reduce costs ala Amazon. The holy grail of software startups. Given this post, I think it makes sense that YC is pivoting to include more hardware startups in its portfolio. Software is so saturated that people are starting to regard the majority of it as free. The people who do pay for services like Twitter & Facebook are the advertisers and business owners who have probably observed questionable ROI on average for the past few years. I don't expect a bottle of coke to be free, and I don't expect a condom [1] to be free. So the "unit economics" make more sense in hardware (tangible/consumable product) land. Network effects are still important, but shipping a product and collecting revenue from each sale even if you still have negative margins lengthens your ability to stay in business, giving you valuable time during which you might hit critical user mass or achieve economies of scale. [1] http://techcrunch.com/2015/08/09/y-combinators-l-condoms-provides-safe-sex-on-demand/ http://techcrunch.com/2015/08/09/y-combinators-l-condoms-pro...
- _sentient 11y ago
  If you have negative contribution margins, scale only accelerates your demise. Driving toward scale with those economics is exactly what it means to "lose money on every sale, but make it up in volume". Is selling something at a unit loss better than shipping something for free? Maybe, but in the case of software the marginal cost per unit is near zero, so scale can be achieved without huge amounts of capital. Hardware doesn't quite enjoy quite the same leverage.
  - roymurdock 11y ago
    > If you have negative contribution margin, scale without an appropriate reduction in total cost only accelerates your demise. Which is the hallmark of a non-viable business. I agree that it's easier to scale software, but I'd be interested to hear whether or not you think software is a saturated space that has engendered a sense of entitlement in many would-be customers. If you can't convert/monetize your userbase, nothing else really matters.
KaiserPro 11y ago
Its the classic suspension of disbelief. Previous companies made a loss, but in the end started to make a stonking profit (google, airbnb) However they seem to be the exception not the rule. Currently in london there is an explosion of highly integrated iphone ebay apps. Quite why they (the investors) think its a great idea to fund so many clones is beyond me. But then the economics of startups are odd. like broadcasting seeds, you expect infant mortality. However this acceptance of utter failure has creeped up from the seed funding stages into series a,b,c and even d (twitter still cant make money.) Its fine if you manage to sell your shares onto the next sucker. But the problem is that each round bring a bigger price of failure.
LordHumungous 11y ago
It's pretty funny that this even needs to be said, but for some reason it does. This stuff is business 101. Irrational exuberance anyone?
- spinlock 11y ago
  On the one hand: who cares? It's private, non-leveraged private money. It isn't a debt bubble like the mortgage crisis and hasn't infected the public markets like the 90's. Caveate Emptor and all that. On the other hand: the suckers at this table are pension funds and other LPs that are terrible at picking managers. A few good years of returns and money will flood from underfunded pension plans into VC .... just in time for a nice healthy correction. If I was relying on a pension to retire in the next decade or two, then I'd be worried.
  - idlewords 11y ago
    All this dumb money is tying up perfectly good engineers that could otherwise be working on useful stuff. So in that sense the process is harmful even if you don't care about whose pockets get emptied.
  - rodgerd 11y ago
    > On the one hand: who cares? It's private, non-leveraged private money. In many cases it's also destroy existing models, so when they collapse, there will be no new business, and no old business, either.
  - LordHumungous 11y ago
    If we've learned anything about the financial markets in the last 10 years (well, last 200 years), it's that bubbles wreak havoc everywhere.
  - JonFish85 11y ago
    "It isn't a debt bubble like the mortgage crisis and hasn't infected the public markets like the 90's. Caveate Emptor and all that." I've heard that a lot, but I wonder if it's as harmless as people say? If/when this bubble pops, won't that have a pretty tough spiral effect? Granted it might not be as deep as the late-90's bubble, but I'd have to think that this will be pretty grim when it happens too. Along with sky-high valuations come sky-high salaries, which breed high rent & purchase prices for homes. Along with that comes high tax revenue and such. If suddenly a young engineer's expected income drops from $150-$200k/year to $60k, that could be pretty rough. Granted it probably will affect the coasts a lot harder than the central US, but I'd think it'd have national effects regardless. Salaries drop, suddenly people can't afford their houses, so they either have to sell at a loss or try to hold on to it. What if a sizable chunk of the population is no longer able to afford college loans? You also mentioned the pension problem; if tax revenue starts to dry up because housing prices goes down, that could exacerbate a problem that's already popping up around the US.
Mahn 11y ago
The worst part of it is that companies with bad unit economics are not just shooting themselves in the foot for the sake of "growth" or simply faking hotness, but that in acquiring users for more than they are worth they effectively drive acquisition costs up for everyone else in the industry.
brianmcconnell 11y ago
What's driving a lot of the idiotic investment is FOMO (fear of missing out). It is a powerful thing and can override a rational assessment of a businesses chances for success. This combined with a lack of historical perspective is dangerous. Nearly _every_ smartphone app you see had a voice/phone counterpart a few years ago (remember 777-FILM or #TAXI?), most of them are long dead, and were killed off by the same market forces that will release their latest mimics from their mortal coil.
- seiji 11y ago
  This is why there's a dearth of reasonable funding these days. VCs, the bad ones (which most of them are), are flock-driven creatures. Nobody wants to step out of line, and that's a problem when something new, novel, or actually different walks in your door. The flip side of FOMO is "if nobody else is doing X, I won't do X either." Startups can get $100k in seed money by yelling on the street in soma. Startups can get $100 million by tickling andreessen in the right spot and chanting forbidden words from the before time. Nobody can seem to get $5 million to bridge the gap between living-in-coder-poverty and being able to hire a real team for more than two months.
- sjg007 11y ago
  Yes but #TAXI never showed up.
the_economist 11y ago
You have to admit, though, that there is nothing quite like the feeling of paying $7 for an Uber pool to go all the way across San Francisco, especially when it's surging 3.9x.
tvladeck 11y ago
The reason this is complicated is that the burn rate of the business is determined its net margin (NM) and the viability of the business is determined by its contribution margin (CM) (NB I didn't say gross margin - they are slightly different). CM is extremely hard to calculate because "fixed" costs - in practice - do scale with the number of customers. But on the other hand, if you have a positive CM, it may make sense to invest heavily in capacity, leading to negative NM.
yorkedork 11y ago
While I'm not intending to be heavy-handed and reductionist, I think the (macro) trend(s) we've seen in (domestic) startup investment since 2008-2009 can satisfactorily explain this behavior. Disinflation & deflation, capital flows and political friction preventing effective (any?) fiscal policy have produced an environment where private capital set on a given rate of return on investment is chasing increasingly risky organizations [1][2]. Large firms have been sitting on enormous sums of cash; e.g., why is it that the most capitalized company on earth isn't investing aggressively. In lieu of investment, many of these firms have been focused on engineering stock buybacks. So, the thesis: why are so many firms pouring money into startups with increasingly questionable fundamentals? Because hands previously gripping bundles of capital have (nominally) more capital than they did with decreasing options for productive investment and downward pressure on returns. 1. http://www.economist.com/blogs/freeexchange/2015/04/puzzles http://www.economist.com/blogs/freeexchange/2015/04/puzzles 2. http://krugman.blogs.nytimes.com/?s=low+inflation+return+investment http://krugman.blogs.nytimes.com/?s=low+inflation+return+inv... P.S. I recognize that I'm probably a bit left field for this group as I'm not a libertarian, I support strong regulation and I question the marginal value of lots of Valley products.
- idlewords 11y ago
  I think this is a pretty clear failure of capitalism, since the whole point of having greedy, top-hat-wearing capitalists chasing profits is to have them re-invest that profit in the hopes of making more. In the meantime, they compete with each other and end up magically allocating resources in a socially useful way. Instead, big companies sit on their profits (like you say), while startups compete for the attention of a small group of investors who behave for all the world like the central planners of old, deciding how to allocate money based on their own tastes, interests, and gut feelings, rather than anything resembling a market test. Goes off to have red flag dry-cleaned
  - 7Figures2Commas 11y ago
    Correction for you: I think this is a pretty clear failure of corporatism...
amelius 11y ago
What I don't get is this: the freemium pricing model is often used, but what few people seem to know is that selling below cost is also called "predatory pricing" [1] and it is illegal. And there are good reasons for that. So... why are we letting the market get ruined by this phenomenon? [1] https://en.wikipedia.org/wiki/Predatory_pricing https://en.wikipedia.org/wiki/Predatory_pricing
- grkvlt 11y ago
  Not exactly, and I'm not even sure 'freemium' falls into these categories anyway. Selling in a way that is deliberately designed to drive off competition is illegal, assuming you can prove it. Selling below cost is just called 'making a loss' and is perfectly legal, if generally unsustainable ;) Here are two scenarios: 1. I sell product A at a loss, intending to attract customers who will then buy product B at much higher margin, making me a large profit - legal. 2. I sell A at a loss to attract company X's customers and drive them out of business, then raise the price of A once they go bust - illegal and predatory pricing.
  - amelius 11y ago
    Yes, but what is happening right now is that start-ups are taking funding, build a brand on VC money, hence drive everybody else practically out of business (and blocking potential newcomers), while making losses year after year. To me that sounds pretty much like predatory pricing (and anti-competitive behavior in general).
    - nostrademons 11y ago
      Only in the particular industries they operate in. And the whole point of this essay (and the reason this is a problem) is because these are bad industries, known to have bad economics, and companies are using VC money to paper over the bad economics. Just ignore the herd and look for overlooked industries which don't have bad economics. That's what you have to do to survive as a startup founder anyway. It's pretty analogous to the family next door who goes and buys a yacht on credit cards even though their income can't support the payments. Yes, it's annoying to watch people have nice things they didn't earn, and yes, they do marginally prop up the price of yachts. However, were you really planning on buying a yacht anyway? They will get their come-uppance when the bills come due, and it's not worth worrying too much about what other people are doing in the meantime.
satjot 11y ago
Homejoy seems to be the most recent example of non-sensical unit economics.
deleted 11y ago
[deleted]
bsder 11y ago
There are two sides to this: 1) A business with good fundamentals doesn't need a VC. If I've got cash flow, I can probably get a loan with a bank on much better terms than any VC will give me. If I don't have cash flow, well, okay, I need a VC. But then, tautologically, my business doesn't have good fundamentals. 2) VC's only care about unicorns. Since VC's make up their whole portfolio based around the 100X+ returns on a single company wiping out the losses from the rest, fundamentals are irrelevant. Being in the hot buzz which enables you to flip to somebody else for 100X is far more valuable. A business with good fundamentals sells for about 10X which is nowhere close enough to offset the rest of the losers.
- eldavido 11y ago
  Re (1), I just tried to get a loan from Wells Fargo last week for a consulting business with a few hundred K in annual revenue, and it was an incredible pain in the ass (multiple years of balance sheets/income statements, tax returns, trips to the bank, and all for, like, 25% of one year's profit-sized loan) -- there's truly an opportunity to disrupt small business lending, but the hard part there is capital aggregation.
zxcvvcxz 11y ago
Does anyone else think that these unoriginal, doomed-from-the-start startups are a direct result of funding institutions looking for founders that appear really good "on paper"? You know, experience with this BigCo, a degree at that IvySchool, etc. Even YC may be becoming guilty of this, as it seems like a top school brand is a prerequisite. Or the more sinister metric, do you have growth? PG wrote that startup=growth, and that growth is the all-encompasing metric. Might this incentivize some prestige-seeking 'entrepreneurs' to do things that don't scale like pumping money into convincing users to join their website, or making fake accounts? Not that growth and a founder's unsustainable touch early on aren't excellent things for which to strive. But in any system in which there is prestige to be gained, there will be those who will match patterns and fool the heuristics of the gatekeepers.

372 points by _sentient 11y ago

I was nodding my head in agreement until I got to this line > where you make more than you spend on each user, and it gets better not worse as you get bigger, you may not look like some of hottest companies of today, but you’ll look a lot like Google and Facebook. Wouldn't Facebook be an example of a company with bad unit economics?

pbreit 11y ago
Considering Facebook is a website with zero marginal costs and zero acquisition costs, no. It makes way more $$ than it spends, especially marginally/per-unit.
- jegutman 11y ago
  Yea, and why not just look at the actual history of FB where they were quite easily able to pay for server costs at an early point with ads. It's possible they hit a point where they were losing money, but 100% at any point past the very beginning if they wanted they could've invested less and been a profitable business. Possibly not a business that would've existed for the long run and it might have opened the door for a competitor, but they could have drawn down money out of the business they had built. Many of the companies people complain about actually couldn't do that because they don't have any ability to raise their prices without losing all of their customers.
steego 11y ago
You're accounting for Facebook's and Google's business model all wrong. The end users aren't the customer. Advertisers are the customers. Think of Facebook and Google more like giant hydro-generation plants that have to continually work to divert the flow of attention of its users to its customers. Like any hydro-generation plant, you want to capture a monopoly from this recurring source of income so you can dictate premium prices from your customers.
- LAMike 11y ago
  A+ analogy
- nostrademons 11y ago
  They also have basically zero user-acquisition costs, on both the user and advertiser side. CAC (customer acquisition cost) is usually the largest variable cost for most businesses. Things like server costs, electricity, etc. are tiny in comparison. Cut CAC and your margins skyrocket. Indeed, the reason why Google & Facebook are profitable is because they're a very effective way of cutting CAC for other businesses. Their revenue is another businesses's marketing spending, and yet they're still better than the alternatives for driving customer conversions.
- eggie 11y ago
  To see these systems like massive hydro-generation plants, you first have to assume that human attention for advertising is an infinitely-renewable resource. Revenue is certainly increasing rapidly in recent years: http://www.iab.net/about_the_iab/recent_press_releases/press_release_archive/press_release/pr-061115 http://www.iab.net/about_the_iab/recent_press_releases/press.... Maybe there is no ceiling in sight.
eggie 11y ago
Unlike the others replying to you, I tend to agree. At least, I am dubious that they will "keep customers forever", which seems to be a key part of good unit economics. Things change, sometimes very fast.

deleted 11y ago

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pbreit 11y ago

I've gotta think one category he's talking about are the delivery services. I still have not seen a decent articulation of the end-to-end economics. But they can't be terrific. I know, for example, that Sidecar pays drivers up to $20 for a single delivery and just can't see how this is viable outside of rare exceptions. At least Instacart prices the item being delivered (and I suspect never gives you the yellow ticket price which pretty much every Safeway item gets nowadays).

exelius 11y ago
I agree; delivery services will only make sense with autonomous delivery (which I suspect is the long-term plan for all of them - Uber included). But realistically, the R&D required there is crazy if you're trying to be first to market - Amazon and Uber are investing billions in this, and they're the competition. Once drones or autonomous cars become widespread, this business becomes a commodity and anyone without a legacy business they have to migrate will be at an advantage. So I have no idea why these companies are getting funded other than it's a problem that's simple enough for a really smart university student to tackle.
- _sentient 11y ago
  Uber is profitable in many of its mature markets. This is while charging less than half what you would pay a legacy taxi service, while paying drivers more than they would make at the same. This is the direct byproduct of strong network effects on both the supply/demand side, paired with operational excellence on their part. Self driving cars would bring the marginal cost down even further, but they have built a stunningly good business with or without a quantum leap in automation. The same probably isn't true for many other Uber-for-X companies, particularly those with underwater unit economics.
  - exelius 11y ago
    Yeah; Uber had a unique opportunity because the taxi business was stuck in the 20th century and had a bad case of regulatory capture as a result. That said, in Uber's more "mature" markets you're starting to see a lot of the problems that caused the taxi business to regulate in the first place: too many drivers, no way to guarantee steady revenue as a driver, etc.

cm2012 11y ago

As a side note, unless you have a secret sauce (something unique to your company, like better proprietary data, lower operating costs, etc.) all acquisition channels will decline in effectiveness over time, making it harder to make unit costs work. This is generally known as audience fatigue.

ececconi 11y ago

The one product that I use and pay for that is so good that I recommend to all of my friends is Spotify. I'm so surprised how few of my friends actually pay for it though. They're willing to put up with ads and reduced quality for just $10 a month. Other services I found so good that I recommend to all of my friends but do not pay for because my data needs are very small are dropbox and evernote. I bet some of my friends wonder why I wouldn't spend such a small amount of cash for their usefulness. Getting people to pay for digital services is hard.

jobu 11y ago
> They're willing to put up with ads and reduced quality for just $10 a month. I see two reasons for this: 1) Free is huge. Most people are willing to put up with a lot of bullshit for free. 2) Netflix. We pay $7.99/mo for essentially infinite TV on multiple devices, but $9.99 only gets me audio on one device at a time. It seems like a worse deal, so why would I pay?
- martian 11y ago
  Also: never underestimate laziness. Typing in a credit card takes work. Re: Netflix/Spotify price differences. The relative size of the libraries (vs all content in the domain) is something to keep in mind. Netflix gives users access to some videos, but Spotify gives users access to almost all songs [1]. [1] Can't find precise estimates for sizes of libraries, so apologies for the argument from anecdotal evidence.
  - ghaff 11y ago
    OTOH, $120/yr for music is, depending on your assumptions and how you measure, actually pretty high compared to what people have historically spent on recorded music. [1] I know I've been on the fence about paying for a subscription given that I already have a big library of most of the music I care about. It's not so much that I'm too lazy to subscribe but I'm very slow to sign up for services that are going to hit my credit card every month. Netflix video streaming is close to worthless for movies. But combined with DVDs it's pretty good. [1] http://recode.net/2014/03/18/the-price-of-music/ http://recode.net/2014/03/18/the-price-of-music/

ykumar6 11y ago

The exception may be for companies that have clearly recognized network effects. In this case, your product may not be valuable without a lot of users, customers or cars .. You need to spend to get to critical mass, but I'm sure it's important to articulate a plan on why your business becomes profitable from that point onwards. Too often, there isn't a tipping point or that tipping point is very hard to reach and companies never become profitable

minimaxir 11y ago

Let's extrapolate the argument to the second order. Mobile gaming, for example, has bad Unit Economics. Games like Candy Crush Saga and Game of War spend absurd amounts of money in acquisition. ...which is Facebook and Twitter's primary revenue stream. There is a possibility of a domino effect.

sjg007 11y ago
Hmm.. I think they have whales that drive revenue.
highCs 11y ago
> Games like Candy Crush Saga and Game of War spend absurd amounts of money in acquisition. I think this is wrong. These games have strong invite-friend mechanisms and have high retention. That's why they are popular in the first place. No source at hand though.
- minimaxir 11y ago
  That's how it used to be years ago. The economics have changed; due to the increased competition in that marketplace and the extreme aversion of users to paying for things, freemium games must use social engineering to survive. Whales only play one game at a time.
  - highCs 11y ago
    I see, that's interesting.
  - corysama 11y ago
    Yep. "A service launching this week will tell you that Machine Zone is currently spending somewhere around $12 per user with AdColony, InMobi, and Unity Ads, up to $20 per user with Vungle, and between $2 and $30 per user with Chartboost." http://venturebeat.com/2015/08/12/this-service-tells-you-what-supercell-machine-zone-and-other-big-publishers-spend-on-user-acquisition/ http://venturebeat.com/2015/08/12/this-service-tells-you-wha... GoW has very low retention. Users who stick around in GoW are the kind of people who like to spend a lot of money to feel empowered. But, finding and keeping those people is very expensive because it involves churning through a whole lot of users who aren't like that.

eldavido 11y ago

@sama: right on with this. SV $ metrics are always measured in revenue growth, not free cashflow, margin, etc. Measuring revenue works fine for high-margin businesses, which software has been for a long time. Now that we're using VC to finance resource-intensive SaaS companies (e.g. analytics) and even cleaning/home care/service companies, there's a need for collectively higher financial sophistication. Revenue growth is a good proxy when you're selling zero-marginal cost products; not so when you're selling 95 cents of cost for $1.

kansface 11y ago
It seems like VCs ought to be more sophisticated than to naively apply the model for SaaS to low margin consumer facing products, but I don't know enough - this really could be the case. Similarly, I have no understanding of all the money that flows into the space (from the outside). The margins are low (to non-existent) and the space is brutally punishing. Screw up a persons laundry, food order, or plain just take too long and you have to give away a year's worth of margins to keep the customer. Delivery as a service is a commodity - who cares who delivers your food or does your laundry? At the same time, the cost of switching between providers is as close to zero as it gets (they are doing home delivery after all!). In the parallel universe that is SF, VCs subsidized (thanks!) the industry to the tune of making it comparable (or actually cheaper) in price for me to pay someone to pick up my laundry, wash and fold it, and return it, to doing it myself at a coin operated laundromat. Whenever the service I used raised prices to stop hemorrhaging money, I simply switched to their latest VC funded competitor.
- S4M 11y ago
  I think you explained very well why HomeJoy failed this summer.
Pxtl 11y ago
Well, a "per-user" cost growth-model might work. That is, your business follows the Uber model of geeks on top and "contractors" at the bottom. You can ignore everything other than the contractors with the assumption that you'll outgrow them or optimize them into negligible levels, but you accept he contractor cost in your big "growth curve" pitch.

highCs 11y ago

Advise for game developers: that's why you should not do clones or games which looked different but are actually clones - like not-so-innovative 2d platformers. If you think about an innovation for your next game, think about it twice, will it drive sells, really?

exelius 11y ago

Low margin businesses are all the rage because all the large, high-margin opportunities are either gone or have such huge barriers to entry that startups have to raise a half billion dollars before making an honest attempt. At least that's what I see. Not that we shouldn't chase the expensive ones, but I don't know that VC is the right framework for that.

nostrademons 11y ago
Maybe the solution to that is to go after small, high-margin opportunities, ideally growing ones. http://paulgraham.com/startupideas.html http://paulgraham.com/startupideas.html
- exelius 11y ago
  This is currently the model that most big consulting companies use: find a thousand niches and fill them all with people. I have a feeling that if you enter these markets as a startup, you'll find they're not really as high margin as they look, and that the margin will get eaten up by integrators anyway (integration work doesn't scale exponentially and causes your costs/outputs to lag your pipeline). Anyway it's not a bad idea; just not one I feel is especially well suited to the VC investment model.
  - ghaff 11y ago
    It's also the model for a lot of business software that caters to some specialist requirement, industry vertical, etc. Just look at the huge partner ecosystem of Salesforce for example. Something like 160,000 people attended Dreamforce. Some of that is large software firms and in-house end-user development of course, but a lot of it is small ISVs with niche add-ons.
  - nostrademons 11y ago
    I think the idea is to pick niches that are small now but will become big in the future. Build the only programming language available for the Altair and you have a high-margin monopoly on a market of a few thousand machines. Build the only operating system for every IBM PC and clone, and you have a high-margin monopoly on a market of hundreds of millions of machines. That's behind the common SV wisdom of "catch a wave", "ride a trend that's larger than yourself", "find markets, don't try to create them", etc. The pitfall is that it requires some degree of future-prediction, and predicting the future is left as an exercise to the entrepreneur. The guy who built the first programming language for the Altair is the richest man in the world; the guy who built the first programming language for the Alto [1] has largely been forgotten by history. [1] https://en.wikipedia.org/wiki/Xerox_Alto https://en.wikipedia.org/wiki/Xerox_Alto

beat 11y ago

Moving matter rather than information is inherently expensive. A lot of the current darlings are about moving matter around. Their best bet is to achieve monopolistic dominance by being radically more cost-efficient than the old-school industries they disrupt, but it's still expensive.

martian 11y ago

The number of companies that have bad unit economics is, I agree, substantially higher than it should be. But I'm not sure this explains the bubblegum expansion of valuations and rounds we're seeing today. There are many thoughtful comments on the perceived bubble from people all over the industry. I'm not qualified to say one way or the other, but I did enjoy Mark Cuban's recent post on the matter. [1] My company, Thumbtack, got a lot of this right early on. Years ago we doubled down on getting the unit economics right. So right that we were (IIRC) profitable for a month or two before taking a big VC round. Not sure how many other companies can say that. But at the end of the day, if the bubble is a bubble and it pops, knowing that we would survive and be able to make a profit is hugely satisfying. My advice to any young startup is figure out how to make money early on. It's the rare Google/Facebook that can blow up and use the platform to sell ads. Most startups will not do this, but many can still make good money doing important things that people will pay for. [1] http://qz.com/356620/mark-cuban-is-absolutely-convinced-we-are-in-tech-bubble-and-its-worse-than-the-last-one/ http://qz.com/356620/mark-cuban-is-absolutely-convinced-we-a...

LAMike 11y ago

Is Sam talking about Fanduel and DraftKings?

powera 11y ago
Those two certainly apply IMO, they both have The Next Zynga written all over them. Any investment where you have to spend the money buying every ad on TV has a red-flag that the valuation isn't nearly what people claim it is. Actually, Zynga itself is another one (though it's a public company). I don't see any evidence Zynga will ever be a profitable company, and it has no valuable assets, so I think it's fair value is pretty close to $0.
- vinceguidry 11y ago
  TV ads can be quite price-effective if you have the right strategy, are catering to a broad enough market, and have a good pro. Fantasy football has such broad market appeal that pretty much any ad buy is going to reach a significant number of people that play it.

shubhamjain 11y ago

I don't get why we always cite Google, Facebook, WhatsApp, Instagram as an example of companies that have shown the way. While, those companies are great in their work and business, they didn't really start with an aim of providing value but as just-another-side-project. Why do we ignore the thousands of online businesses that might not be raking in billions but are successful by every measure? A reason why I look forward to products like Bare-metrics, and AeroFS. The problem I see with seeing these companies as an example is that most people think around the ideas that they feel good about. It is disappointing that so many people are just driving towards building another photo sharing app or a low margin business.

worik 11y ago
Exactly. It is silly to aim for billions. Aim for making a living by providing a service that some people will pay for. Small percentage of people paying a small fee multiplied by the Internet. The maths works. As more and more people realise that "free" means "costs are hidden" more and more people will start paying small fees for what once was free. It will never be a high percentage, but high enough
mbesto 11y ago
Google and Facebook are cited because they generate an ungodly amount of cashflow/profit and have manage to do it in a smaller timeline than their equally financially regarded counterparts (Google took 15 years to reach that of the revenue that took Coca Cola took 100+ years to reach). I'm curious as to why you consider Baremetrics a success and by what measures? No offense to the guys at Baremetrics (they're product is well executed and I reference their SaaS metrics constantly), but their financial performance is not great [0] given their funding raise and valuation [1]. They're losing more customers than they gain, they're presumably cashflow negative (for a team of 6 engineers at competitive salaries, you're looking at $750k/year cost) and their ARPU/LTV numbers are really low (in relation to their low number of customers). Right now they're getting 10x on revenues, which is crazy high. [0] - https://demo.baremetrics.com/?start_date=2013-11-13&end_date=2015-09-20 https://demo.baremetrics.com/?start_date=2013-11-13&end_date... [1] - https://angel.co/baremetrics https://angel.co/baremetrics

applecore 11y ago

In today's environment, it's better to be one of the "hot" companies with presumably poor unit economics. Otherwise, your competition will out-market and out-sell you every month simply by spending more money.

vinceguidry 11y ago
If you can achieve profitability, then you could presumably wait for your competitors' business models to fail and then rake it in when all their customers have to migrate. They pay all the costs to build up your customer base then go away.
- deleted 11y ago
  [deleted]
- nemothekid 11y ago
  >then you could presumably wait for your competitors' business models to fail Isn't that essentially playing the market? You might be waiting until the bubble bursts - which puts you in the same position as everyone else trying to short this bubble thats supposed to pop any day now. And even if you are profitable now, the effects of a bubble doesn't mean you will be profitable afterwards.
  - vinceguidry 11y ago
    The market is not a company. If you're playing anyone, it's your competitors. Understanding your competitors is much easier than understanding the market. Actually running a business in the space makes you much more familiar with the unit economics of it. If the market fails, that is, if people decide they no longer wants the service you're both offering, then you're both hosed. If you feel there's a bubble, that is, if you feel that demand for a product / service is going to eventually collapse, then the rational response is to get out of that market, assuming your position is liquid enough to do that, and invest in asset classes that will do well if and when the market collapses. You don't start taking short positions unless you have specific reason to believe a specific company isn't looking good. Otherwise volatility could cause you to lose a lot of money in a very short period of time. Also, you can't short a whole market, you can only bet against it.

aliston 11y ago

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. The first 3 are essentially the same thing and the 4th is related.

roymurdock 11y ago

Kept waiting for him to drop the phrases "network effect" and "economies of scale" but it never happened. AKA burn to acquire users until you're so big that you can throw your weight around to reduce costs ala Amazon. The holy grail of software startups. Given this post, I think it makes sense that YC is pivoting to include more hardware startups in its portfolio. Software is so saturated that people are starting to regard the majority of it as free. The people who do pay for services like Twitter & Facebook are the advertisers and business owners who have probably observed questionable ROI on average for the past few years. I don't expect a bottle of coke to be free, and I don't expect a condom [1] to be free. So the "unit economics" make more sense in hardware (tangible/consumable product) land. Network effects are still important, but shipping a product and collecting revenue from each sale even if you still have negative margins lengthens your ability to stay in business, giving you valuable time during which you might hit critical user mass or achieve economies of scale. [1] http://techcrunch.com/2015/08/09/y-combinators-l-condoms-provides-safe-sex-on-demand/ http://techcrunch.com/2015/08/09/y-combinators-l-condoms-pro...

_sentient 11y ago
If you have negative contribution margins, scale only accelerates your demise. Driving toward scale with those economics is exactly what it means to "lose money on every sale, but make it up in volume". Is selling something at a unit loss better than shipping something for free? Maybe, but in the case of software the marginal cost per unit is near zero, so scale can be achieved without huge amounts of capital. Hardware doesn't quite enjoy quite the same leverage.
- roymurdock 11y ago
  > If you have negative contribution margin, scale without an appropriate reduction in total cost only accelerates your demise. Which is the hallmark of a non-viable business. I agree that it's easier to scale software, but I'd be interested to hear whether or not you think software is a saturated space that has engendered a sense of entitlement in many would-be customers. If you can't convert/monetize your userbase, nothing else really matters.

KaiserPro 11y ago

Its the classic suspension of disbelief. Previous companies made a loss, but in the end started to make a stonking profit (google, airbnb) However they seem to be the exception not the rule. Currently in london there is an explosion of highly integrated iphone ebay apps. Quite why they (the investors) think its a great idea to fund so many clones is beyond me. But then the economics of startups are odd. like broadcasting seeds, you expect infant mortality. However this acceptance of utter failure has creeped up from the seed funding stages into series a,b,c and even d (twitter still cant make money.) Its fine if you manage to sell your shares onto the next sucker. But the problem is that each round bring a bigger price of failure.

LordHumungous 11y ago

It's pretty funny that this even needs to be said, but for some reason it does. This stuff is business 101. Irrational exuberance anyone?

spinlock 11y ago
On the one hand: who cares? It's private, non-leveraged private money. It isn't a debt bubble like the mortgage crisis and hasn't infected the public markets like the 90's. Caveate Emptor and all that. On the other hand: the suckers at this table are pension funds and other LPs that are terrible at picking managers. A few good years of returns and money will flood from underfunded pension plans into VC .... just in time for a nice healthy correction. If I was relying on a pension to retire in the next decade or two, then I'd be worried.
- idlewords 11y ago
  All this dumb money is tying up perfectly good engineers that could otherwise be working on useful stuff. So in that sense the process is harmful even if you don't care about whose pockets get emptied.
- rodgerd 11y ago
  > On the one hand: who cares? It's private, non-leveraged private money. In many cases it's also destroy existing models, so when they collapse, there will be no new business, and no old business, either.
- LordHumungous 11y ago
  If we've learned anything about the financial markets in the last 10 years (well, last 200 years), it's that bubbles wreak havoc everywhere.
- JonFish85 11y ago
  "It isn't a debt bubble like the mortgage crisis and hasn't infected the public markets like the 90's. Caveate Emptor and all that." I've heard that a lot, but I wonder if it's as harmless as people say? If/when this bubble pops, won't that have a pretty tough spiral effect? Granted it might not be as deep as the late-90's bubble, but I'd have to think that this will be pretty grim when it happens too. Along with sky-high valuations come sky-high salaries, which breed high rent & purchase prices for homes. Along with that comes high tax revenue and such. If suddenly a young engineer's expected income drops from $150-$200k/year to $60k, that could be pretty rough. Granted it probably will affect the coasts a lot harder than the central US, but I'd think it'd have national effects regardless. Salaries drop, suddenly people can't afford their houses, so they either have to sell at a loss or try to hold on to it. What if a sizable chunk of the population is no longer able to afford college loans? You also mentioned the pension problem; if tax revenue starts to dry up because housing prices goes down, that could exacerbate a problem that's already popping up around the US.

Mahn 11y ago

The worst part of it is that companies with bad unit economics are not just shooting themselves in the foot for the sake of "growth" or simply faking hotness, but that in acquiring users for more than they are worth they effectively drive acquisition costs up for everyone else in the industry.

brianmcconnell 11y ago

What's driving a lot of the idiotic investment is FOMO (fear of missing out). It is a powerful thing and can override a rational assessment of a businesses chances for success. This combined with a lack of historical perspective is dangerous. Nearly _every_ smartphone app you see had a voice/phone counterpart a few years ago (remember 777-FILM or #TAXI?), most of them are long dead, and were killed off by the same market forces that will release their latest mimics from their mortal coil.

seiji 11y ago
This is why there's a dearth of reasonable funding these days. VCs, the bad ones (which most of them are), are flock-driven creatures. Nobody wants to step out of line, and that's a problem when something new, novel, or actually different walks in your door. The flip side of FOMO is "if nobody else is doing X, I won't do X either." Startups can get $100k in seed money by yelling on the street in soma. Startups can get $100 million by tickling andreessen in the right spot and chanting forbidden words from the before time. Nobody can seem to get $5 million to bridge the gap between living-in-coder-poverty and being able to hire a real team for more than two months.
sjg007 11y ago
Yes but #TAXI never showed up.

the_economist 11y ago

You have to admit, though, that there is nothing quite like the feeling of paying $7 for an Uber pool to go all the way across San Francisco, especially when it's surging 3.9x.

tvladeck 11y ago

The reason this is complicated is that the burn rate of the business is determined its net margin (NM) and the viability of the business is determined by its contribution margin (CM) (NB I didn't say gross margin - they are slightly different). CM is extremely hard to calculate because "fixed" costs - in practice - do scale with the number of customers. But on the other hand, if you have a positive CM, it may make sense to invest heavily in capacity, leading to negative NM.

yorkedork 11y ago

While I'm not intending to be heavy-handed and reductionist, I think the (macro) trend(s) we've seen in (domestic) startup investment since 2008-2009 can satisfactorily explain this behavior. Disinflation & deflation, capital flows and political friction preventing effective (any?) fiscal policy have produced an environment where private capital set on a given rate of return on investment is chasing increasingly risky organizations [1][2]. Large firms have been sitting on enormous sums of cash; e.g., why is it that the most capitalized company on earth isn't investing aggressively. In lieu of investment, many of these firms have been focused on engineering stock buybacks. So, the thesis: why are so many firms pouring money into startups with increasingly questionable fundamentals? Because hands previously gripping bundles of capital have (nominally) more capital than they did with decreasing options for productive investment and downward pressure on returns. 1. http://www.economist.com/blogs/freeexchange/2015/04/puzzles http://www.economist.com/blogs/freeexchange/2015/04/puzzles 2. http://krugman.blogs.nytimes.com/?s=low+inflation+return+investment http://krugman.blogs.nytimes.com/?s=low+inflation+return+inv... P.S. I recognize that I'm probably a bit left field for this group as I'm not a libertarian, I support strong regulation and I question the marginal value of lots of Valley products.

idlewords 11y ago
I think this is a pretty clear failure of capitalism, since the whole point of having greedy, top-hat-wearing capitalists chasing profits is to have them re-invest that profit in the hopes of making more. In the meantime, they compete with each other and end up magically allocating resources in a socially useful way. Instead, big companies sit on their profits (like you say), while startups compete for the attention of a small group of investors who behave for all the world like the central planners of old, deciding how to allocate money based on their own tastes, interests, and gut feelings, rather than anything resembling a market test. Goes off to have red flag dry-cleaned
- 7Figures2Commas 11y ago
  Correction for you: I think this is a pretty clear failure of corporatism...

amelius 11y ago

What I don't get is this: the freemium pricing model is often used, but what few people seem to know is that selling below cost is also called "predatory pricing" [1] and it is illegal. And there are good reasons for that. So... why are we letting the market get ruined by this phenomenon? [1] https://en.wikipedia.org/wiki/Predatory_pricing https://en.wikipedia.org/wiki/Predatory_pricing

grkvlt 11y ago
Not exactly, and I'm not even sure 'freemium' falls into these categories anyway. Selling in a way that is deliberately designed to drive off competition is illegal, assuming you can prove it. Selling below cost is just called 'making a loss' and is perfectly legal, if generally unsustainable ;) Here are two scenarios: 1. I sell product A at a loss, intending to attract customers who will then buy product B at much higher margin, making me a large profit - legal. 2. I sell A at a loss to attract company X's customers and drive them out of business, then raise the price of A once they go bust - illegal and predatory pricing.
- amelius 11y ago
  Yes, but what is happening right now is that start-ups are taking funding, build a brand on VC money, hence drive everybody else practically out of business (and blocking potential newcomers), while making losses year after year. To me that sounds pretty much like predatory pricing (and anti-competitive behavior in general).
  - nostrademons 11y ago
    Only in the particular industries they operate in. And the whole point of this essay (and the reason this is a problem) is because these are bad industries, known to have bad economics, and companies are using VC money to paper over the bad economics. Just ignore the herd and look for overlooked industries which don't have bad economics. That's what you have to do to survive as a startup founder anyway. It's pretty analogous to the family next door who goes and buys a yacht on credit cards even though their income can't support the payments. Yes, it's annoying to watch people have nice things they didn't earn, and yes, they do marginally prop up the price of yachts. However, were you really planning on buying a yacht anyway? They will get their come-uppance when the bills come due, and it's not worth worrying too much about what other people are doing in the meantime.

satjot 11y ago

Homejoy seems to be the most recent example of non-sensical unit economics.

deleted 11y ago

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bsder 11y ago

There are two sides to this: 1) A business with good fundamentals doesn't need a VC. If I've got cash flow, I can probably get a loan with a bank on much better terms than any VC will give me. If I don't have cash flow, well, okay, I need a VC. But then, tautologically, my business doesn't have good fundamentals. 2) VC's only care about unicorns. Since VC's make up their whole portfolio based around the 100X+ returns on a single company wiping out the losses from the rest, fundamentals are irrelevant. Being in the hot buzz which enables you to flip to somebody else for 100X is far more valuable. A business with good fundamentals sells for about 10X which is nowhere close enough to offset the rest of the losers.

eldavido 11y ago
Re (1), I just tried to get a loan from Wells Fargo last week for a consulting business with a few hundred K in annual revenue, and it was an incredible pain in the ass (multiple years of balance sheets/income statements, tax returns, trips to the bank, and all for, like, 25% of one year's profit-sized loan) -- there's truly an opportunity to disrupt small business lending, but the hard part there is capital aggregation.

zxcvvcxz 11y ago

Does anyone else think that these unoriginal, doomed-from-the-start startups are a direct result of funding institutions looking for founders that appear really good "on paper"? You know, experience with this BigCo, a degree at that IvySchool, etc. Even YC may be becoming guilty of this, as it seems like a top school brand is a prerequisite. Or the more sinister metric, do you have growth? PG wrote that startup=growth, and that growth is the all-encompasing metric. Might this incentivize some prestige-seeking 'entrepreneurs' to do things that don't scale like pumping money into convincing users to join their website, or making fake accounts? Not that growth and a founder's unsustainable touch early on aren't excellent things for which to strive. But in any system in which there is prestige to be gained, there will be those who will match patterns and fool the heuristics of the gatekeepers.