Economic dislocations create opportunities for financially disciplined companies to leapfrog competitors. The dot-com bubble produced Amazon, eBay and Priceline, while the Great Recession provided the backdrop for Uber and Airbnb to flourish, to name a few.
Downturns have also been the death knell for companies too dependent on a free-flowing venture-capital spigot.
What commonalities enable some startups to succeed in trying economic times while others go bankrupt? And what does the answer tell us about the companies that will emerge from this pandemic and become household names in the coming decade?
Hint: Unit economics matters.
VCs: Growth Is Out, Profitability Is In
In really robust economic and funding cycles, it’s not difficult for businesses to get funding sufficient to accelerate growth — enough to quickly achieve scale — without any plan on how they’ll become profitable.
Even in less capital-rich cycles, a strong management team with an innovative idea can get funded through the next milestone, and the next, well before they have a viable, self-sustainable business model. A decent business plan can carry a startup for a solid 12 to 24 months, through several funding cycles.
Recessions, however, change everything. Young companies must become viable and self-sustaining fast, without constant capital infusions.
For those who were paying attention, there were warning lights blinking before the dot-com bust and Great Recession. This time is different. Not many of us saw coronavirus coming, and we went from free-flowing funding to slamming the brakes in the VC equivalent of 3.2 seconds. If your business’ survival is dependent on raising outside capital in the near future, be forewarned: No matter how warmly received your concept was six months ago, the cash may not be there now.
VC funds launched from 2012 to 2015 have already called down 70% to 75% of their capital, according to Pitchbook. As VCs triage their portfolios with extensions and bridge rounds, there is just less capital for follow-on and new investments. Further, VCs are worried about their own LP post-pandemic funding. Evidence of the caution can be seen in the fewer number of deals and capital invested in April and May.
Let’s look at those commonalities.
Great Business Concepts, Not Yet Great Businesses
We’ve all heard the Warren Buffett-ism, “Only when the tide goes out do you discover who’s been swimming naked.”
Prior to the pandemic, companies that made the case that they could achieve scale quickly were staked with significant investments. No one cared that they were burning through piles of cash. Fast, expensive growth is now superseded by smart, profitable, sustainable growth. So if you rely heavily on expensive customer acquisition channels, such as paid search, it may be time to explore new, less costly avenues, such as organic content to drive SEO and brand recognition, or inexpensive social ad platforms.
Take a close look at your unit economics. Under what scenario(s) do you generate a positive contribution margin, defined as profit less all variable expenses? If you’re not operating at a positive contribution margin, you are burning much-needed cash before accounting for fixed costs.
It’s critical to compute contribution margin after accounting for your fully loaded costs, because fully loaded costs reflect reality.
If you run an ecommerce company, for example, that figure is not limited to just your cost of goods sold (COGS) and cost to acquire a customer via paid search words. It must also include general marketing, customer support and the employees performing these tasks. Many companies exclude marketing and support to make their unit numbers look appealing, but all they’re doing is fooling themselves.
Webvan, Poster Child for Bad Unit Economics
The promise of fast delivery of quality groceries at competitive prices did not originate with Peapod. Rather, Webvan, with an Accenture CEO at the helm and backed by Sequoia and Benchmark, IPO’ed in November 1999 and was quickly valued at over $1 billion in market capitalization.
That was real money back then.
If the name doesn’t sound familiar, that’s because Webvan decidedly did not have a self-sustaining business model. It expanded aggressively, well before it understood its true unit economics. The company contracted with Bechtel to build 26 automated warehouses at a cost of $1 billion. There was no indication that consumers wanted their groceries delivered, and management had no experience in the notoriously stubborn supermarket distribution model.
So, while it was funded by top-notch venture capital firms and led by visionaries, when the dot-com bubble burst, Webvan was in serious trouble. As the economy soured, investors’ appetites changed from growth to sustainable and profitable. The company’s focus on “getting big fast” virtually guaranteed that its unit economics did not make sense.
Webvan filed for bankruptcy in July 2001 and donated its inventory to food banks.
Interestingly, a decade later, Amazon hired many of Webvan’s top employees to lead its Fresh business. The key was waiting for customer demand to manifest, and the technology infrastructure needed to handle the business model to mature, before entering the market.
In a more recent example, I have been as negative as anyone on the future of WeWork, not as a customer but as an investor. Flexible-duration office space was an exceptional idea to accommodate the many startups made viable with the advent of cloud and everything as a service. However, the economic model, where WeWork stretched out operating lease lengths, front-end-loaded the commensurate benefits (first year free!) and piled on unnecessary accoutrements (free beer!) while taking mostly short-term rentals did not make sense.
WeWork was obsessed with growth at the expense of finding a model where its unit economics made sense. It had to continue to expand at a frenetic pace or growth would have decelerated massively.
Leadership never got the unit economics right, but that’s not to say the idea doesn’t have merit. With today’s inordinate uncertainty, wouldn’t many companies sign on for a flexible, short-term space where they can get through COVID-19 with a minimal commitment?
A titan of commercial real estate — think Brookfield Properties — could swoop in to acquire WeWork’s leases at a massive discount, downsize the service offerings and create a sustainable and profitable business model that works today rather than being predicated on hopes of attaining scale in a few years.
Will You Be A Success Story?
After the dot-com bubble burst, there was no way VCs were bailing out high-growth startups that couldn’t survive without a steady stream of funding. Given this reality, the reason companies like eBay and Peapod succeeded and endured becomes clear: Discipline, a focus on becoming self-sustainable and a business model that did not depend on a series of huge cash infusions.
Growth companies that emerge from the pandemic stronger will be the ones whose technology investments make their businesses more efficient, and that spend wisely on marketing, sales and other functions. Only then will unit economics make sense.
My advice: While your competitors cut people and likely service levels, invest in systems that will allow your company to better and more cost-efficiently serve customers. There will be a successor to WeWork that will make it, and likely make it big. But it will be operating with an entirely different mindset, cognizant there really is no free beer.
I see a number of possibly transformative companies that will take ideas that made sense pre-COVID and pair them with a self-sustainable ethos. If you think your business will be my success story poster child in 10 years, tell me why on LinkedIn.
Josh Burwick is an active private technology investor with a particular focus on software, Blockchain, e-commerce and sports betting technology. He has served as an interim CFO and advised on strategic fundraising for a variety of technology companies, ranging from Series A to Series D rounds.