The Profit Motive
I had an interesting conversation with a friend who operates a traditional business (not tech, not venture backed, not “growth”) last week. He buys a lot of software from tech companies and he observed that not one of them operates profitably. And that makes him a bit uncomfortable as he has always operated his businesses profitably. He mentioned to me that when he has taken capital from investors he has paid them back in full in less than a year each time, from the profits that the business is generating.
It got me thinking that there is something about tech, particularly venture capital-backed tech, that allows us to operate for what seems like forever without a need to generate self sustaining profits.
This can be a fantastic way to generate value when the opportunity is large enough (Google, Amazon, Facebook, Twitter, etc). But it is not a fantastic way to generate value when the opportunity is constrained, either by a smallish market size (TAM) or by a ton of competitors (little to no barriers to entry) or a number of other factors.
Value is generated when the capital required to get a business to sustainability (usually positive cash flow, but I will include exits here) is meaningfully less than what the business is worth when sustainability is reached.
As the capital requirements go up, because of sustained losses year after year after year, the business needs to become worth ever more money at sustainability.
The mistake I think we make in the startup/tech/VC sector is that we look at things like Google/Amazon/Facebook/Twitter, or more recently Uber/Airbnb/Slack, and we think that every business can execute the same playbook. The sad truth is that not every business can execute that playbook and, as a result, many startups consume way too much capital on the way to sustainability and value is lost, not created.
The never ending question that founders and management teams and boards face is whether to invest for growth (aka lose a ton of money) or work towards profitability (but constrain the growth of the business). It seems like every board I am on and every company in our portfolio is always asking this question.
Where I come out on this issue, and always have, is that the growth has to be responsible (positive unit economics on growth spend) and that the path to profitability needs to be well in sight. I would add to those two constraints that a management team ought to be able to get a business profitable in a pinch without killing the business, if necessary. Clearly these “rules” should not apply to very early stage companies. They become relevant and possible once a business has a growing customer base and revenue stream.
I think very few companies in our portfolio and any VC firm’s portfolio will pass these tests right now. Some do but not many. We have a few companies in our portfolio that are operating profitably. We have a few more that are in operating with profitability well in sight and could get there in a pinch without hurting the business too much. But the vast majority are burning money like its water and there is plenty more where it came from.
Perhaps it is true that there will always be money to fund burn. Or perhaps it isn’t. But even if there is endless capital, many founders and teams will wake up one day and realize that all of that burn they accumulated is now a hurdle they have to overcome. And many won’t overcome it.
The profit motive is what makes capitalism work. Businesses are ultimately valued as a discounted set of future cash flows. Positive cash flows. If you can’t generate profits in the future, your business will not be worth anything. So profits are key. And yet we don’t seem to value them in the tech/VC/startup world very much. Maybe we should.
I was having a very similar conversation with the Wistia guys the other day. They wrote an awesome article on the ups and downs of their financing process ( https://wistia.com/learn/cu… ).I run a small theatre company that also has a tech component, so I was curious about how to best structure a deal to give us options to grow at our own pace. They pointed me to the new version of the Indie.vc terms which have a buyout clause baked in in case we want to either buy back the business because we’re at the size we want to be or because we want a bigger round with different terms for growth. I still need to read more but I think it could be a good place to start.In any case, in my opinion the key is to be honest and open about the type of company you are and the type of company you want to be. Investors appreciate that, and just because you arent a gajillion dollar company doesn’t mean you can’t find investors that align with your values and vision.
This sounds a lot like a lifestyle business rather than a business suitable for VC style investment.
You said “We have a few companies in our portfolio that are operating profitably.” — So, no pain, no gain. VC ROI predictability is like the risk/reward tradeoff from choosing to invest in stocks vs bonds.
When I ran my first internet company, we had a board member who was thoughtful, persistent and diligent, and he pushed us toward being profitable, not hyped, at every turn.There were other, louder voices on the outside (it was 1998) that cried go big or stay home.On the month we sold to Yahoo, our company was also profitable, and on a path to stay that way for good. It gave us the confidence to act even more surely on behalf of the customer and our team, and the resilience to make our own choices.Thanks, Fred.
This is where actions speak louder than words. Nobody ever knows the real numbers but wikipedia says:”In August 1996, Flatiron Partners invested $4 million in Yoyodyne in return for a 20% stake.At Yoyodyne, Godin published Permission Marketing: Turning strangers into friends and friends into customers. In 1998, he sold Yoyodyne to Yahoo! for about $30 million and became Yahoo’s vice president of direct marketing.”Now I assume it was Fred who was willing to do this deal. I assure you that so many VC’s (or non-founder CEO’s) would never consider something remotely similar.
Well said Fred!This is a part of the startup community that is growing, with many more founders asking themselves these questions to determine if they are really able to play by the same playbook as the giants in the industry. For many, creating a profitable company that works out of profits may be just as satisfying (as your friend can attest) and give a discipline to find product/market fit faster.I started INFLECTION as a conference and community to share more stories of interesting profitable companies and its been eye-opening to see how many folks have built substantial companies with a profit mindset from the start (check out the videos on the blog).Profit sharing is another related topic of interest, as if a company is generating significant profits it can give employees more liquidity than the stock they are getting at startups that may never have a positive exit. As Hiten Shah says in this tweetstorm, Profit Sharing Is The New IPO
Very true, and becomes even more relevant as we head into a slowdown.
The combination of close-end fund structure that most of the VC world abides by coupled with investing in early-stage companies likely begets the industry’s severe bias towards unprofitable growth and the hope to sell to a bigger fish.The case study of Sales Force v Oracle (rise of SaaS) showed both how much less capital SalesForce needed to start and how much longer it needed to achieve profitability. That is quite a conundrum. Does that mean it’s easier to start technology companies but they’re fundamentally more fragile?Perhaps the above reality will result in two important long-term shifts in private equity fund structure: open-end funds and longer-term horizons. I read in the WSJ that family offices are bringing more investment decisoins in-house and that they tend to have very long time horizons. The move to open-end funds may also increase liquidity and transparency in the private investment industry, which would be good for everyone except those below average fund managers who are personally successful because of their management fees.
Fred.Using same analysis, other than perhaps BTC as unit of currency how would you view crypto companies at this stage? Should cash flow be the same metric? My gut says yes but curious about your thought process
“The mistake I think we make in the startup/tech/VC sector is that we look at things like Google/Amazon/Facebook/Twitter, or more recently Uber/Airbnb/Slack”The mistake everyone makes is that none of the above pay all the full stack freight both north-south (app to infrastructure) and east-west (core to edge and actor/network to actor/network). They are all reliant on 3rd parties and events that occur beyond their control. They are all siloed in a winner takes all game on top of TCP/IP. Fred alludes to and wholly buys into the winner takes all model and therefore can never escape from it.Crypto is just a rationalization of all that is wrong with the internet; it shares all the same weaknesses and lack of true economic foundation for sustainability. It appeals to a generation who grew up under a settlement and identity free, trustless protocol stack. But while some perceive the need for these elements they all cut against the fully distributed model from the outset.So how can any crypto company have a “profitable” model? Crypto is just a big neighborhood lemonade stand with all the kids buying drinks from their own profits selling the lemonade mix they got from Mom (as well as the working capital and assets).
I love this post. Here is the problem I have not been able to solve. I really have thought many times about trying to do it, but I just can’t get the economics right.Once you take money from a top tier VC like Fred (edit saying he is the exception not the rule and that is not me being a fan boy, I should say it is ten times worse if you take VC money from not a top tier VC) you are on the get big or go home path.I actually take issue with this statement: “work towards profitability (but constrain the growth of the business)”I do not believe this statement is accurate for many businesses.I am not saying it is inaccurate for some businesses.But what I am saying is that it is VERY hard to switch paths once you have taken VC money.I can tell you my lawyer at DLA Piper (former Cooly) said I was the only one he saw ever do it.I had a board member tell me once Phil, lie to me, lie to your mother for all I care, but don’t lie to yourself.I have seen shit tons of value get wasted when people lie to themselves and think, huge growth is right around the corner.We are just in a “dip” and we will come out of it, if we just spend money.I’d love to have a fund that just took businesses that had fit and got them to profitable cash flow businesses. I could do that.BUT:The brain damage to investors and management means you really can’t do it.You have to say to current investors, write down this investment and be patient. Why do they want to do that?You have to say to management, we are starting with cuts and they start with you. Why do they want to do that?And you have to have capital that isn’t interested in you finding the next Twitter, but just getting a return.I’d love to hear anybody’s thoughts.
Ask a VC what their benchmarks are. Is it one unicorn per fund ? Is it the top IRR of VCs of their fund size? That will tell you all you need to know.
As we know well, Paul Graham at Ycombinator just defines a startup as going for explosive growth (my wording).From the arithmetic I’ve seen on VCs, they can’t hope to stay in business raising rabbits, chickens, sheep, goats, cows and horses and, instead, must go for unicorns.So we have a dichotomy: (1) All across the US, border to border, village to NYC, we have successful entrepreneurs. Maybe they do a really good job running 10 franchised fast food shops and get annual income well north of $500,000. Somehow on the Internet, I see a lot of targeted ads from Southeby’s with aerial videos of gorgeous estates in Connecticut, lots of Georgian architecture and nice landscaping, maybe $20+ million; if only from the location, I doubt that the people in those houses got VC money. Yes, for a $20 million house, need annual income way above $500 K. Maybe some of the entrepreneurs are in big truck, little truck businesses. My guess is that nearly all the families that pay full tuition, room, and board for their kids at Ivy League colleges are just such entrepreneurs, without VC funding. Really, except for the founders of Microsoft, …, Facebook, the wealthy people in the US own and run businesses. (2) Nearly none of those wealthy people ever got even a dime from either VC or private equity. From what I’ve seen in yacht clubs, nearly none of the owners ever got VC money.Net, VC is aimed at only quite narrow aspects of US business.
Yep, that’s the VC model.
When I went to raise a minority round, one of our must-have terms was a buy-sell provision so that we would be able to buy-out the VC if we thought the business would be better off without one. I only knew that this was a critical term to have because the CEO at my private equity company always included those. It was an invaluable clause (actually, I can put a $ value on it because we excited a few transactions after exercising our buy-sell rights). BUT:The brain damage to investors and management means you really can’t do it……And you have to have capital that isn’t interested in you finding the next Twitter, but just getting a return. An open-ended fund should accomplish what you hope for and such funds exist. This fund structure is not in vogue for VC and PE and you typically find it in mutual funds and hedge funds. Open-end funds are similar in complexity and cost for a General Partner to implement as a closed-end funds. It is a little harder for fund managers to figure out carry in an open-end fund.Open-end funds are better for investors. First, open-end funds provide more liquidity for investors. Second, open-end funds are better aligned to deliver a target IRR because open-end funds are able to reinvest earnings (i.e. Evergreen clause). Third, open-end funds are less subject to market cycles because they don’t time out. Fourth, the close-end fund structure promotes investing in deals in order to hit the threshold that allows GPs to raise the next fund. Fifth, on the back-end, the close-end structure promotes sales as soon as possible because it gets GPs carry sooner.Family offices and high-net worth individuals have investment time horizons that align with running an open-end fund and I wonder if the next economic downturn will result in a change in fund structure preference.
I’m so glad to hear you say this but…The VC industrial complex has played a massive role in this being the tech norm. So say I’m 33 (I’m not but play along) and just left a full time job to pursue a startup idea. I don’t have a lot of money and I really have no idea how big it will be, no one really does.But I need to eat and pay a medical bill for my kid if I need to so I need to raise money to at least buy me time to build the business. Software, as we all know, take a lot of upfront investment to get off the ground. What are my choices? Bank loan isn’t happening. I don’t know a lot of rich people or have family with experience that can help fund this idea. IndieVC, TinySeed, and others are (finally) one option but really new and there aren’t many of them. Or the dominate one: go raise VC.In order to raise VC money I immediately have to start thinking about the business as having a TAM that makes sense for a VC sized business, and that means thinking in terms of growth instead of profit. So we have to play the game otherwise the business doesn’t exist at all, which makes no sense as 99% of tech businesses should be thinking profits, not growth.And you say maybe we should value profits over growth?
Maybe, the next stage of technology is that there won’t be “technology” companies, just companies. I have said this for a decade. What if I just use technology to beat my non technology competitors, I always us plumbers as an example.
Technology companies are often traditional businesses that felt the tailwinds and figured out how to build a sail.
When the ROA is low, leverage is your friend.
Your example perfectly illustrates the conflict between the founders needs to pay the bills and the VCs needs to achieve high growth in order to flip the company to a PE for a big multiple.A little self-reflection on the part of the would-be entrepreneurs is in order. I want to start a business and I need to pay myself. OK the VC model doesn’t work for me because I need to generate profits in order to pay myself. Also, taking VC money increases the fragility of the business because it’s encouraged to operate at a loss.How long can I stay at my current job so I can pay the bills while I build my new business to get as close as possible to revenue before committing full time?I am 33 and have done this twice. Both times, the businesses were not investable in the eyes of VCs. Both times I had to manage my family, my primary job, and the time in the business I wanted to be in full-time before doing it full-time.Your life’s circumstances may prohibit you from taking the leap. Or, you may only be able to take the leap if you have an idea that can be VC backed so you can pay yourself.The rise of Title III investment platforms will help entrepreneurs be able to make the leap. As you rightly pointed out, the total equity those platforms have is small. If what I’ve seen of these platforms in the private equity real estate space is any indicator, the quality of opportunities is extremely poor. This is good because people are funding projects with little regard to the risk. This is bad because the underwriting standards seem to be low. This is where new businesses may have an advantage over real estate, or other private equity. It is harder to downplay the risk of a new company with 0 revenue compared to the risk of a speculative triplex in suburban Phoenix (yes, those are back, don’t be surprised).
Keeping it real, Elia.
If CAC>LTV then you have a problem
Here is the thing, that is easy to say but shit hard to calculate.Let’s make numbers easy: I spend $100 to acquire a customer. They spend $200 of LTV because my marginal cost is $0 Ok CAC < LTVBut my underlying business costs me $1m.So if I have 10 customers I am f’d. If I have 10,000 I am kicking ass.The question is TAM AND how many competitors you have going after the market AND how they are funded.So the challenge is on a scale. If there are 10,000 total customers and I have 20 competitors willing to lose money……..well then it is seeing who can wait things out.Edit, I have no idea how disqus processed this.Edit, if you put in a < sign without spacing it puts in an = sign after every word.
Agree. Shit hard to calculate
BINGO.And that is the lie that bad startups tell themselves.See the comment above about complex system v simple.
.And, that problem is fatal.JLMwww.themusingofthebigredcar…
The people over the years I’ve had the tech-VC model vs traditional cash flow growth model conversation with Are the very same people I’ve had the btc isn’t backed by anything and thus worthless conversation with. Jury still out in who is right at longterm equilibrium
He buys a lot of software from tech companies and he observed that not one of them operates profitably.What’s a lot of software? And how would he know if they are profitable unless they are public companies? Is this just a ‘looks and quacks like a duck’ conclusion. Are these SAAS companies or is he really buying software ‘a lot’ and installing it on his PC or Mac or some machine? The companies that are selling software that gets installed (which is what it sounds like when you say ‘buys a lot of software’ ) are typically the type that are profitable and in a niche.He mentioned to me that when he has taken capital from investors he has paid them back in full in less than a year each timeThis sounds more like a short term loan rather than ‘taking capital’.
Let’s say I owned a restaurant right now. I could buy my payroll, inventory, and point of sale software all from people that operate at a loss.I assume that this is what we are talking about, because the way restaurants get funded is in this way.BTW: I was asked to invest in this one and turned it down…….bad move: https://thestarboard.com/
Nah don’t sweat it. By the ‘casino’ theory if successful you would have maybe taken on another investment and lost your shirt on that. Also at the point in time you made the decision you did it based on what you felt was the opportunity. And restaurants (despite the success here) are notoriously difficult and for good reason. All depends on the chef and other key people. Things happen.Here is a short story about a restaurant. Many years ago across the street from where my offices are a new Irish Pub type place opened up. Was backed by investors and the people who operated it had another successful location elsewhere operating for years. They did so well the first week the parking lot was packed and overflowed into the surrounding residential neighborhood (of expensive homes) and they approached us to be able to use our parking lot. They offered some ok amount (may have been $500 per month?) which of course I ended up negotiating up to some ridiculous amount of money. I just dug up the contract. I got them to pay $3800 per month for the lot! They were offering several hundred and the rest of the board wanted to accept that. I got (am bragging to be clear) $3800 per month for a parking lot. How many spaces? 38 spaces. 38 spaces. $100 per space per month! And this is suburbs not Center City as you know.  For valet parking no less. Plus indemnity and so on.But the thing is this. The food sucked. So after several months of jammed packed operation they ended up not needing the parking at all but still payed for it. Why did the food suck? Different market. Bad chef. Their other location was in kind of back country area and the only game in town. Our area? Picky (lack of a better way to say it) jewish foodies. No way they go for the same type of quality. To them this is like a turnpike rest stop I am guessing. The location also had failed multiple times in the past (‘out of sight out of mind’).Here is the other detail deal/negotiation wise. Strike when the iron is hot. I shoved this thing through when they had so much business there were cars in streets wrapped around the neighborhood that surrounded it. I worked like a madman to get them to agree to the terms and sign the contract. Knowing that as soon as the crowds subsided (was around St. Patricks day) they would in no way need the parking and pay anything for it.The restaurant eventually closed – went out of business. This was for a restaurant that was so hot in the first few months they were willing to pay anything to solve the parking issue. Other funny detail the valet parking company didn’t want to use the lot because they didn’t want their drivers crossing the street or something like that. You know in part how I got this done? I dug up research on what others pay for parking in places like stadiums and so on. Of course I only dug up what supported a high value that I was asking. And of course because they were stupid and lazy (and they needed the space and were flush with money) they paid the amount (maybe I asked for $4k and then accepted $3.8k as a compromise..). Note part of the deal was allowing them to feel justified in paying the price as opposed to being ripped off by an opportunist (key fact to always keep in mind so someone doesn’t spite you)…. https://uploads.disquscdn.c…
.If you had 30 years experience, you could not have cut a better deal. Bravo.$100/space/month is a fair rate, but you were renting them primarily after hours access.Well played.JLMwww.themusingsofthebigredca…
You know why Daniel Snyder bought Six Flags?I know for a fact.He asked Six Flags to buy overflow parking for FedEx field and the price they gave him was so low that he thought, I have to buy this business.I also know for a fact the Podiatrist who was in his wedding asked if he could be the “official” Podiatrist for the Redskins after doing some pro bono work. His response? Sure for $500k a year.
Let me see if I have this straight. He concluded that they were bad business people or operators because they didn’t know enough to get a good price for parking? So it was a tell tale sign of incompetence which he thought he could improve (and thereby make the business profitable)? I didn’t know much about him actually. But with respect to Six Flags he lost his shirt on that one:In 2005, he bought 12% of the stock of amusement park operator Six Flags through his private equity company RedZone Capital. He later gained control of the board placing his friend and ESPN executive Mark Shapiro as CEO and himself as chairman.In April 2009, the New York Stock Exchange delisted Six Flags’ stock as it had fallen below the minimal required market capitalization. In June 2009, Six Flags announced that they were delaying a $15 million debt payment and two weeks later, Six Flags filed for Chapter 11 bankruptcy protection. As part of the reorganization, 92% of the company ended up in the hands of their lenders and Dan Snyder and Mark Shapiro were removed from their positions. Snyder lost his entire investment. This reminds me a bit of when I sold my first business and I on purpose tried to inject inefficiencies and ‘not doing it the smart way’ so that the new buyers would think there was room to go up and improve (note we were very profitable). As opposed to ‘look how smart I am – you won’t do better!’ (which is default what people often do). In fact I remember obsessing and showing them how we take care to staple paperwork to almost appear to have an odd aspergers type obsessions with unimportant details.
He did but this is the hubris of thinking you are too smart.
More precisely the phenomena of thinking you are smart with a small ‘n’ of things you have done. Add to that what happens when the success is early on. It acts in what I call ‘a lever’. It takes on out sized significance.The other side of hubris is that not having it means you will not take the big chance and get fame and fortune.Also in our society all of those magazines at the airport (last I checked which was a long long long time ago) highly the guy with the big balls who did something that others thought was either stupid but then seen as ‘clever’ if it works out.
I’d bet 90% of the revenue of this place is booze and 80% of that 90% is made in 3 months of the year.
.As a landlord, I used to see hundreds of financials from restaurants. Most of them are 50-50.The big issue on whiskey is the pour discipline. If you sit at a bar and see a ‘tender using a pouring device or a shot glass, you know the joint is very well run.There is nobody more generous than a bartender pouring somebody else’s whiskey when working for a tip.The big issue is always the “food waste” factor.Seafood is the most profitable on a per serving basis, but its food waste factor can be 35%.JLMwww.themusingsofthebigredca…
Passing up on an investment in a bar on the “do me” circuit was definitely a bad move, particularly in in the 90s.
In life we all live and learn the importance of investment. I ran over 20 years at a loss. I had a few angel investors at home and a venture capitalist called Uncle Sam that dished out money by the mouthful. It was a pretty long time horizon (I believe most VCs expect returns after 10 years, but I was still learning how to do math around year 10). I will say the biggest psychological change in adulthood is the stakes of “investing” feel higher when you’re playing with your own money instead of the house’s. I think it’s always worth reflecting on what you’d do differently if you were making choices with your own resources. I consider it a good thing that for the most part I did not need to change many habits when going from using other people’s money to my own. I wonder how many entrepreneurs feel similarly about their businesses.
The profit motive is what makes capitalism work. Businesses are ultimately valued as a discounted set of future cash flows. Positive cash flows. If you can’t generate profits in the future, your business will not be worth anything.This entirely discounts the (absolutely true) ‘greater fools’ theory of valuation.
Differences of opinion are what make horse races and some people on Wall Street rich. Or, as above a PDF of the Michael Lewis, The Big Short is available for free athttps://themodern.farm/stud…
And yet we don’t seem to value them in the tech/VC/startup world very much. Maybe we should….and…The mistake I think we make in the startup/tech/VC sector is that we look at things likeWhose’we’ (suckah)?  This is why I have the saying ‘you can only be as honest as your competition’. Where ‘honest’ is just really a set of behaviors that the individuals in the group take on that then force pretty much everyone to operate the same way to get ahead.   Line from Dirty Harry luncheonette scene. With children this is ‘Mom, her parents are letting her, so why can’t I..' With online dating this is fudging your age…
Dating and age? Uh, if he has money enough, she is already old enough, and he is still young enough, then that’s enough and “the right stuff”!!!! From the upstairs Department of Politically Incorrect Real World Paid Full Tuition Reality Checks. :-)!!
Fairly predictable on the timing of this post. The downturn has come, markets are being squeezed, VC will be more scarce, companies will contract and only those that are sustainable will survive. While I like to hope that the craziness of the VC funded tech world will learn this time that your assertions (which I agree with) are the right way to run businesses, it won’t.
.May I borrow the crystal ball tonight?I agree more with you than you do with yourself.JLMwww.themusingsofthebigredca…
Old explanation: “Many are culled. Few are frozen.”Most successes are Darwinian victories of the survival of the fittest.The big surprise is the number of (1) silly directions that fail and (2) good directions that are neglected. Partly people keep trying (1) due to the surprising role of luck.There are important fields where there is good engineering for low risk projects, but, net, on average, Sand Hill Road and computer science are very poor at actually engineering successful startups. I.e., too large a fraction of the successful startups are from Lady Luck.
The DuPont analysis paints a nice framework for a process (vs result). https://uploads.disquscdn.c…
.Very few founders could work this math on the first try during their first month of existence.JLMwww.themusingsofthebigredca…
Probably, but a VC can.
.Haha. I had enough math I could have taken my degree in math v civil engineering.I doubt too many VCs could derive the calculation of ROE using Profit Margin, Asset Turnover, and Financial Leverage.JLMwww.themusingsofthebigredca…
.In tech there is a reliance on the “greater fool” theory which surrounds the notion that somebody will pay for the growth, the history, the story. That a VC is deserving of an exit even if there is no profit.We have companies going public that will never sniff a profit in a million years and, yet, we have “underwriters” who put their name on offerings which cannot possibly be more thorough in their disclosures.If one reads the offering memorandum of, say, SNAP, it was all in there.SNAP is my favorite current example of an arrogant management who selected an underwriter who seduced the public into buying that POS stock when the founders retained control.What SNAP has wasted on their goofy Spectacles initiative could have started 10 other companies.https://www.fool.com/invest…At least their CFO was smart enough to see the handwriting in the income statement, balance sheet, and statement of cash flows.JLMwww.themusingsofthebigredca…
Many VCs got a free ride in 2000 (they were the Bernie Maddoffs of the time). The rest of the story can be even more nefarious. GS can go long on the Credit Dafault Swap of the same company that they arrange the financing too. Take a look at UNFI / SUPERVAlU.
A PDF of apparently the full Michael Lewis, The Big Short is available for free download athttps://themodern.farm/stud…
Have any insight on this particular Goldman move. We may be seeing the sequel to this movie. Taking positions long cds and short the asset. In this case unfi is down 80% from its highs.
The idea of going long on one asset and short on a related one is old, going back at least to E. Thorpe, Beat the Market, later called “covered call writing”, later analyzed by F. Black and M. Scholes, poorly understood by the founders of LTCM (Long Term Capital Management), later modified by some on Wall Street due to concerns about the tails of the empirical, over time, distribution of the asset (or maybe changes in the asset or the logarithm of the asset, etc.), and mentioned in the book The Big Short needed a lot of modification for mortgage bonds during the lead up to the crash of 2008. That is, mere covered call writing now is a long way short of what caused the crash of 2008.The usual mathematical analysis of the idea of long this and short something else related is a narrow special case of stochastic optimal control, e.g., my Ph.D. dissertation, E. Dynkin (student of Kolmogorov and Gel’fand and long at Cornell), Controlled Markov Processes, the work of R. Rockafellar at U. Washington, R. Wets, UC Davis, D. Bertsekas, MIT, the rest of a large literature, a project I worked hard to propose at IBM’s Watson lab (ignored by management), and recently a hot topic at the department of Operations Research and Financial Engineering at Princeton (long chaired by E. Cinlar, whose star student taught me an exceptionally good course). Some people have claimed that stochastic optimal control is forever the ultimate form of artificial intelligence — I don’t claim that.In practice, proceeding mathematically, it’s an applied probability calculation.Generally a huge issue is computer time — a big stochastic optimal control problem could bring million square feet server farms or super computers to their knees for months at a time. For nearly all the applications and in particular for covered call writing a big issue, likely the main issue, is assumptions about the relevant stochastic processes (assuming we know what a random variable is, a stochastic procerss is one random variable for each point of time, and in the case of, say, ocean waves or the weather, also space). In particular, regard the prices of the two assets as increment processes, that is, have a random variable for each increment or change in the prices of an asset between two points of time. By the central limit theorem, with mild assumptions a stationary (the probabilistic assumptions don’t change over time) independent increments process becomes a first order Gaussian process which people like; they also like the Sugar Plum Fairy which is even more realistic!Or, can take the applied probability approach as just a heuristic, make a lot of largely unverified and unreasonable assumptions, do the arithmetic, get answers, over some time interval in the past see if the answers make money, assume for some relatively short time interval in the future enough aspects of the universe are sufficiently the same, have a lot of relevant anomaly detectors (statistical hypothesis tests with null hypotheses that nothing has changed) monitoring the situation, and hope to make some money.Thinking about such things, I wrote F. Black at Goldman-Sachs and got back a nice letter from him that he saw no applications for math on Wall Street. Only later did I hear about James Simons.It’s not my money!Instead of Wall Street, I have a startup, with a lot of progress, and dirt cheap to start, with some intellectual property and technological barriers to entry.One of the lessons, clear enough in more than one book from Michael Lewis, much as in the story of The Little Red Hen in Mother Goose, about things that are new, powerful, and valuable is that nearly necessarily not many people will be interested until, e.g., in the case of the hen, the hot, fragrant bread loaves are fresh out of the oven, etc. The people with going businesses and/or established careers want to keep doing just what they’ve been doing and not much consider anything new until they get slapped on the side of the face by compelling empirical evidence from threatening successes of others.E.g., as in The Big Short get back objections “we have no confidence in your ability to predict macro economic trends”. Okay. But don’t need that, or confidence in the next arrival of ET. Instead, as the movie started, “They did what no one else thought to do — they looked.” That is, motivated by some early clues, find and look one by one at a relevant sample of the home mortgages — just look. No small town banker would ever approve such loans.”Greenspan just said that bubbles are regional and defaults are rare.”. In a strict, literal, and narrow sense, Greenspan was correct. But some of the mortgage backed securities were full of “really bad loans”. So, from some people who took Greenspan’s statement as more general than appropriate, get some greedy people to write some unique insurance policies, CDS (credit default swaps), on the corresponding bonds with the “really bad loans”.Doing that could make money one bond at a time.To crash the whole industrialized world economy, just get the rating agencies, AIG FP (American International Group Financial Products group in England), conservative but clueless institutional investors buying mortgage bonds, and some investment bankers selling CDOs (collateralized debt obligations) of collections of risky tranches of mortgage bonds too complicated for either the rating agencies or the buyers to understand.For understanding and exploiting with relatively low risk things that are new, powerful, and valuable, there are exceptions from good research in applied math, physical science, medical science, and engineering funded by the US DoD, NSF, and NIH.Then as J. Simons once explained “We made a LOT of money.”.And that’s my movie review for this morning!
Never a truer word.
The difference between a movie star and everyone else.. hmm.Mainly, teeth. 🙂
.You demean cosmetic surgery, friend. Merry Christmas.JLMwww.themusingsofthebigredca…
Merry Christmas, Jeff.. friend.Maybe I am sensitized by the fact that Santa brought me new teeth. Kind of traumatic weeks for me but with amazing results. I rejected “Hollywood white” though. :)Christmas fairy told me that I shouldn’t talk about these things but I don’t care.
.Does your bite now keep pace with your bark?Merry Christmas — is it weird having Christmas in the summer?JLMwww.themusingsofthebigredca…
Absolutely. :)On summer Christmas, I guess that we southern hemispherers are accustomed to it. The weird part is the snowy decorations at the stores and maybe also that the reflexive inner mood that winter brings and reinforces, is absent. But people are happy enjoying the reunion with family and friends and, a fact northern foreigners don’t get at first, is that we are getting ready for the summer vacations that begin for most just after the year’s end, in a few days. Most kids are on vacation till March 1.I love this part of the season.So, no snow but a good vibe avalanche!
Mainly, timing / desire / more desire.
Yes.Timing. Time is the enemy.
“…not every business can execute that playbook and, as a result, many startups consume way too much capital on the way to sustainability and value is lost, not created.”Well, who is funding that capital and advising on allocation? Investors, not just Founders, need to read the tea leaves and help discern fiction from reality. There are a lot of responsible parties when visions of grandeur cloud reality. It’s not just executing a playbook, it’s executing a playbook that is based on reasonable expectations, not pipe dreams.
From what I see in my work with Startups and early Scaleups is that investors, boards and entrepreneurs conflate the Volume Ops business model of B2C and some B2B businesses with the necessary design, competencies and metrics of Complex Systems businesses (many B2B and most enterprise Saas businesses). Failure to understand that these two models are mutually antagonistic causes many young B2B/enterprise tech companies to spend way too long in unprofitable growth as they meander their way, or as they founder, need to restart, or go out of business altogether.
Jeez, Phil. A little jargony but bang on.It’s simole and big or it is complicated & biggish, but not both!
.It is not the profit “motive” which makes capitalism work; it is “actual” profits.Wanting to go to the pay window is not the same game changer as walking from the pay window with your pants pockets full.Small, but important detail.JLMwww.themusingsofthebigredca…
Man, learned this so many times the hard way in Vegas 🙂
My only caveat would be that it is not even just ‘actual’ profits, it is banked profits. 🙂
Small, but important detail.Seems that these types of easily missed details can make all the difference. Easier to recognize this truth than to live it.
If really matters little what the micro environment is for any VC fund. The duration is way to short. It’s pretty clear that the macro environment for the next 30 years will be productivity gains that the world has never seen. The FED (and sometimes the FRED) look in the rear view mirror a little too often (recent bias). Take the full employment hypothersis that the FED has been arguing year after year. There are 100 million Americans 25-54. Anyone really think that 10 million of these people aren’t ready to work in the new economy ?
If you are playing with your money / reputation, the next bet is the only one that really matters.30 years from now means nothing.
What are you betting for? probability is your friend, possibilities make good headlines. The S&P 500 is trading at a 14 multiple of earnings. There havent been many times where this multiple hasn’t been a gist horse buying opportunity for 5 -7 year investing horizons. If you don’t have 5-7 years, liquid municipal tax free bonds look very good now, tax equivalent yields are approach 5-6%.
A good agent operating inside networks of influence within the wider industry. Emily Blunt seems to have found such. She’s now everywhere, when once she was a jobbing English actress playing supporting roles opposite movie stars.
VC role. It’s why agents move into studio exec jobs.
This topic of profits always brings back David Heinemeier Hansson and his “PROFITS!” mantra, where everything else is “BULLSHIT!!”. 🙂 Edit. It was “BULLCRAP!”.
That is a great talk. https://www.youtube.com/wat…
Yes, it’s a good one, and entertaining. He makes me laugh out loud. He blew his “PROFITS!” on a Zonda 🙂
Think about this a lot.There are businesses that find their model and those that are built to satisfy it. Therein lies the break for me.Great post-thanks!
Even if you think you got no shot at profits but you can still get additional funding , you’re not going to turn it down.
.Same behavior as a crack addict?Who bears the most fault? The addict or the supplier?JLMwww.themusingsofthebigredca…
Let’s just legalize it.
As a former VC during the 90’s bubble, I can recall several board meetings where founders/CEOs were encouraged to grow and burn with the idea that there would always be capital available.They the bubble popped, the capital dried up, and investors got amnesia. A lot of potentially good companies when out of business because they simply could not get profitable enough to sustain the business. Some were able to remain alive, but lacking growth capital they became zombies.I agree with Fred that there are times when the market is extremely large, the competitors well funded, and growth is an imperative to capture share.I can’t help but believe that “easy money” has made many tech execs and board members alike complacent when it comes to be good stewards of the capital that has been raised. It pays to have board members who have been through a few cycles to be a voice of reason and guide young founders/CEOs to scale responsibly.
Great statement. Then the entrepreneurs feel totally screwed. BUT it takes two to do this, one to encourage spending the other to spend.
I just posted this last week – about unit of value and unit economics – on the crunchbase blog, https://news.crunchbase.com…It includes a unit economics tool we built at ADV to think about a startup in numbers.
I agree with you more than you do yourself (thanks JLM).One nuance is that the true unit of value transaction may be rather more difficult to identify and measure than one might suppose. For example, for an online streaming site the core transaction is a viewed stream, not the amount of contact you have, or territories you can deliver to etc etc. But getting a handle on the number of viewed streams can be very tricky and the more you use a proxy for the unit transaction the greater the risk that you are measuring the wrong thing.
“The sad truth is that not every business can execute that playbook.”Sadly, that’s how many ICOs have been thinking. They all want to be the next Bitcoin or Ethereum.
Yikes Willy!!!These are the Blockchain standard bearers?Happy Hols partner!
They sure are, and I don’t mind them being that, despite not being perfect.Back at you and family. Safe travels !
Which is their failed analysis and flawed thinking. Ethereum is not like Bitcoin. Try not to be like Ethereum. Try to be what they can never be. That is the ‘next’.
ForIt got me thinking that there is something about tech, particularly venture capital-backed tech, that allows us to operate for what seems like forever without a need to generate self sustaining profits.So, to borrow:Tech to be, or not to be, that is the question:Whether ’tis nobler to sufferSlings and arrows seeking outrageous fortune,Or to take arms against the sea of Wall StreetAnd, with small profits, ignore them.But there is more: Tech, even without unicorn hunting, has some astounding advantages over Main Street businesses.In simple, blunt terms, with tech, we can let the computers do the work.In a little more detail, at ad rates long reported by Mary Meeker at KPCB, a Web server popular enough to stay busy sending content and ads can generate surprisingly large revenue and pre-tax earnings for astoundingly little opex and capex. E.g., I’m getting to the end of building my first server for my startup. Last night I installed a Western Digital Enterprise Storage hard drive with 2 TB (terabyte, trillion byte) capacity.My back of the envelope arithmetic from some of the Meeker data and some of my software timings indicate that kept half busy that server should generate about $250,000 a month in revenue.Yes, the now tricky assumption is the part about “kept half busy”. But basically that just says that have some happy users/customers, that is, supply something enough people want enough which is standard for any business.My server was plugged together from less than $2000 in parts. That so little capex could result in such revenue and pre-tax earnings is one heck of an advantage for tech, much better than anything available to a Main Street business such as rental housing, auto repair, auto body repair, dentistry, medical radiology, pediatrics, landscaping, new/used car sales, pizza or Chinese carryout, a French bistro restaurant, asphalt paving, residential housing general contracting, insurance agency, raising livestock, etc.E.g., for pizza, each one sold needs lots of supplies — flour, yeast, salt, cheese, sausage, waxed paper, a box — along with labor, an oven, the rest of a kitchen, a storefront, careful attention to hygiene, etc.
Thanks @fredwilson:disqus for a great perspective on a significant barrier to entry for customers. It makes it clear why customers often really do *need* the codebase locked up in escrow in the event of business failure.In my limited startup experience, boards are often split on the objective (growth or profitability). That tension can be healthy, but more often it seems to be a shifting of the goalposts.Finally, thanks for the memorable metaphor of “burning money like it’s water”!
You know what the chances are of you running an escrow codebase? Less than zero. Same for me. Cheaper to move on.
I had a potential enterprise customer request that we escrow our code base. It was a deal breaker for them. We were selling a SaaS product that included a combination of CRM and to-be-built custom billing software. They obviously did not understand that the software wouldn’t just work if took control of an AWS instance. Fortunately, complying with their demand was inexpensive.
Yup that is when you know you are dealing with a fool. You are right sometimes easier to let the fool be a fool. Only problem….they will be a fool with other things.
The older I get, the bigger my CAC gets
I’ve actually met several founders who are running companies that became profitable in year 2. I’ve learned a lot regarding their insights. I think if you have a business model in which you are comfortably profitable with just 100-500 users, although that is not necessarily conquering the world or becoming a unicorn, then I think that would be a good business model to test, since you wouldn’t necessarily need any VC funding.I do have a feeling with the current bear market and oncoming economic recession that VC funding will dry up considerably, so this would be the best time to try different profitability models.
Two points:1. when you say:”I think very few companies in our portfolio and any VC firm’s portfolio will pass these tests right now”and”the vast majority are burning money like its water and there is plenty more where it came from.”How do their managements respond when you put the above home truths to them?2. You refer to the merits of “positive unit economics”I agree, and as my first startup had no capital and had to finance itself from positive cash flow this has never been far from my mind, but my experience has been that people I have been trying to help don’t even really understand what ‘unit economics” means. In some businesses by their nature it is difficult to directly measure unit costs and revenues, but I have been more than a little appalled by the misunderstanding on this point. People often don’t seem to grasp that growth metrics don’t mean automatic benefit for the company, sometimes it’s just more cost.
Isn’t the first rule in VC that the company needs to get to a 5x to 10x return and that’s what makes honoring the other rules so difficult?
Profit is what you add to the total costs and it represents the value you bring to the deal. Make sure it is worth it and fair.
Simple, sensible, and smart – definitely something all us entrepreneurs need to think about much more deeply – though I think many of us (us included) are extremely focused on making this transition.It’s pretty clear there are times when cash flows abundantly, and if you are building an innovative business into a large TAM, it’s a great time to take a shot at the growth and unit economics game (though too many even let unit economics get away from them, which at times in the past, we’ve done – but it’s bc we’re testing channels).With a tightening national and international monetary environment, with potential macro risk off the scale, even though VC and other funds will have tons of dry capital to deploy over the next 1-3 years – I think most sensible entrepreneurs are looking a lot more closely at their balance sheets and cash flows and looking to tighten up wherever they can and move toward profitability or at least cash flow break even in advance of the worst happening (if it happens (ie large recession, which I personally believe and have forced myself to believe is coming super soon).
Somewhat related thread on HN today:Over half of older US workers are pushed out of longtime jobs before they retire (propublica.org):https://news.ycombinator.co…I commented too, here:https://news.ycombinator.co…