How To Tell When A Startup Turns Into A Business?Innovation

Adam Neumann in January 2019

WeWork co-founder Adam Neumann.

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The recent IPO odysseys of Uber and WeWork are more than a couple of isolated stories of entrepreneurial overreach. Uber’s IPO fell far short of its predicted valuation of $100 billion. WeWork (recently rebranded as We), after slashing its valuation from $47 billion to $10 billion, postponed its public offering and had to be rescued from bankruptcy by its largest shareholder. These disappointments may foretell the end of the long string of IPOs in recent years based on ridiculously high valuations. In the future, we are likely to see potential investors increasingly asking a simple question: can this startup be a viable, profitable business? 

It’s easy to see why investors, seeing stratospheric valuations, are eager to take the companies public and reap a windfall. And since Congress raised the limit in 2016 on the number of shareholders a private company may have before being required to disclose financial information, venture capitalists (VCs) have become incentivized to keep their major investments private longer while they drive up such valuations. Breaking the barrier on the number of private shareholders enables startups to offer options to new employees that enable additional rapid scaling for more years without the company having to go public.

When growth rate is the most important variable in valuation it is in a VC’s best interest to keep a company private as long as growth rates are impressive or accelerating. And when profitability is not an important variable in valuation then growth becomes easier to stoke because new customers do not have to be profitable to increase valuation. If investors are insensitive to the profitability of any customer (now euphemistically referred to as “unit economics”), then growth can be manufactured to the detriment of the company, its employees and other stakeholders. 

But if you take profitability seriously into account, then—IPO or no IPO—Uber and WeWork are still startups, not businesses. Becoming a self-sustaining, value-producing enterprise requires five things: 

A proven business model. A business model is a stable description of how a company makes a satisfactory profit. It describes the product, how the product or service is created and delivered, who the potential customers are, how will they be found and solicited and what the product or service sells for and how much it costs (the unit economics). 

A proven sales process. Each product or service with more than a handful of customers needs a sales process that finds and attracts potential customers and successfully converts some fraction of them into actual customers, all at a definable cost.

Proven customer satisfaction. Viable businesses understand the value customers see in a product and exactly how that value is being created and delivered in a way that earns the company a favorable reputation.

A proven competitive advantage over competition. All good ideas are soon copied, so every company must not only demonstrate their advantage over potential competitors but also how that advantage can be maintained.

Reliable and appropriately scalable operations. A quality product or service cannot be delivered without reliable operations. And new customers cannot be accommodated without scalable operations.  That means that the cost of delivering an extra unit needs to be equal or lower than the last unit. 

Uber and WeWork, along with several other companies that recently went public, have demonstrated everything except a profitable business model. WeWork, for example, may be able to point to one city or one building as profitable, but they cannot describe how every city or every building, within a plausible range of real-life variations in pricing, competition and regulations will be profitable. Without a proven profitable business model, your company is either a startup or a failure. And without a verified business model a company has no justification for going public.

The recent poor performances of IPOs have suddenly impelled VCs to focus on the unit economics of their portfolio companies.  The prospectus for The We Company demonstrates that some VCs had only a vague idea of the actual business models of the companies they had invested in. 

Granted, VCs can and should invest in companies without proven business models—that is their business. And they can and should charge hefty risk premiums to their limited partners for their services by touting their experiences in determining which companies have better chances of finding or perfecting their business models. But they have put too much faith in the “get-big-fast” (GBF) strategy, which prioritizes growth over demonstrated profitability. 

GBF uses aggressive infusions of capital to dominate markets. GBF strategies theoretically work for markets where network effects or economies of scale dominate unit economics and startups are in a race to capture market share to survive. GBF strategies can be major competitive advantages for VCs with large funds that invest in industries with these characteristics because they can out-invest rivals backing other startups with similar strategies. The belief in the infallibility of GBF has led to the raising of larger and larger funds, with the $92 billion Vision Fund now dominating all others.

The problem comes from investors and founders that together aspire to global domination of their sector and then to dominate adjacent sectors, like Uber with food delivery or We with co-living spaces. Proving the profitability of one business model is difficult enough, particularly on a global scale, but adding complexity to a business model postpones the time when the company can demonstrate the ability to provide consistent, dependable, customer-satisfying services and products that will be profitable.  

The assumption has been that because VCs like GBF, then public investors will, too. But public investors are in no position to continue pumping billions more into companies that have been distracted from perfecting proven business models. And because founder-CEOs have succeeded only at achieving growth and been encouraged to de-prioritize profits, it’s not clear that they are the right people to lead these companies once they’re public. They might not even know how to construct profitable business models. That was clearly the case with Adam Neumann, the founder of WeWork.  Twitter had to change CEOs multiple times to find someone who could finish the job of making the company sustainably profitable. And as public investors increasingly understand that what really separates a startup from a business is profitability, we may see lower valuations but far better business models.  It could be a win for everyone instead of a windfall for a few.

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