Principles for Capital Allocation
European Straits | Work in Progress
Hi, it’s Nicolas from The Family. This Work in Progress edition discusses how to allocate capital if you have to optimize for low margins in our transitioning economy.
This is an edition of my newsletter European Straits accessible only to paid subscribers. The goal of the Friday Reads is to furnish ammunition to investors and financiers that will let them dig deeper on whatever topics pique their interest.
Today, I’m following a suggestion by my colleague Balthazar de Lavergne and focusing on a simple question: How should one allocate capital in low-margin businesses? This is round 1 in a series of posts related to capital allocation in general (which I plan to turn into a handbook—if there’s interest 😉) 👇
1/ Something that we see over and over at The Family are the difficulties that some of our portfolio companies have when investors find their margins to be too low. Investors are usually ready to deploy capital in tech startups because they expect the business to grow exponentially, eventually reaching high margins once it reaches a large scale. Here’s Stratechery’s Ben Thompson in an update earlier this week:
Software has significant capital costs, and mostly zero marginal costs, which means there is a big need for up-front investment combined with unlimited upside.
What we see are many businesses with margins that are indeed low. But this is usually a feature of the industry the startup is trying to enter, and the business’s fundamentals can be quite strong with a clear path to generating profits in the future. Let’s dive a bit into what investors should pay attention to when analyzing a low-margin business’s financial model: namely, free cash flow and how to allocate it.
2/ To frame the discussion, let me quote an old blog post of mine about the importance of free cash flow as opposed to profits:
A key feature of Amazon’s business model is how it uses its cash flow to finance its radical innovation, which in turn enables Amazon to keep on growing and to generate even more cash flow…
How can Amazon generate such a high level of cash flow? Well, it’s because of their negative cash conversion cycle and their impressive growth. And won’t Amazon be forced to slow its growth at some point? Well, maybe, but it will be a mortal danger for a company that literally feeds on growth.
Cash flow numbers mean a lot in the digital economy because they reveal the capacity of a tech company to finance the continuous reinvention of its business model and thus signal what really counts in this new world: perpetual growth. High-rate growth is a permanent feature of tech companies’ business model.
We’ve been taught to think that corporations last forever—even if they never actually did. In the [Entrepreneurial Age], we have to accept that corporations are indeed mortal, and that the key to any tech company’s survival is growth fueled by radical innovation and cash flow.
3/ As you can see, the main idea here is that free cash flow can keep on growing, even if margins are thin (even negative), only as long as the business itself is growing. From an investor’s perspective, this raises two critical questions:
Where’s the room for additional growth so that you can reach a scale large enough so as to generate high margins?
In the meantime, how should the free cash flow be allocated to complement capital brought by outside investors?
4/ The first question is why investors interested in tech companies are so obsessed with the size of the market. You need a large market to cross that threshold beyond which you can have economies of scale (either supply-side or demand-side).
Unfortunately, it’s likely that the COVID-19 crisis will accelerate the transition to a more fragmented world, in which only a few markets (mainly the US and China, and to a lesser extent India) will have the size that tech startups in most industries need to reach a scale large enough to generate high margins.
But what about all other markets, including Europe (due to its fragmentation) and Africa (same) that don't have that kind of scale? How should capital be allocated when a business isn't operating on a market as large as the US, China or India?
5/ The answer is that the free cash flow derived from a low-margin business on a not-so-large market should be reinvested in enlarging the scope of the business so as to increase the margins. Here’s what I wrote in 2016 in my 11 Notes on Amazon:
Without Amazon’s own inventory (and the cash flow it generates at the expense of suppliers), it would be very difficult to invest in and improve the customer experience, since they would constantly need to raise more cash; and without the marketplace, Amazon would be incapable of maintaining its profits and losses above the waterline. Amazon’s own retail business and the marketplace are loosely coupled, complementary businesses that enable sophisticated financial engineering dedicated to growth.
6/ Note, however, that during the first stages of building a tech startup, it is not the founder’s job to strategize about long-term capital allocation:
Long before he ventured into engineering Amazon’s financial model, Jeff Bezos had to spend several years focusing on one thing only: building the best online retaileryou could dream of—starting with selling books.
Only then, when all that growth came and started generating free cash flow, could he start reflecting on how to allocate it so as to expand the scope of Amazon’s business and generate the profits that would make the business less reliant on outside capital.
For companies that have not reached that stage, founders shouldn’t bother too much with corporate finance, which means that it’s the investor’s job to ask themselves such questions: Where’s the room for additional growth? And if it’s not about more market share on a large market, are there opportunities to extend the scope of the business by way of proper capital allocation?
7/ There’s something else, however, that an investor certainly can discuss with a founder, and that’s the hybrid nature of the business (software/non-software), and the expectations on both sides of the table. Two parameters are especially worth everyone’s attention and should be analyzed together: margins and defensibility.
My thesis is that the two are mutually exclusive, meaning some kind of balance needs to be found. Businesses that come with low margins (usually ones that are less about software) are more easily defended, while those that generate high margins (by way of software’s characteristic increasing returns to scale), are difficult to defend if growth slows.
In other words, if you’re at the software extremity of the spectrum, only fast growth prevents competitors from catching up on you. It’s easy to sustain that type of growth if customers keep wanting your product. On the other hand that precious growth can be slowed down, and even abruptly halted, for so many reasons:
You own most of your market and there’s no room for additional growth—which will only become more frequent in a world fragmented by COVID-19.
8/ To help drive the point home, let me offer a classification of businesses that relies on how capital is distributed between what I call the Southern Side (which is all about software) and the Northern Side (all the rest, starting with having tangible assets on your balance sheet and a large number of employees on your payroll).
Indeed, we’ve long since entered a world where all businesses are hybrid—part software, part non-software. The whole question is the balance between the two. We can see it as a sliding scale, from Category 1 (no software) to Category 5 (pure software):
Category 1 is about essentially tangible activities with a little bit of software that’s almost immaterial: a website to advertise the company’s value proposition and phone number, or a newsletter to announce summer sales and boost the product when Christmas is approaching.
Category 2 is essentially the same but with a software-driven distribution channel deployed in addition to tangible distribution. This is what all traditional retailers are doing on the grocery market these days with delivery and e-commerce.
Category 3 is where many startups land these days, as software is now eating more tangible industries. Companies at this level have tangible assets and/or employees that make their business more defensible, but their margins are low and they have a rather hard time scaling up.
Category 4 is a software-driven business that relies on tangible assets owned and operated by others. This is the case of marketplaces, managed or not, such as can be seen with Uber and Airbnb. But this kind of setup used to exist in the past with franchise businesses (McDonald’s).
Category 5 is a business that relies so much on software that it doesn’t have tangible assets on its balance sheet (not even servers, since those are provided by either Amazon or Microsoft) and not many employees (except for maybe a salesforce whose payroll is a fraction of sales).
9/ Knowing where a business stands on that scale is the most important thing anyone (executives, investors) should have in mind if they want to succeed in the Entrepreneurial Age. There are two fields in particular where a business’s positioning between the Northern Side (Category 1) and the Southern Side (Category 5) has profound consequences.
One is the company’s culture. The way executives think and reach decisions is very different depending on your category. Similarly, the nature of the day-to-day work is different for the majority of employees, which means that the culture will end up being radically different. For instance, for traditional retailers that are mostly in Category 2 selling online is like operating one more store (which is why most websites by traditional retailers suck). For companies in Category 4, tangible assets and people are just the other side of the marketplace (which is why Uber doesn’t care that much for their drivers—although they’re making efforts).
Another is the bundle of unit economics, strategy and corporate finance. From Category 4 upward, the network effects derived from software (demand-side economies of scale) dramatically outweigh the supply-side economies of scale (large volumes, lower unit costs). Unit economics depend on the category to which the business belongs. It then commands a specific approach to capital allocation to make the most of the company’s distinctive value chain. Again, software is all scalability (you can grow very quickly as long as there is room for it); at the other extremity, non-software is defensibility (it's difficult for a new entrant to compete with you).
So again, the more scalable, the less defensible: we see it with Uber, which is very scalable, but any stumble is potentially fatal as new competitors (Lyft, Didi, Grab, Ola, Bolt...) engulf the market. Conversely, the less scalable, the more defensible the business: we see it with all the tech entrepreneurs (including Jeff Bezos!) who have painfully discovered that it’s impossible to compete with traditional retailers when it comes to selling groceries. Those retailers might suck at software, but their business is still highly defensible because of the importance of tangible assets and employees.
10/ In conclusion, here are the questions that all investors and executives needs to ask themselves when it comes to capital allocation within a low-margin business:
If the business generates free cash flow, how large can it grow given the market?
If the market is not that large (as is the case for most European startups), where should the free cash flow be reinvested so as to expand the scope of the business?
To which category does the business belong on the non-software/software sliding scale?
Depending on the category, what should the priority be? Scalability or defensibility?
Finally, are there decisions to be reached when it comes to capital allocation so as to tip the balance in a way that’s favorable to the business?
As always, please don’t hesitate to reach out if you want to pursue this discussion or if you’d like me to dig deeper into one of the questions above 🤗
This Wednesday, the free weekly edition of European Straits was titled 11 Notes on Y Combinator.
And here’s the related reading list if you want to learn even more about Y Combinator (also make sure to read the chapter dedicated to Y Combinator in Jessica Livingston’s Founders at Work):
The Aha! Moments That Made Paul Graham's Y Combinator Possible (Robert Greene, Fast Company, November 2012)
Y Combinator, Silicon Valley’s Start-Up Machine (Nathaniel Rich, The New York Times, May 2013)
The Importance of Proprietary Deal Flow in Early-Stage VC (Mark Suster, Both Sides of the Table, May 2013)
Asset Management Is A Bizarre Industry Ripe For Disruption (David Teten, Forbes, November 2013)
Sam Altman (Reluctantly) Says Y Combinator Has An Accelerator Monopoly (Anthony Ha, TechCrunch, May 2014)
How much do Y Combinator founders earn? (Ryan Carey, 80,000 Hours, May 2014)
“Guys, Let’s Grow The Hell Out Of This Company”: How Y Combinator Startups Go Big (Max Chafkin, Fast Company, February 2015)
Stanford, Michael Bloomberg Now Back Every Y Combinator Startup (Douglas MacMillan, The Wall Street Journal, October 2015)
Venture Capital and the Internet's Impact (Ben Thompson, Stratechery, October 2015)
Sam Altman's Manifest Destiny (Tad Friend, The New Yorker, October 2016)
Paul Graham at The Family (me, European Straits, April 2017)
Y Combinator Has Gone Supernova (Steven Levy, Wired, June 2017)
Why Seed Scaled (Bryce Roberts, Medium, October 2018)
Y Combinator, Not Lambda School, Is Unbundling Education (Byrne Hobart, Medium, October 2019)
Y Combinator abruptly shutters YC China (David Coldewey, TechCrunch, November 2019)
Changing policy, Y Combinator cuts its pro rata stake and makes investments case-by-case (Jonathan Shieber, TechCrunch, April 2020)
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From Normandy, France 🇫🇷