The problem with profitless startups

http://nymag.com/daily/intelligencer/2014/04/problem-with-profitless-start-ups.html

by joshreads • 12 years ago

76 50 12 years ago

tl;dr the author argues that the ultra-cheap venture backed services are a problem because while they're using money from VC firms and being patient, they're driving out local businesses, and they'll ultimately fail, leaving a hole in the local service ecosystem.

arbuge• 12 years ago

If that's the problem, it should eventually autocorrect when the investors give up permanently and local businesses return.

wffurr• 12 years ago

That word "autocorrect" masks quite a lot of suffering on the part of local business owners who close up and lose their livelihood and investors (including pension funds, retirement accounts, etc.) which lose their money.

Sure, in the long run it all works out, but in the short term there's quite a lot of turmoil.

notahacker• 12 years ago

Even if that invariably happens it's not much consolation to the local business owners bankrupted because their skinny margins couldn't compete with the "disruptive" idea of running at a massive loss for two years. Venture capitalists make a loss inducing formerly marginally profitable businesses to make a loss represents a deadweight loss to society overall even if the service gap gets filled.

That said, most of the named business lines are those particularly easily replaced even if the threat of other VC-backed businesses coming into the market still exists: those inclined to open sandwich shops or market themselves as handymen aren't likely to be too worried about more online threats emerging in future, and the savvier ones are instead figuring out how to get profitless startups to provide them with low cost marketing.

hagbardgroup• 12 years ago

Not impossible. Private equity is itself young. Venture capital is even younger. It may be an artifact of our particular time, place, set of tax policies, and financial system.

bowlofpetunias• 12 years ago

You do realize that those local business are run by people with families to feed, and that "eventually autocorrect" does not "autocorrect" the ruining of their lives?

001sky• 12 years ago

The purpose of predatory pricing is remove the auto-corrective components of the ecosystem. It follows that it should eventually autocorrect is wholly speculative: b/c The markets can remain irrational--longer than you can remain solvent

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couradical• 12 years ago

They also argue that this poses a long-term potential problem for VC as well. Eventually an institutional investor wants their money back. Eventually they have to settle up and see who the Amazons are vs. the Pets.com. That forces businesses to transition towards exit in some fashion, if they move to IPO, this shift forces them to make a shift (to become profitable) which will kill some.

I don't see how that's a controversial point, but it's a distinction that a lot of people who aren't in tech, or around startups don't get.

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wmf• 12 years ago

I don't think we need to worry about VCs robbing their investors. Both sides of that transaction are pretty smart people who can take care of their own interests.

As for the startups, I think your comparison of Amazon and Pets.com is astute. For each of these companies, are we looking at an unprofitable early stage of a company that will eventually become profitable (e.g. Amazon, probably Uber) or are we looking at a company that can probably never become profitable? The former seems fine even if it causes some temporary disruption, but the latter is just waste.

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beat9• 12 years ago

I think the professional institutional investors who run pensions and what not are fundamentally different from some Grandma investing her life savings in a "hot stock". Venture capital is just another diversification checkmark for such big funds.

A VC once told me that he thinks most venture funds don't really stand a chance of making money at all. The reason they have money to invest is because there's such a surplus of cash from institutional investors who need the "venture capital" checkbox. The lower-end VCs don't get the best deals and have to settle for leftovers, so their chances of getting lucky in a get-lucky business are that much lower.

At any rate, no honestly run pension fund is actually putting its capital at significant risk by tossing a few tenths of a percent at a collection of VC funds.

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bthomas• 12 years ago

Does Uber Black Car really subsidize UberX?

I find it hard to believe that UberX isn't profitable alone - Uber just takes 20% of fare.

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johnrob2• 12 years ago

If they don't pay the drivers enough, there won't be any drivers. 20% is probably not a hard rule.

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rdudek• 12 years ago

How do we know that some of these businesses are losing money? Looking at the menu of SpoonRocket that the author listed, you could make the same meal for less.

I have a feeling that the profit margins are very low, but I do not think they're in the negative.

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aantix• 12 years ago

Paying employees, executives, money for the car leases, gas, all while located in SF?

An $8 meal, they make it at $4. With one avg engineer on salary at 125K, (~10K a month), you'd have to sell 2500 lunches with a $4 profit to cover just his salary.

I'd bet they're losing money.

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anoncow• 12 years ago

Outsource the engineer. At 30-40k salary per annum, they can scrape by on 625 to 833 deliveries a month. 20-28 deliveries a day. You still have to look at paying the delivery guys and managers.

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johnrob2• 12 years ago

The article actually missed one angle: increasing cost of living. It's not just that prices are dropping for services like food/trasportation/etc, but that it's happening while rent prices are going up. If anything, local service prices ought to be rising along with rent. It's doubly striking that they are dropping.

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sharemywin• 12 years ago

Their workers aren't independent contractors because they don't offer their services to multiple companies. The IRS will figure this out and get their taxes. Next, eventually when the employee count is big enough they will sue for things like minimum wage, breaks etc.

also, it takes nothing to start one of these businesses and compete therefore profits can't get too big. The business doesn't really scale.

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PublicEnemy111• 12 years ago

As someone who recently accepted a job in silicon valley, I've started to become concerned that there is a bubble. I feel there are many parallels between 1999 and today. I would love to be convinced otherwise because I am concerned with job security, but I can't escape the feeling that the "music" will soon stop. At the very least I'd like to hear people's opinions on whether there is a bubble or not

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highace• 12 years ago

If it looks like a bubble and acts like a bubble...

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Edmond• 12 years ago

It is unlikely that those who stand to profit from a bubble would acknowledge it....up until the housing market came crashing down there was a continuous stream of people on CNBC talking up the market....the same happened in the first dot com bubble, you can expect the same now.

The new excuse is that even if there is a bubble it will be contained. It does seem an entire bubble economy has been created in SV where bogus companies provide bogus products and services for other bogus companies. Maybe in this case any collapse would be contained, but I guess we'll have to wait and see.

As the expression goes: Anything that can't go on will stop.

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ritchiea2• 12 years ago

Isn't the crazy thing that it can go on? There's enough money at the top of the economy that the rich can keep investing in startups as an asset class and not really feel the losses even though they seem huge to those of us who get by on a salary from a job. The real question is: will the investments keep coming?

My guess is it continues. Hedge funds as a whole also perform below market but see continued investment because of the promise that they will have tremendous returns when a firm succeeds. Startups get money from the same sort of investors. People who are only investing a portion of their portfolio, chasing big returns and mostly unconcerned about losing some money along the way.

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LandoCalrissian• 12 years ago

So the biggest difference to me is that the 1999 bubble was completely built on the backs of everyday investors. It was a rush to IPO and easy money, and eventually the market got wise and the whole thing fell apart.

The new paradigm is far more interesting, since it's almost all the investment comes from VC and Angel Investors. I think these entities can leverage risk far better, since they may lose a few million here and there, but when they hit a whale they really hit big.

I think there might be 'micro bubbles' within the industry that may implode under their own weight (F2P mobile games companies come to mind), but I think that's largely separating the wheat from the chaff.

I know some will disagree with me on this analysis, but I don't really subscribe to the sky is falling theory. The tech industry is now big business, that's not going to change.

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ajiang• 12 years ago

Regardless of my opinion on whether or not we're in a bubble, the argument of "it's different this time because..." is used in the build up of every bubble we've ever experienced.

Stock bubble? Economic stability and the wonderful controls the Fed has on monetary policy. No more economic cycles.

First tech bubble? The internet is a wonderful thing we haven't had before - new opportunities, etc.

Everything is different until it isn't.

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GFK_of_xmaspast2• 12 years ago

Right now there's so much money sloshing around here because (a) there's nowhere else for it to go and (b) everybody's doing it. What happens when there is somewhere else for it to go?

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GFK_of_xmaspast2• 12 years ago

Of course it's a bubble. Stack that paper now.

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pbreit• 12 years ago

There's possibly some decent arguments in there but they are shrouded by inanity. They aren't "profitless-on-purpose". They understand the simple fact that a dollar is better spent building the business than sitting in a bank account. The author simultaneously degrades startups for not having other business lines to fund them while also degrading the VCs that do. The retirement funds care about returns not portfolio business model nuances. Pretty much every credible "money losing" business I've seen needs to be able to project out profitability at modest scale. Google Shopping Express and Ebay Now are far more perplexing form a cost perspective. If physical businessed can't compete on cost then rents need to come down or they need to figure out how to benefit from their advantages (location, service, etc).

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mathattack2• 12 years ago

Remember that Priceline had a history of loss leaders. Amazon was patient in making money too. A couple million here or there is pennies if you're funding the next big thing. This turns into a way for companies to subsidize early adopters. Yes, the interface may not be perfect, and you never know what will appear in the box, but if you'll give us a go, you'll get an $8 lunch that might just be good... Sounds fair.

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smacktoward2• 12 years ago

Not all startups are created equal.

The biggest difference between (say) Amazon and the startups discussed in the article is that the startups in the article are aggressively local. "We deliver lunch in the Bay Area" doesn't scale to other communities as easily as "We ship books to anywhere from a giant warehouse in the middle of nowhere" does, since the former requires building up local infrastructure (meal prep, delivery, legal/regulatory compliance, etc.) for each expansion.

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mathattack2• 12 years ago

Fair enough. If a VC wants to toss money at them, why not?

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cookerware• 12 years ago

I remember a coworker telling me in a condescending tone 'this is how a startup runs, you break even and try to expand market share, burning investors cash and growing without profit' when I asked about how it is that our company that has not made any profit in the past 4 years serving enterprise customers is able to still be solvent. What if investors suddenly stop injecting cash? Financials would be negative in the first quarter.

I never understood the working models of growing at the sole expense of investors money. Because I don't know but last time I checked capitalism and free market still is king, and they always have a history of major market correction. When something's not efficient or something's offplace, market has a tendency to correct itself, in a big, unexpected, ruthless sort of way and we've seen this again and again, but history seems to teach people nothing.

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beat9• 12 years ago

Wow, this article is kind of clueless.

First, the VC money isn't going to cost-cutting - it's going to growth. In theory, virtualizing the business processes should lead to higher efficiency and naturally lower costs. This model has been proven out in other fields - it's the Big Box model of retail that created giants like Wal-Mart (although a better comparison would be specialist big box retail like Guitar Center). So the VC money is going to building out the business model infrastructure, not selling a sandwich cheaper than the local shops.

Second, these businesses on the edge don't have enough market share to make a massive dent in the local market - and it's ludicrous to think that they could do so by losing money on transactions at scale. By the time they pose a real threat to local business, they will be profitable. They must be, because the markets are too large to be subsidized by VC forever.

Third, a lot of the businesses that are threatened are not "mom and pop" at all. Taxis? That's a local oligarchy protected by politics. Food delivery? Ever heard of Domino's Pizza or Jimmy John's?

Fourth, these can create new opportunities for local business. I can now get food delivered to my door by one of these startups, but the food comes from excellent local restaurants (the mom and pop ideal) that otherwise could not possibly get a delivery service working profitably. They've outsourced the business model, not the food prep.

And then there's the handwringing about how the long-term professional institutional investors who run pension funds and the like might go broke on venture capital, not realizing what a tiny sliver of that market VC is - it's a diversification strategy, not a core. The biggest concern would be if a VC collapse led to a broader stock market collapse, a la the dotcom era. Not likely.

Yeah, dumb article.

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jbooth4• 12 years ago

You totally missed the point of the article.

The lunch that guy described is impossible to deliver for $8 in the US, and especially in SF. That business makes no sense, ever. Losing money while making a unit profit on that lunch, ok, let's see where that goes. Getting my business by selling to me below cost? I'll do business with you all day but as soon as you raise the price, I'll switch to the next startup offering me a subsidized lunch. There's nothing 'long view' about that. No vision there.

This trend, if it's as big as the article makes it seem, is way more worrying to me in a 'bubble' sense than the color.com thing.

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beat9• 12 years ago

No, I got that. You missed the point of my critique.

It is impossible to scale that $8 delivery lunch large enough to provide any significant threat to local business. There simply isn't enough VC money for the hundreds of millions that would take. The scruffy little startup trying that model will either raise prices long before profitability, or will run out of money and disappear.

But a standardized delivery model that is a straightforward service charge, made possible by modern tech? Hell yeah, that's a good business model - and it's good for the mom and pop restaurants too.

Now, if you can point me to the mom and pop food delivery service...

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beat9• 12 years ago

Out of curiosity, I did some research on SpoonRocket. First, I caught the article author deliberately misrepresenting the Series A:

"it’s just raised $10 million in venture capital expressly so it can keep its prices low". The linked article said nothing of the sort. It said Series A, yes, but not that it was to subsidize pricing. Second, that Series A just happened on April 9 - this week. They haven't had time to even cash the checks yet! (they had a $2.5M seed in 2013, per Crunchbase. If VC thought that money was wasted on cost-cutting, they wouldn't be paying Series A)

Second, SpoonRocket differs in a couple of ways. First, they're a food+delivery service. They don't drive for other restaurants, and they don't have a restaurant space (and associated costs for service and location-driven rent). They only do two meal choices a day, and those are driven by ingredient availability. They're much more like a wholesale bakery than a restaurant.

Their technical edge isn't just communication, either. They have heating systems built into the cars. So I'm assuming they simply fill the cars with meals and send them out, using software to track closest car to the customers, in a high-density urban area. When a car runs out of meals, just come back for a refill.

This is an extremely efficient model, for both food production and delivery, outstripping the benefits of restaurants that have to offer a diverse choice-driven menu, and delivery services that have to do one-off deliveries to support that consumer customization of their food.

So I think it is absolutely reasonable that they could profitably deliver $8 meals.

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ForHackernews2• 12 years ago

It sounds like for a lot of these companies, their idea for "growth" is cost-cutting. This isn't even economics 101, it's simple common sense: if something is cheap, more people will buy it.

It turns out selling at below-cost prices is a fantastic (though ultimately futile) "growth hack".

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beat9• 12 years ago

If that's true, then they will find out why it's a losing strategy when they run out of money, and their VCs will hopefully learn not to fund companies whose business model starts with loss-leading commodities against established market giants.

But I find it hard to believe VCs are that stupid.

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al2o3cr• 12 years ago

"They must be, because the markets are too large to be subsidized by VC forever."

cough Salesforce cough

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lauradhamilton• 12 years ago

Interesting argument, but I sort of doubt that local small businesses and bootstrapped startups really need to worry too much about VC-backed startups that truly lose money on the the margin.

In general startups that lose money on the margin do not last very long.

Anyway, if the theory is that this food delivery service is selling under cost in order to get rid of the competition, well, then they are going to be displeased to discover that the barriers to entry for a food-delivery service are not particularly high.

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lazylizard• 12 years ago

meanwhile, enjoy your consumer surplus.

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The problem with profitless startups

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