Startup investing: The problem with ‘traction’

“We are all failures – at least the best of us are.” - J.M. Barrie

I had argued that for various reasons we may see a bust in the startup investing market. A controversial part of this argument centers around “traction” and its validity as a metric to value and fund startup companies, which, along with other indicators unrelated to profit such as revenues (or GMV), has become easy rule of thumb to determine which companies get capital and on what terms. Where does this all lead to?

Taking a step back:

While this may be true for some businesses (we will come to that later), startup investors have increasingly started believing that creating an expansive or dominant position in terms of consumer acquisition is sufficient to build enduring businesses, while everything else could be figured out later. To this end, investors and entrepreneurs have measured ‘top-lines’ and marketing milestones as a measure of success. This also means that in most cases, startups and growing companies are not focusing so much on reducing cost as much as spending on the exigencies of rapid ‘scaling’ by way of ‘customer acquisition’ - very fashionable phrases in the investing world.

Traditionally, this sort of model would have run into early trouble, with investors asking how this could be a healthy way of attaining profitability in a competitive market and given that profits in the long run have little to do with revenues or initial spurt in customers. Businesses take years, sometimes decades, to innovate, build brand recall, trust, respect and reliability that not only is successful in capturing markets but also in sustaining them.

A question of innovation:

Innovation, in simple terms, is an investment in technology, skills, processes and know-how that reduces costs, while increasing quality and access to products. Most ‘technology’ startups today (and we aren’t talking of Google) are not as innovative as we would like to think. In most cases, little research and development is required to adapt new goods and services to a new platform (mobile or web). Such technologies do not usually contain a sufficient amount of novelty required to make them patentable under law. That is to say in layman’s terms - the law believes anyone can come up with it and hence it isn’t first movers advantage that is worthy of legal protection.

In the absence of innovation and therefore, protected intellectual property, there is little by way of assets that large amounts of capital can bring to these new technology businesses except marketing and sales spend justified by an imagined “stickiness” of consumers that flows from a deep-rooted, misplaced and unwavering urge to scale.

Are customers actually sticky? Conventional economics says that this would depend a lot on how elastic or inelastic the prices of the goods can be upon adoption and on the quality of innovation and protected intellectual property. Brands come and go, unless they are built and maintained profitably. Cigarettes, accountants, software applications and restaurants may not follow this rule; they can be “sticky” and prices can be inelastic, i.e., customers will not or cannot move from one good or service to another quite easily and are therefore unwilling to switch over unless prices change drastically, and not without pain. Even applications that involve externalities such as social media have seen quick growth and quick downfall as user preferences have evolved.

So if there is no competitive advantage conferred by (a) innovation or (b) inelasticity of pricing and ‘stickiness’ of services, then how does acquisition of customers constitute a viable asset?

The distortions:

Ignoring this and assuming everyone is in the race for a monopoly in sectors that do not necessarily lend themselves to one, millions of dollars are being invested competitively by venture funds. The rising pile of investments is used to sell goods and services below cost (which, in most cases, in not reduced substantially due to the new business model) and acquire customers (who have no incentive to stick except for temporary low pricing).

This is how much a lot of money that has been invested privately has found its way into technology companies which have never turned a profit. This has also resulted in considerable disruption to the competitiveness of markets in which these businesses operate. Profitable businesses that raised capital in a conservative manner, cut costs and built innovative products are being disrupted by loss making behemoths who are merely heavily capitalised and marketed aggressively.

There is indeed a lack of regulation of the world of private investing and the law does not require a company to turn a profit to raise large amounts of private capital. There isn’t anything wrong with this - this is useful and necessary for the growth of business. However, regulation is also intended to aid in the development of markets, and restrict and prohibit practices that are stifling of innovation, disruptive to competition, free trade and equal opportunity.

In this regard and at least in the Indian context, there are several new technology companies (e-commerce businesses and cab services, to name a few) that present a clear case of abuse of dominant position. The Competition Commission of India has been fairly ineffective in interpreting and implementing the provisions of the (Indian) Competition Act, 2002 in a manner that prevents companies from serving customers below cost and disrupting profitable businesses.

It appears that by the time we have conclusive determination on complaints filed against certain companies, the competition would already have been wiped out. This wouldn’t be so tragic and indeed may have been truly disruptive if these profitable businesses were replaced by more efficient models instead of inefficient ones that are preserved by excessive capital infusion.

Scaling for failure:

Investors are funding businesses under the assumption that they are (a) technology businesses (b) in a market that favors monopolies and (c) ‘sticky’ in terms of customer preferences.

These assumptions have caused private investors to assume that the game involves pushing entrepreneurs to scale rapidly so as to provide returns in multiples, multiples that are ostensibly earned by businesses built on wiping out competition, acquiring consumers and by expanding rapidly. Growth on steroids that few entrepreneurs would undertake in the manner contemplated unless the cash was flowing only for that purpose.

This not only has affected the healthy growth of businesses that have raised these investments but also entrepreneurship in general, where bootstrapping/lightly capitalised innovators are often confronted with predatory pricing and unfair trade practices fueled by a deluge of inefficient capital.

Meanwhile in the public markets:

Popular chain of local pubs in Bangalore Pecos has decided to raise a small amount of money from the public, yes from the public. Pecos has turned away private equity and believes the venture funded approach to business does not suit its style of growth. It is ostensibly a cash cow that has been running profitably for 25 years and has not needed expansion to survive - it has outlets numbering in the single digits and a loyal base of customers.

Private equity, venture funds and angel investors, today, pretend not to understand Pecos’ kind of business, which does not involve quick expansion into a number of outlets capturing a large number of customers and burning money in the process. The returns apparently will not be superlative to compensate for the rest of a fund’s failed investments.

The others have failed because their competitors got “funded” because they had more “traction”, and this has created a whole bunch of luckless entrepreneurs who have failed in a race to nowhere. Things may soon look up, once investors and entrepreneurs are wiser for the experience and a little less heavy in the pocket. And after all perhaps all is fair in love, war and business.

“Success is not final, failure is not fatal.”- Winston Churchill