New Rules of the New Economy

Sep 23, 2019
Blog

Let’s take roughly several innovative tech companies, like Lyft, Uber, Slack… Do you know what they have in common? All of them are loss-making! But how come? How is it possible that they remain to be well-known and successful? Why do investors give their money to those who have been unprofitable for years and can make old-school market strategists, accustomed to EBITDA and price/equity indicators, cry? Is this another financial bubble or a change of rules?

Since many of Andersen’s projects fall within the domain of financial technology, we were curious to find out how it works:

Venture capital funds

When investing in high-risk enterprises, venture funds overestimate the costs. They are not the type of investors to be scared with losses: 75% of projects invested by venture funds do not show meaningful ROI, while the remaining 25% brings sufficient profit (or make VCFs go bankrupt, but that’s another story). Such investments can create a real pyramid! Seeing the value of the company inflated by previous investors, subsequent ones can invest without even thinking what exactly in. That’s how it works! But wait, how many stupid millionaires do you know?

Dumping of young companies
They enter the market with their quality hi-tech products and allow people to use them practically for nothing! When a tech company of new type enters the industry, traditional organizations hardly have any chance. For example, when was the last time you called any other taxi except Uber since it appeared in your place? The company of new type provides its services better, cheaper, and in a more convenient way than competitors do. The same Amazon steamrolled the market thanks to the free delivery of goods. If you get used not to pay for the delivery (or to search for a taxi conveniently), you won’t stop using it. But why are these startups, investing huge amounts of money in infrastructure, promotion, and product quality, do not try to offset expenses? Why don’t they go broke after ruining their “traditional” competitors?

Methods of business valuation
Let’s suppose that the usual analytical indicators are really outdated. What to pay attention to if quarterly growth and the ratio of the stock value to profit don’t cause reverence anymore? For current expenses, a new type of company has the concept of sunk cost – costs for development. Yes, they have been made already. Yes, they can be shockingly huge. However, they won’t affect business operating results anymore. Indeed, does it really matter how much you paid your programmers if in a couple of years you can have ten million users a day, like Slack? What about Blizzard that gathered 12 million players in few days after the release of World of Warcraft Classic? Even the author of these words could not stand it and bought a subscription. What metrics should be used to evaluate such things? Every startup with good ambitions should be mentally prepared to scale to the global market.

New market infrastructure
Well, now we know the reason, don’t we? An innovative company sells digital goods, not physical ones. Today, in order to sell more, you do not need to produce more, just advertise more, and gain audience interest. No sunk cost (well, in simple terms) matters now, because the cost of marketing will still be greater. Therefore, marketing indicators become a kind of more interesting. How much does it cost to attract a subscriber? Will they leave tomorrow or stay? What is the dynamics of audience growth? Who cares about your EBITDA, let’s get new customers! Now successful is not the one who proudly shows a profit in the quarterly report, but the one who shows a good unit economy on an individual user.

Conclusion
Investors understand what they are doing. Hi-tech companies make traditional enterprises suffer. Marketing indicators are more important than production ones. Unit economy decides. Traditional metrics do not work for a growing business that directs all resources to further sustainable growth. Yes, by definition, these are all bubbles. But the paradox is that they are changing the very structure of the economy. And even if these bubbles burst, it will not become the same.

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