Principles for Capital Allocation (Round 1)
European Straights, 2020-04-24
Can’t get enough of European Straights. So much important content.
Problem Statement(s)
Investors don’t like low-margin businesses [comparing them to high-margin software post the hockey stick curve].
But low margins can be a feature of the market, not software.
When will the low-margin businesses grow enough to command higher margins?
Free Cash Flow (CFC) to the Rescue
Ex: Amazon uses FCF to fund its radical innovation. Growth —> FCF —> Growth, etc. Negative cash conversion cycle (i.e. they pay for goods only after they’re sold).
FCF determines if the company can finance its evolution and growth.
FCF can keep growing even with thin/negative margins, only as long as the business is growing.
Using FCF
Q: how to allocate FCF to complement external funding?
A: using FCF from low-margin business on a not-so-large market to enlarge the scope and increase margins.
It’s the job of a startup founder to reach the point of growing and reaching positive FCF. It’s the job of an investor to think of capital allocation at that stage.
Markets and Fragmentation
Economies of scale are only possible after a certain market size.
Fragmentation of markets —> smaller size —> less opportunities for EoS [economies of scale].
Margins and Defensibility
Mutually exclusive —> need to find a unique balance.
Low-margin businesses (less about software) are more easily defensible; high-margin (software, due to increasing returns to scale) are harder to defend when growth slows.
Software: only fast growth defends you from the competition. But you’re not immune:
o You own a large market share —> nowhere to grow —> slowdown
o Your customers start hating you due to the shift in tastes / political agenda —> slowdown or drop.
Hybrid Businesses Based on Capital Distribution
1. Category 1: tangible businesses with immaterial software (simple website, email list, etc).
2. Cat 2: Cat 1 + software-driven distribution channel (in addition to the offline channel).
3. Cat 3: (end game for unfortunate startups) Software eating tangible industries. Tangible assets, lots of staff, defensible position, but low margins and hard to scale.
4. Cat 4:software-driven businesses relying on tangible assets owned and operated by others. Marketplaces, Uber, Airbnb. Even McD franchise.
5. Cat 5: no assets (cloud servers), not many employees.
Where to Go from Here?
Succeeding now requires knowing where the business stands.
Consequences for Company Culture
Decision making by execs is different for CAT1-5
Work structure is different for employees
Traditional retailers (Cat 2): online is just one more store.
Marketplaces (Cat 4): tangible assets and people are just a side of a marketplace.
Unit Economics, Strategy, Corporate Finance
CAT 4-5: network effects from software (demand-side) dramatically outweigh supply-side EoS (higher volumes, lower unit costs).
Unit economics —> specific approach to the company’s capital allocation.
Conclusions
The more scalable – the less defensible (see Uber).
For software firms competing with defensible offline is not an easy feat.
Need to have an idea how much FCF can grow the company’s market share (and is the market large?).
If the market is not large —> reinvest elsewhere (where?)
Where does the firm sit in terms of CAT 1-5 and how defensible/scalable is it?
Are there opportunities to go up the CAT 1-5 scale?