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.


  • 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?