In the last decade, we witnessed the spectacular rise and subsequent unprecedented series of implosions of several massive startups such as WeWork, Veev, and Hopin. Many of these failed in a similar fashion, while others who managed to survive suffered from deflated valuations. In their zealous pursuit of growth, perhaps to emulate successful predecessors, several startup founders shifted their focus from value creation to valuation building. Therefore, when the era of easy capital came to an abrupt end, tech companies faced the brutal realization that their sky-high valuation businesses had been built on a house of cards.
Fueling the Tech Bubble
The transformation from unicorns to unicorpses did not happen overnight; in fact, it has been long in the making, spanning over a decade. In 2008, amidst the financial crisis, the Fed cut interest rates and enacted quantitative easing measures to avert a second Great Depression. However, these supposedly temporary measures became more long-term. The US government also bailed out many financial institutions that were deemed “too big to fail” in the process, despite them being the ones architecting the financial crisis itself. As rates were suppressed to encourage spending, capital became cheap and investors began moving capital from traditionally safe asset classes such as government bonds to riskier ones like publicly traded stock, property development, and venture capital.
Flushed with cash and confident in the fact that they would be bailed out if they were big enough, investors were emboldened to make increasingly risky investments.
Unlike private equity where the valuation of a company is based on current financial performance (P/E ratio), the valuation of a startup is less clear-cut, as tech startups do not usually start off by being profitable. Hence, around 2010, venture capitalists began to think of the valuation of a startup as a multiple of its revenue (the P/S - Price: Sales ratio), as revenue is often a reflection of growth, and growth is an indication of product-market fit, subsequently pointing to the potential of a startup. When this method of evaluation was initially used, the base assumption was that the unit economics made sense. Pretty soon, as investors started looking for even more creative ways to make money, this assumption was quickly disregarded, which set us up for a tech bubble.
Blitzscaling: A Double-Edged Sword
Generally, a startup can decide how they want to grow to account for different factors: efficiency, speed, and certainty. They can stick to one approach, or alternate among different options.
Figure 1: Blitzscaling : the lightning-fast path to building massively valuable businesses
Blitzscaling is the approach in which a startup decides to prioritize speed over efficiency to be the first-to-scale in the market, in the hope of reaping the benefits of economies of scale, or network effect, or both. This means rapidly building up your team and quickly expanding your market, often at significant loss in the process. This approach is further encouraged by some investors as it allows startups to reach a higher valuation much faster since they are paying to buy revenue. Higher valuations also mean that investors are growing the value of their investments (albeit on paper) until they can actually cash out. In an era where capital is cheap and accessible, it is acceptable to lose money as long as you are growing.
Unlike the fast scaling model where market conditions are certain and cost is understood and predictable, blitzscaling takes place in an uncertain setting, such as unknown market size, unproven product-market fit, or unclear competitive advantage. Therefore, it also comes with massive risk. Moreover not every startup should be blitzscaled. For those whose product is without a built-in mechanism for network effect to take place or an unclear pathway to capitalize on economies of scale, blitzscaling is merely an acceleration to perdition. Even for those with these two conditions, success is not guaranteed. Yet, many naively bought into the idea that as long as you grow and dominate the market, you could always figure out how to make a profit later.
The Dangers of Negative Blitzscaling
Ultimately, blitzscaling is about growth, ideally to amplify and accelerate the core value creation of new technology. Yet, in the process of blitzscaling, many startups seem to have forgotten their raison d'être, and overly focus on valuation building instead of value creating. This naturally pushes startups towards “negative blitzscaling” (negative unit-economics blitzscaling), where they massively scale their operations and aggressively subsidize their products (at a loss) to outbid competitors for market share. However, with negative unit economics and structural unsustainability, few were able to truly achieve the market dominance they had hoped for, let alone generate real profits from this force-fed scale. When funding dried up, these ‘negative blitzscalers’ did not have a strong, profitable core business to fall back on. The plan to use investors' money to outbid competitors only gave them temporary dominance until there was no more money to burn, and they realized that price discounts did not produce the same level of virality and stickiness in user retention as basic product improvement.
With mounting losses, and a sustainable business model still many years away, investors have two options: either charm traditional incumbents into acquiring these “glitzy blitzy” startups or take them public with the hope that retail investors will buy into the hypergrowth narrative, barring their inability to generate profit. The catastrophic outcome of crumbling valuations has been clear for all to see. WeWork’s rise and fall, along with Uber’s deflating stock prices, are examples that reveal the vulnerabilities of negative blitzscaling. The impact has also moved beyond the US, as we witness high-profile casualties in younger startup ecosystems in China and India such as Shihuituan or Zomato. Uber, Grab, or Gojek underwent painful periods of valuation deflation and restructuring when their public listing was corrected by the market.
Back to Business Basics
It will take time for tech startups to unlearn the negative blitzscaling approach as it has been deeply embedded in the psyche of a generation of founders and investors alike, but tech has lost its ways, and it needs to rediscover its roots.
As a founder, one should understand if and when blitzscaling is appropriate, and the associated risks with that method of growth. Above all, they should never ignore the fundamentals of running a business:
- Ensure a healthy financial runway to manage market uncertainties
- Build up positive unit economics for your product
- Index on user retention, virality, revenue, and steady growth
Capital-fuelled battles are becoming a thing of the past (for now), and that is something to celebrate. It means less dilution to founder ownership and more power to your customers. It means focus on business fundamentals. Get your customers to adore and pay for your product. The better loved will prevail over the better funded. Most importantly, any startup needs to be default alive; it needs to be a sound business before being a fast growing business.
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1Blitzscaling: the lightning-fast path to building massively valuable businesses
Endnote:
Hoffman, R., & Yeh, C. (2018). Blitzscaling : the lightning-fast path to building massively valuable businesses. Currency, an imprint of the Crown Publishing Group, a division of Penguin Random House LLC.
