118. Economic Theory in Venture Capital, Part 1 (Mark Suster)

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Mark Suster of Upfront Ventures joins Nick to cover Economic Theory in Venture Capital, Part 1. We will address questions including:

  • You’ve written about a major lesson from Clayton Christensen’s book, the Innovator’s Dilemma, which was one of ‘deflationary economics.’ Can describe what this means and why it should be a focus for startups?
  • In light of deflationary economics, what are the key questions that a founder should ask him/herself about the business?
  • Why is it that incumbents have such a hard time responding to startups w/ this approach?
  • What should new market entrants focus on when it comes to price vs. functionality?
  • At a high-level what are your thoughts on the trade-offs between growth and profitability?

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  • Seph

    Great interview. Some notes below. All quoted text from Mark unless otherwise indicated.

    @2.30
    Mark’s origin story.

    @9.30
    The Innovator’s Dilemma, by Clayton Christensen. Deflationary economics.

    @10.20
    “What he basically said is the most successful new entry model is competing [against] non-consumption.” The success of the Sony Walkman as an example.

    @11.25
    “When you compete with non-consumption you’re usually launching an inferior product… It’s not as good because if it was the same level as the existing market you would have to spend millions… to get it to that level. So you’re creating an inferior product that is cheaper and at a lower margin. But what happens is that by solving a problem that didn’t exist before… and by targeting a new customer eventually your product gets better and better. And as the product gets better the market starts to ‘trade down’… because you get good enough that people no longer want to spend 20x, 30x, 50x, 100x the price point and you end up creating a much bigger market.”

    @12.20
    Maker Studios as an example. Mark invested at $4.5M valuation and sold less than 4 years later at $700M valuation. !!! Maker Studios reduced the cost per minute of video production literally by 2 or 3 orders of magnitude.

    @13.40
    Salesforce as an example.

    @13.48
    Nick: “Totally reinventing a market or creating a new market by accessing mass market consumers and completely different use cases.”

    @14.45
    “If you want to build something that has massive scale, if you want to build something that grows very quickly… which means out of the gate higher risk, less chance of success, more competition… then what you need to think about is how [to] offer a product that will appeal globally to masses of consumers… [and] keep the cost base so low that I can achieve that level of scale. And through scale comes lower percentage margin but higher overall margin because [of] a much larger market.”

    @15.30
    Google as an example. Ebay as an example.

    @16.40
    Storage as an example. Mark mentions MakeSpace. He wrote a very good post on this:
    https://bothsidesofthetable.com/makespace-raises-an-additional-17-5-million-and-unveils-strategy-to-make-public-storage-the-next-49765401ff6d#.7jigmmn7y

    @18.00
    Blockbuster and Netflix as an example.
    Barnes & Noble and Amazon as an example.

    @18.30
    Discussion about why market incumbents have a hard time to innovate.
    Short answer: incentives matter.

    @20.30
    Discussion about focus on price versus functionality. Important to consider how to eventually monetize the concept.

    @21.45
    Advice to Mark from Bill Gross: “If you really want innovation, you have to be 10x better at something than anyone else in the market… If you aspire to [being] 10x better, and it’s an interesting market, assume that there will be 5 or 6 other people trying to do it at the same time. That’s just how innovation works… so best execution ends up winning… When you come up with a concept, you aspire to be 10x better… If you’re amazing as a company, at best you will be 2x or 3x better. But 2x to 3x better, [with] other people in the market massively trying to compete at the exact same time as you, is what it takes to create an amazing company.”

    @22.45
    Ring as an example of focusing narrowly on a market segment with great success.

    @24.00
    Discussion of how to reconcile the startup’s 10x objective with the massive capability of the incumbents.

    @24.50
    “Solve a narrower use case or solve a use case which hasn’t been solved.”

    @25.50
    Ring is already doing hundreds of millions in revenue. !!!

    @26.00
    Discussion of Growth vs. Profitability.

    @26.28
    “Investors value growth above all else, in general. But over time they have to see a way that it will be profitable growth. It’s ok to sacrifice short term profitability for long term growth.”

    @27.35
    “Anytime you are making investment in sales, in geography, in engineering, you are spending money on… people in advance of the revenue that they help you generate… and you couldn’t run a business like this unless you have access to capital… Otherwise you have to finance [growth] from your own cash flow… [and] by definition grow more slowly because you don’t have the dollars to expand as fast.”

    @28.18
    “You want a profitable business in the short term if you don’t have access to capital. Or if you want to run something that hits profitability faster but by definition sacrificing long term growth.”

    @28.30
    “If you want a business that succeeds at [large] scale, and if you don’t grow fast but you’re on to a really important concept, the biggest risk is that capital will back people who do want to capture that big market opportunity faster than you. So you will find that all your competitors become very capitalized and then it becomes hard to compete.”

    @29.45
    “Cost of Capital” as an important consideration. A higher Cost of Capital corresponds to increased dilution of existing equity at a financing event.