Scaling Up: When Do Unit Economics Matter?


by Varun Gupta

Valuations of three of the most spoken about technology companies that are arguably still only scaling up: Facebook at $65 billion (General Atlantic got in today for 0.1% stake at a valuation, 30% higher than the previous month’s); Twitter at $7.7 billion; LinkedIn at ~$3 billion. What really are these companies being valued on? More importantly, what should an entrepreneur focus on – valuation or intrinsic business model? Sadly, the adage of “test, and then invest” is not being used to test the business model, but only to seek a superficial product-market fit.

When Facebook, foursquare, Twitter, etc., get rewarded through the means of valuation on the number of registered members they show every month, it is unlikely that they are as driven to increasing ARPUs. The predominant thought in the industry is to get the user base; revenues and profits will follow through some mysterious force of nature. This, inexplicably, assumes that the user base is captive, upcoming competition can never fight scale, and that members will always turn into consumers. When Orkut and MySpace had their day in the sun, Facebook came along, asked consumers if it could import contacts from Orkut/ MySpace and made those social networking sites largely redundant. Is Facebook that infallible natural monopoly that James B. Stewart, a columnist for SmartMoney magazine and SmartMoney.com, makes them out to be. David Skok also says that there is a clear tipping point when one is recognized as the market leader and beyond which it can shut out any competition. Can we really make these deterministic generalizations from ~13 years of Google’s history or from the ~35 years since Microsoft was founded?

I would boldly (possibly, foolishly) argue that these new-age tech startups, and importantly VCs, have got it wrong. Any extraordinary margin game will attract competitors, companies flush with dollops of money at sky-high valuations are more likely to make sub-optimal investment decisions, and in a fluid, paradigm-shifting world, no one has a natural monopoly that will last. To be sure, I know tech startups can be hugely successful – Google has numbers to back up the ~$200 billion valuation and probably has a value proposition that not many others do. There are many others, which have undoubtedly created immense value. But, generalizations about valuation in perpetuity cannot be made when we don’t have enough of a sample size to suggest what perpetuity looks like for a tech company. Like any other bubble in the past, it seems there is no obvious connection between valuation and revenues and profit. If 600 million users are not enough to roll out the secret (undecided) business model, I wonder where the inflection point is.

Entrepreneurs beware! If you want to lead a rich, famous life for the next 5-15 years, seek the highest valuations. If you want to leave a legacy, build a business that can last into perpetuity! Figure out what product-market fit means to you – in my mind, it should not the point at which you capture enough users, it should be point at which you can get enough users to pay enough money that makes the business viable. Unit economics matter. Venture Capitalists: Let entrepreneurs create businesses – if it’s all real, they will become celebrities.

Am I completely missing something here? 

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