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Benchmark Capital’s Bill Gurley, USV’s Fred Wilson, and Andreessen Horowitz’s Marc Andreessen recently raised concerns around cash burn and how it’s becoming a key metric for investors. With an abundance of capital, some startups are executing on “land grab” strategies and making significant investments in user acquisition with hopes to monetize in the future.

These strategies are appropriate for some companies, as long as they create fundamental value and capture a portion of that (associated) value. The problem is that we are seeing valuations at excessively high levels without the promise of true value. This has created a false sense of exuberance for startups and a false sense of urgency – invest heavily in acquiring users or be left behind. It has resulted in a shift in focus from building a sustainable business model to having the largest user-base, raising the most capital, and making the biggest splash.

There is an inherent assumption that scale helps with monetization – in many cases, it does, but in some cases, it may not. There are popular strategies startups are employing to build scale.

Assessing the effectiveness of these strategies and their potential is what is needed to identify the winners from the crowd. Here are the strategies with the key metrics to assess them.

funding, capital, startupThe “Borrow and Build”

Companies in markets with strong network effects rush to spend every resource they have in capturing as many users as possible. This creates a virtuous cycle – attracting new users increases the value of the network, which makes it easier to attract other users, leading to higher market share capture. Once the market “tips” (the network acquires the bulk of the market), companies can then start thinking about monetizing that user base (through advertising, data analytics, payment processing, etc.)

The inherent problem here is that with the innovation in products, business models and services, there are new markets emerging, with an unclear path to profitability or monetization. These markets are nascent enough to have a long lead-time until a clear winner emerges and monetization actually begins. To muddle things even more, the monetization strategy for these new markets is often unclear when startups begin to acquire users.

This strategy only works in markets with natural monopolies (the largest player captures the entire market). Additionally, there needs be a plausible moat (either a significant cost of switching for customers or a significant barrier to entry for new entrants) to sustain a natural monopoly. For example, messaging platforms definitely have network effects, but they do not have a moat (in other words, if WhatApp starts charging users a non-trial fee, they can easily switch to Viber, Line, Skype, WeChat, GroupMe, Kik, etc.)

Key Metrics to Watch:

  1. Level of virality (k-factor) for users on the network (strength of network effects)
  2. Cost of acquisition per user
  3. Revenue potential per user (a good way to compare different monetization models)
  4. User engagement (% active users)
  5. Cost of switching for users

The “Freemium”

Companies employing a freemium pricing model bet on the fact that once a consumer starts using their product, they will see enough value in it and upgrade to a paid, more advanced version of the product at some point. The freemium model works well in markets with strong network effects because the value of the network increases for paid users even as you get free users in the system. LinkedIn, for example, has executed beautifully on the freemium model. The value of the network for paid subscribers increases even as free users sign up. Evernote is another example of a successful execution of the freemium model that has not relied on network effects.

The challenge with a freemium model is that with a low conversion rate (of free users into paid users) and a high cost to serve, it quickly becomes a money-losing proposition. There are a few important metrics to monitor to assess the effectiveness of this strategy.

Key Metrics to Watch:

  1. Cost of Acquisition (CAC) of free and paid users
  2. Conversion rate of free users into paid users
  3. Cost to serve free and paid users
  4. Lifetime value (LTV) of paid users
  5. Strength of the network effects (level of virality – k-factor, network utility, etc.)

The “Trojan Horse”

Startups serving enterprises sometimes employ this approach to get their foot in the door. They get users to on-board with a (consumer) product that happens to have an enterprise use case, in hopes that once enough users in a company start using the product, IT will switch the entire company over to a paid version of the product with the appropriate IT controls. This can be thought of as a bottom-up sales process – get users on board and IT will follow.

There are two problems with this model. First, an average consumer and an IT professional have inherently different interactions with any given product, which ultimately creates two very different targets, forcing startups to manage two separate “portfolios.” This model ultimately underserves one “portfolio” and over-serves the other, creating an imbalance in investment versus return and skewing future priorities. Second, it is capital intensive with a two-fold cost structure; it requires resources to acquire users and to serve them, and it requires an enterprise-grade sales and marketing engine to sell the service to IT. Ultimately, it comes down to unit economics; to assess that, here are the key metrics.

Key Metrics to Watch:

  1. Cost of Acquisition of users
  2. Cost of Conversion (Sales process to the IT, LoB Admin, etc.)
  3. Cost to serve individual users and enterprise accounts
  4. Lifetime Value (LTV) of enterprise accounts (taking into account churn, upsell, etc.)

The “Platform”

When a network turns into a multi-sided platform, it creates real stickiness in its user base. A multi-sided platform is a network that connects not just two parties (buyers and sellers, creators and consumers) but multiple parties (creators, consumers, advertisers, developers, etc.). Take Facebook, for example, it connects content creators, content consumers, advertisers, app developers and third-party sites (FB Connect). Building a multi-sided platform requires investing in building critical mass for each part of the network – obtaining users, app developers, and so on.

There are two challenges here: First, aligning value capture with value creation for each platform participant (i.e., can’t charge the users if they are getting the least value from the platform compared to advertisers and app developers). Second, investments must be directed primarily to the part(s) of the network that create(s) the most value. For example, investing to build an apps ecosystem when the volume of users largely drives the value of the network would be an inefficient use of capital. The value capture strategy should be aligned with value creation, and the company should be investing in growing the portion of the platform that adds the most value.

Key Metrics to Watch (for each side of the platform):

  1. Revenue generated per “transaction” (clicking on an ad, peer-to-peer purchase, referrals, etc.)
  2. Cost incurred per “transaction”
  3. Percent of users engaged in transactions
  4. Cost of acquisition per user

The Bottom Line

Building scale is important – in many cases, it is the only way to win. However, building scale for the sake of being bigger ends up destroying value. It should be done with a clear plan to profitability. Assessing the effectiveness of scale building by tracking these metrics keeps profitability in perspective. Additionally, the focus should be on fundamental value creation – if real value is being generated, it will be captured at some point.

Cash burn by itself is not a bad thing. Businesses have always needed capital to grow (with little to show in the bottom for the first few years) – all the way from Intel, Cisco and Oracle to Google, Salesforce.com, and Facebook. Being capital efficient is the hard part. The fundamentals of building a sustainable business haven’t changed. Focus on value creation, and the rest will fall into place.

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