Newsletter #14: Startups Need Great Capital Allocators Too

In fall of the year 2000 I was a young J.P. Morgan associate, sitting in the conference room at the  Greenwich, Connecticut headquarters of a leading private equity firm.  The CFO of the firm walked in and made a comment almost as an aside, but which had a big impact on me: “the key is to save money where it doesn’t matter.”

At the time, the American economy was in the midst of the eCommerce bubble.  Startups were raising funds from venture capital firms, and then racing to spend those funds to scale as fast as possible.  And unbeknownst to them, many were on the verge of imploding due to their undisciplined capital allocation: eToys (undisciplined inventory management and poor marketing spend), Pets.com (marketing spend was 20x revenues in 1999, for instance), and Boo.com (undisciplined marketing spend) were just three high-profile examples.  Perhaps that is why this CFO’s comment stood out to me: while it was so intuitive, it was in stark contrast to the insanity of the market environment at the time.  Many of these companies were spending mindlessly, unaware of what it meant to be good capital allocators.

Many of the biggest and best enterprises in the world became so because of legendary allocators of capital.  Warren Buffett of Berkshire Hathaway.  Henry Singleton of Teledyne.  Morris Chang of Taiwan Semiconductor.  Mark Leonard of Constellation Software.  And many, many more.  Looking further back in history, John D Rockefeller was a legendary allocator of capital at Standard Oil.  So was Andrew Carnegie of Carnegie Steel, as well as Cornelius Vanderbilt across his wide-spanning business empire.  One could also argue that Lee Kwan Yew, the founder of modern Singapore, was an incredible capital allocator.

But strong capital allocation skills aren’t the exclusive property of large, established companies.  In fact, one of the main reasons so many of these enterprises became so successful is because they were shrewd with their capital allocation from the outset: by saving where it didn’t matter, by remaining flexible and liquid while patiently waiting for the right opportunities, by shrewdly assessing potential capital allocation opportunities, and then by having good conviction and pouncing when the right opportunities presented themselves. 

Warren Buffett addressed directly the need for patience and discipline when he said, “in allocating capital, activity does not correlate with achievement.  Indeed, in the fields on investment and acquisitions, frenetic behavior is often counterproductive.”

Henry Singleton spoke to the importance of saving where it doesn’t matter and maintaining financial flexibility while you wait for opportunity: “We’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted, so my idea is to stay flexible.  My only plan is to keep coming to work every day.”

Likewise, it is crucial that early-stage consumer companies become strong capital allocators from their earliest possible days.  In fact, undisciplined capital allocation / running out of cash is cited as the biggest reason startups fail, according to CB Insights.

These days, it is all too often that startups optimize for simplistic ratios, and therefore fall prey to the erroneous belief that they are making good capital decisions, when in reality they are trading dimes for nickels.  For instance, many startups cite a 3x+ Return on Ad Spend (ROAS) as a sign of success, and blindly feed the ad machine if they are exceeding a 3x return.  This 3x rule of thumb is oftentimes absurd, in that it does not take into consideration whether that 3x return to revenue is actually profit positive.  For instance, a business which has 80% margins can drop money to the bottom line with a 1.2x ROAS; whereas a business with a 10% profit margin is not profitable with a 5x ROAS.  Additionally, without direct attribution of the incremental revenue to the specific ad spend, can the company actually make such a causal inference?  In many instances, the attribution is heavily assumption-laden, and the answer is a resounding “no.”

Another misunderstood ratio that is regularly cited is CAC to LTV.  CAC (Consumer Acquisition Cost) is an expense metric; whereas LTV (Lifetime Value) is a revenue metric with an ambiguous measurement period.  Again, many startups and venture capital firms cite a LTV to CAC ratio of 3:1 as successful.  In actuality, this is (once again) dependent on profit margin rates and the time horizon for lifetime value.

In summary: it is important for startups to establish a good capital allocation strategy and discipline from the outset, and to really think about what optimizes for their unique business, if they want to eventually become big successes over time.  And yet, the following keys to that capital allocation strategy should always include:

1. Saving where it doesn’t matter;
2. Remaining flexible and liquid while patiently waiting for the right opportunities;
3. Assessing potential capital allocation opportunities dispassionately and with the right success metrics; and
4. When the right capital allocation opportunities present themselves, having conviction and pouncing on the opportunities.

Mark Leonard of Constellation Software summed it up well in his 2007 letter to shareholders: “the standard we use when we spend our shareholders’ money is even more stringent than that which we use when we are spending our own.”  All consumer startups should be thinking that way.