A year in the life of an Entrepreneur often feels like being on an eternal roller-coaster. Five hundred twenty-five thousand six hundred minutes (no I’m not channeling a song from “Rent”). And every one of them a chance for the up feeling that comes with good news or the depression and panic that inevitably accompanies bad news.
A year ago most of the next-gen fintech lending businesses found themselves in the midst of a down cycle and it felt horrible. The cycle started in early 2016 with a pullback from loan purchasers due to increasing losses and reduced unlevered returns. Not long afterwards the industry had to deal with the Lending Club “Event” that sent waves of panic throughout the ecosystem. A few months later we started to see some of the smaller platforms shut their doors and the larger platforms tighten their credit criteria and reduce burn through RIFs. Earlier this year the major platforms started to grow again and we now find ourselves in an environment where every recent securitization seems to be oversubscribed and well received by the investor community. What a crazy year!
So, I thought it would be worth a follow-up piece to the posts that I wrote when the industry was in its downturn. In Thriving, Surviving or Dying I laid out four critical questions that lending originators had to answer in order to thrive. In What Happens When The Cash Runs Out I laid out the importance of “Climbing the Relevance Curve”. And in I Once Was Lost… I made some obvious statements about what lending was all about.
Be your own judge about whether the points made a year ago are still relevant today. I personally think they are, but I happen to be a bit biased. But having lived through the past year, I feel that there are a few additional points worth sharing now and in future posts that will hopefully add a bit of richness to the view of “success and failure” in the lending ecosystem.
With this in mind, I thought it would be worth adding a new concept to the mix that I call “Know What Race You’re Running.” Put simply: There are business models that are designed to favor a single break-out winner and there are business models that are designed to do quite well alongside a broad ecosystem of players. A flaw I’m seeing quite often is that some Entrepreneurs don’t know what model they’re pursuing and therefore they don’t design or run their business correctly. To make this tangible, it’s worth digging into the differences between “Type 1” and “Type 2” models.
Type 1 business models are designed around “being the best” for a given customer segment. By having the best product/service for a given customer segment, Type 1 businesses aim to attract, service, retain and X-sell customers on the strength of their offering and brand positioning. Many want to create “THE destination” for customers in their segment. They want to make sure that awareness within their target segment is strong and that they lock up marketing and distribution channels that cater specifically to their prospects.
Type 2 business models are designed to “show me the money” by having both attractive horizontal and vertical economics. Horizontal economics are the annuity oriented cash flows (unit economics) and vertical economics are the in-period cash flows (P&L economics). These business models are designed around efficiency and healthy margins and ultimately around bottom line cash production.
The reason why it’s important to know what type of business you’re building is that the best strategic and tactical moves around what it takes to “be the best” vs “show me the money” are different.
A few things to internalize about each model:
Type 1 – Being The Best
- A simple definition of “best”: You need to believe that if a typical consumer in your target segment were faced with perfect information that they’d pick your product every time.
- Almost by definition there can only be one “best” business for a given customer so it takes being obsessive around product, brand, service, the competitive landscape etc. to remain on top
- To carve out this position, a business usually has to provide a great deal of value to their customers which can put pressure on margins and make significant scale a necessity
- War can break out if multiple well-resourced and nimble businesses try to own the distinction of being the “best”. In these cases, value tends to migrate back to the customer, the market becomes fragmented, and nobody achieves scale or generates attractive economics.
- Falling farther and farther behind is a likely outcome when an under-resourced player chases a well-resourced player and they both want to “be the best”.
- The majority of enterprise value creation will fall into the hands of the break-out winner and almost every investment into other entities in the space will prove to be “mediocre at best”.
Type 2 – Show Me The Money
- The truth is that there’s typically room in most industries for multiple well-run players to thrive
- The best operators of Type 2 businesses obsess over the fact that every dollar invested in growth needs to achieve a hurdle rate return and every dollar invested in a non-growth initiative is a dollar that eats into the company’s operating margin
- Designing the company’s infrastructure such that it can earn money at low levels of scale is critical to building a cash machine (most overlooked design principle!)
- Being the biggest or the best isn’t as critical as being really good, extremely efficient and scaling in a disciplined manner
- Operations of Type 2 businesses typically believe that serving your current customers well and offering a slightly more complete product each year is a winning formula
So why does this matter? It matters because certain ecosystems aren’t conducive to supporting a “best” business. But, most Investors want to invest in and Entrepreneurs have therefore built business plans around “Being The Best”. Too many Entrepreneurs design their businesses to give every dollar of margin back to the customer through pricing and functionality and justify it by thinking they’re in a Type 1 race. Rock meet hill. Cash meet toilet.
And the opposite situation is also frustrating. Chasing a break-out winner in a Type 1 race is a near impossible task. Type 1 races are awesome if you can win them but when you don’t you have some really unhappy investors and a really broke company to show for it. I can point to a few businesses that lost ground every year to the dominant player and had to close shop (or are about to). Punching yourself in the face would be more pleasant. Rock meet hill. Cash meet toilet.
With this in mind, the best advice I can give is “Know what race you’re running” and act accordingly!