If you were to spend enough time with me you’d very quickly realize that I’m a bit of a broken record when it comes to giving advice. I’ve found that some of the concepts that I’ve been able to crystallize into simple phrases over the years seem to apply very broadly in the business world. I’ve shared most of these concepts so many times that they’ve become “truths” etched in my gray matter. But I’ve actually found myself challenging one of these “truths” recently (which if I’m honest is quite uncomfortable). Some really interesting start-ups have violated the “truth” and a handful of well respected investors are pouring capital into these businesses and are super excited about them. Start-ups violate good advice all the time (for good and bad reasons), but smart, well seasoned investors should know better which is why I’ve been thinking hard about this particular concept.

The phrase in question that I share all the time is that “great businesses are built on top of good businesses”. It’s a simple statement but one that’s packed full of nuance. And to unpack the concept, it’s important to understand my personal definitions of “great” and “good” businesses:

GREAT BUSINESSES

  1. Are dominant, profitable and stable players in their respective ecosystems
  2. Have brand permission and have assembled the resources needed to capture additional profitable market share in their current markets and expand into new ones
  3. Are coveted by able and willing strategic and financial buyers both for their current and for their future value

GOOD BUSINESSES

  1. Don’t yet dominate their ecosystems, but serve enough customers with their product/service/business model that they make money or will with a modest increase in scale
  2. Are working to build their brand permission but typically only have enough resources to grow their core business
  3. Have created obvious enterprise value and could sell themselves to a strategy or financial buyer (with work) based on their current financial profile

So when I share the advice that “great businesses are built on top of good businesses” what I’m really saying is that there are intermediate steps along the way to greatness and these steps produce stable, valuable businesses in their own right.

And while I still think the advice is generically good (in fact excellent), it might not be applicable to a particular type of business that can leap from bad to great without a stop-over point in-between. To be clear, this class of businesses can and should be scary to investors! Without the creation of an intermediate stable and profitable business, capital needs to underwrite the destination and every leap of faith needed to get there knowing that there’s questionable exit value being created along the way. From a risk/return standpoint, this means that the destination better be a truly exceptional one because the contingent probabilities of assembling the pieces and cracking the code along the way imply low odds of success.

I’ve named these businesses “Act 2” businesses because their first Act isn’t interesting in and of itself because it doesn’t create a “good business”. It’s only with the successful delivery of a second (or third) Act that something of value has been built. This isn’t right or wrong, it just “is”, and underwriting this type of business requires a very particular capital stack and mentality. To clarify why, it’s worth sharing a common pattern that many of these businesses follow:

Step 1: Build a product/service in a market with gigantic TAM that is embraced with excitement by the target user base. The evidence: Extremely high user engagement rates, off the charts NPS scores, significant virality, etc. Is the model profitable: No. Revenue might not even be built into the business model and if it is it could be trivial.

Step 2: Raise capital to fuel the losses associated with building out the product/service and scaling the user base rapidly. Capture a noticeable percentage of the market while maintaining or improving engagement rates and NPS scores. Build brand permission with your user base to set the business up for the future. Is the model profitable: No. Unit economics might still be unknown because revenue might not be built into the business model yet and OpEx/SG&A/Product&Engineering are all consuming cash. The determination could also have been made that the quickest way to scale the base is to give the product away for free (or below cost).

Step 3: Raise capital to fuel product expansion and experiment with various forms of monetization from the core. Is the model profitable: Maybe or maybe not. Either the early forays into monetization work and define a model with fantastic margins or they don’t. The customer base might be willing to pay for a product/service that was historically free. They might be willing to buy additional products/services from the business. Third parties might be willing to pay for access to the business’s customers.  Or not.  Or not at margins that make sense.

All an investor really knows is that Step 1, Step 2 and Step 3 all require capital and the only way they’ll get a return on their investment is if enough profitable revenue can be generated post Step 3 to make the business work. What it requires is that an investor fuel “Act 1” knowing that the business is extremely capital consumptive and could be a wipe-out if the pieces don’t fit nicely in the end. And markets are dynamic with good ideas becoming obvious quickly, so the investor also has to bear the risk of a competitive reaction from incumbents and other talented start-up teams along the way.

Making the concept of investing in Act 2 businesses even scarier is that Founders worry about dilution and have a mistaken view of what “Enterprise Value” really is. A business is “worth” the price at which a willing party is ready to buy the entirety of the business for. If there isn’t a counter-party at a particular valuation, then an Investor is valuing the distribution of potential outcomes when they write a check (i.e. – the option value of the business). This is a rational way for an Investor and a Founder to come to terms on “valuation” because they’re both agreeing to share in the proceeds in various success scenarios. But, in the real world of investing in start-ups this has collapsed to a really sloppy short-cut where Investors and Founders typically agree that at each capital infusion, the new capital should buy 20-30% of the business.  Isn’t the uniformity of what capital buys odd given the diversity of business opportunities and outcomes?  Yup.  It’s the product of sloppy thinking and using “industry norms” and “Founder friendliness” for justification.

So, when I run through the math of a business needing multiple capital infusions (some of which could be quite large) with very little salvage/exit value being created along the way due to the lack of creating a “good business” intermediate step, I’ve come to the conclusion that many of these businesses are terrible investments at the price needed to win the deal. When looked at in the rear view mirror, the best Act 2 businesses will appear to be brilliant bets made by VC “prophets”, but a truly honest forward looking analysis of the distribution of outcomes would likely reveal EV negative bets being made.

And it’s not difficult to define when a business is in the strike zone of being worth a gigantic price. Businesses all eventually collapse to some multiple of future cash flows and the multiple is based on a variety of factors like revenue margins, the volatility and concentration risk associated with the cash flows, the growth rate of the cash flows, etc. So if an Act 2 investor is putting $200MM into a company at a $1B valuation, they’ll have made an OK cash-on-cash return (3X) if the business eventually figures out how to generate 20% EBITDA margins on $750MM of revenue ($150MM of EBITDA at a 20X multiple). Some businesses will trade higher and some will trade lower but hopefully you get my point —— there’s a level of revenue and margin that can define an acceptable outcome. But if the business model is uncertain, the Investor is paying for a distribution of potential business models vs. one that just needs capital to scale, so one could argue that the business needs to achieve a much higher cash-on-cash return to justify the risk.

And it’s not lost on me that there’s a line of thinking that great Founders and great teams won’t chase giant outcomes if they can’t own enough of the businesses. But is this really true or is it a function of the market we’re in? With so much VC and PE capital ready to be deployed, all it takes is a very compelling Founder to convince a source of deep pocketed capital that the distribution of outcomes is more certain than it really is. It’s a truth that every Founder believes they’re going to succeed with near certainty and it’s also a truth that they’re statistically wrong, so the art of investing requires dealing with this paradox. The market is deep enough to allow for EV negative Investments to be made with regularity but it doesn’t mean that the price being paid is an accurate reflection of what a business is worth or that it will generate a good risk adjusted return.

Will I ever invest in an Act 2 business?  With certainty.  I have in the past and I will in the future….but I haven’t and I won’t do it without convincing myself the risk/return is justified.  FOMO and sloppy thinking don’t make for decades long successful track records and that’s all that matters in the end!

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