I posted last week about substance investing versus momentum investing. The trigger was that tremendous round Waymo just announced. Sequoia and other investors chipping in $16 billion on a $126 billion post-money valuation. For a business doing $350 million in annualized revenue. Transactional revenue, non-recurring revenue. That's a 350x revenue multiple. No one can say that multiple is because of today's substance -because then it would be a 5x. This was clearly a momentum investment.
Now, Shub and I would not count Waymo into what we're about to talk about (This is actually a very good company). But that round gave me a few reminders: Over the last fifteen years, we have seen boom-style investments. There are always fads, always trends. VC is great at picking the next narrative and then overfunding it - creating overcrowded categories with too much customer buying choice.
The theme for today: if your startup business only works in times of boom, it's not a sustainable business. I bet anyone reading this who has spent years in venture immediately has an example coming to mind.
This Week On Practical Nerds - tl;dr
Boom cycles can create the illusion that a broken model actually works
Even stellar founding teams cannot fix fundamentally flawed business models
The line between substance investing and momentum investing matters more than most think
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Boom Cycles Can Create The Illusion That A Broken Model Actually Works
Shub and I were putting together a list of examples for this episode, and we kept saying to each other: “my God, this list could be so much longer”. There are so many categories and companies that fit this pattern. But we stuck to five because anyone who's spent years in venture probably already has their own examples coming to mind.
The theme we landed on is this: if your startup business only works in times of boom, it might be a shit business. That's maybe a bit harsh, but let me walk through why we think this matters.
VCs are great at picking up the next narrative and then overfunding it. What happens next is predictable. You get overcrowded categories with too much customer buying choice. Everyone's competing for the same buyers. And then conditions normalize and we discover which businesses were real.
The 2010 Version: Groupon
We thought about what the 2010 version of this looked like. At first we wondered - was there really anything booming back then? The GFC recession was still fresh. But actually, yes. There was this whole e-commerce wave, and venture money was flooding into consumer expansion plays.
Groupon is the example that captures it. The original idea was facilitating group buying to access cheaper deals, mostly hyperlocal stuff. Then it morphed into daily deals more broadly. Local retailers, nationwide retailers - they could all advertise on the platform. Today, get a massage 30% off. That kind of thing.
The timing made sense on the surface. People were short of money. People were out of jobs. Having access to cheaper deals was real value creation. And that's how boom cycles start in venture. You see a category and think: my God, this is amazing, we need to go into it.
Groupon raised $1.6 billion. Take a guess how quickly they IPO'd. Shub guessed three to four years, which was close. It was actually three years and nine months. The IPO valued them at over $12 billion.
Today they're trading at about 3% of that value.
What happened? The customers were churning. The customers were moving on. It turned out that having access to daily deals wasn't actually that material to a US or Australian or European consumer over the long term.
Shub made an interesting point about this. He was researching Coupang, often called the Amazon of Korea, and discovered the founder actually started with a Groupon-style model. They were on the verge of IPO-ing on that story. But they chose to change the model entirely.
The insight was brutal: when you do a group buying model, the vast majority of customers are unhappy. They feel coerced into the purchase. There's this sense of peer pressure or discount-led pressure that lulls them into buying in the moment. But they never feel good about it afterward. There's no reason for them to come back.
Shub called it a one-shot interpretation of how business is done. The model treats transactions as a one-shot game. Which, he pointed out, is perhaps what the VCs back then thought it represented too.
So from a financial engineering perspective, if you played the spread - got in early, got out at the IPO - there was value creation. But for those who bought at the IPO or didn't get out in time, the substance caught up with them. Massively.
The 2014 Version: Fab.com
The next example Shub and I looked at was Fab.com. This was another consumer e-commerce play. Shub remembered it from his earliest days trying to break into VC. He was doing an analysis of unicorns and which bets a certain unnamed investor might place. Fab.com was on his radar.
The model combined luxury goods with some sampling aspect for aspirational e-commerce. The thesis was that incomes were rapidly rising, more people wanted to participate in aspirational brands, and this needed to be an independent category.
The company raised $340 million. It was a unicorn. It had major investors on the cap table.
Here's a detail I didn't know until researching this episode. Do you know how Fab.com originally started before pivoting to flash sales of design products? It started as a gay social network. I'm not kidding. The founders were riding two boom cycles at once. When the social network didn't work out, they pivoted into deals.
The company eventually sold for $15 million. As Shub pointed out - and I have to say this was a great pun - isn't it cosmically ironic that a company built on fire sales ended in a fire sale?
Shub and I were discussing what investors liked about it at the time. The answer seems to be: e-commerce, consumer, fast growth. Take my money, you're amazing at marketing, you're amazing at building a brand. Does that remind you of anything happening right now?
Shub made a broader observation here. When you think about it, it's incredible how themes change but the patterns stay so similar. Every super cycle plays out with some extremely well-executed large winners. But if you were to treat the whole category as an ETF, that ETF would perform terribly. Ninety-five percent of the companies become complete write-offs.
So it's also important that you don't invest in a company just for the theme. Even if the theme plays out, it matters that you're in the right company executing on that theme.
No One Can Fix Fundamentally Flawed Business Models
I want to push back a little on something Shub said, or at least add to it. I can agree that execution matters, but I think it's more than execution. Your company's model fundamentally has to be a working business. And if it's only working because of the boom, it doesn't matter who the team is.
The team at Groupon must have been absolutely stellar. The team at Fab.com must have been very, very good. Otherwise they wouldn't have unlocked that kind of funding. But if your model only works in boom times, it will not sustain. It doesn't matter who the team is.
I think that's something venture actually fools itself on. The industry is all about finding the right founders, and then everything else will fall into place. But no, it does not.
Now, can you build an outlier without the right team? Also no. So it's correct that we obsess with founders. But you cannot make the reverse-engineered argument. You cannot say that just because you have great founders, you'll also have a great business. Actually, most of them are not great businesses.
For anyone reading this, go back to our episode about graduation rates from unicorn to decacorn. Compounding is very, very difficult. And it has to do with the market you're in, the model you've chosen, the compounding modes you build into your business. Very few companies get this right.
And unfortunately, boom cycles do not foster it. Boom cycles ignore all of that. Boom cycles just give you money to grow.
The Uber-for-X Era: Homejoy
Shub knows this one better than I do. Homejoy was like a handyman or errands-on-demand service. Cleaning, handy work, various activities at home that you typically get blue collar work for.
Shub told me that when he started in VC, it was one of the hottest models you could copy. One of the easiest businesses to start if you wanted funding. Not to execute, mind you - it's a very hard business to execute. But it was a very easy business model to quickly raise seed and Series A money around the world.
A lot of firms used to call themselves Homejoy for X, Homejoy for Y. That's how deeply ingrained it was in both the VC and founder communities.
But as Shub pointed out, if the whole premise of something is that it's deeply accepted as a consensus view - that one of the easiest things you could do is just call yourself a Homejoy for X - you're already abstracted so many layers away from reality. The story is completely on extrinsics, nothing to do with intrinsics. That's a recipe for disaster.
The reality of these businesses requires very deep hyperlocal execution strengths. You need density on the blue-collar workforce side. You need high quality service delivery because you're sending workers into people's homes. There's a very fine tolerance level for how many mistakes can happen before a business like that implodes.
For most businesses, that's a tough bar to clear. Homejoy didn't clear it. Most of the businesses that copied it didn't either.
The company actually branded itself as Uber for professional services. Founded in 2010, right when Uber had seen extremely fast growth. So for the next eight years or so, we saw Uber for X everywhere.
Just because you're riding on a boom cycle doesn't mean you're a great business.
The "OG": WeWork
How could Shub and I do this discussion without WeWork?
I would describe WeWork as a real estate company that wanted to tell a story of community and love. They talked about software that makes you feel belonging to your fellow coworkers, even though those coworkers aren't even in your business.
It was born out of the gig economy narrative. The idea that everybody is becoming a freelancer. Traditional organizational barriers will blur and break up. We're moving into this almost meditative state of work as belonging. And WeWork was creating the spaces for all of that.
Underneath all of that, the company took leases in many cities and broke down the re-rental model into smaller and smaller spaces. Per square meter, the rent was actually ridiculous. At full utilization, it would have always had great gross margins.
Unfortunately, it just didn't have good utilization. So they created a real estate business that accumulated a huge amount of fixed costs they couldn't get rid of. They internalized that utilization risk.
Two components that I actually like in businesses. But it missed the final piece. WeWork was unable to sell as variable cost. Variable cost selling would have been okay - the more money you make in your business using my spaces, the more money I make with you. But no, it was fixed fee because that's how rental works. And when you don't master utilization, you crumble.
The company reached an IPO at a $47 billion valuation. Then it completely crashed and burned. Shut down. Delisted. Went bankrupt.
It did make one person very rich. So again - a momentum investment that worked out if you rode the wave at a good entry point and exited at the right moment. From a financial engineering perspective, this could have been a success for some. From a sustainable value creation perspective, it was a fundamentally broken business.
Shub mentioned the Apple TV show We Crashed. He said he has no idea how much is fact versus creative liberty, but assuming even half of it is true, it gives an interesting perspective.
He also pointed out the confluence of factors in 2018-2019 when WeWork was at peak valuation. Apple had zoomed to the highest valuation ever. Uber was about to go public. Chinese companies were going public at $100 billion plus. The Vision Fund had arrived - $100 billion, a completely new paradigm in venture. Never before seen and, dare I say, never since seen either.
So you had this perfect storm. The belief was you could write a great founder or leader to any outcome size. There was no limit to how large VC funds could become. The gig economy and sharing economy were the next big thing.
WeWork was perhaps the poster child that got perfectly swept up in that storm. In that sense, it fits the description of something that only works when this confluence comes together.
The company raised $13 billion in equity. One-three billion. Bankrupt.
The Line Between Substance Investing And Momentum Investing Matters More Than Most Think
Shub actually suggested we swap out one of our planned examples for something more recent. The virtual event boom during COVID.
Remember that time when we all couldn't step out of our homes and Zoom and audiovisual communication was the only way we interacted? I didn't mind it, honestly. Shub said he didn't either.
But there was this narrative. Now things will never be the same again. We need solutions where everyone is at home. People never get together at all. This is the future of events. The future of getting together. The future of human interaction. The future of all social interaction.
Companies building audiovisual conferencing, virtual team gatherings, meeting solutions - they were raising astronomical sums in less than a year.
Shub and I used to chat about these solutions even back then. We kept asking: is this really a long-term solution? Is this really something that will sustain itself for any length of time whatsoever? Forget a VC fund cycle - any length of time?
Hopin is the example. The company started during the pandemic, raised $1 billion, and reached an $8 billion peak valuation. All within the window of pandemic restrictions.
Think about how long we were actually restricted. And in that window, a company got to $8 billion.
Hopin sold for $15 million.
Now people might say: but Zoom. And yes, Zoom was the eventual winner. But let me tell you what winning actually looked like.
End of December 2019, Zoom was at around €60 per share. COVID hit the Western world. Over the next ten months, it zoomed - well done, I know - to €477. About an 8x increase.
From there, it sustained that value for roughly another year and a half. And today it's at €76. So the compounded average growth rate from right before COVID to today is about three and a half percent per year.
Your S&P index would have performed much better over that timeframe. That's pretty poor.
So even the winner performed poorly from a certain perspective. Though Shub made an argument that maybe Zoom isn't even the winner. Maybe it's Microsoft Teams and Google Meet. Companies that already had the distribution and infrastructure.
What's Today's Version?
We'll leave it up to everyone's imagination what the current version of boom-cycle investing looks like. I'm just saying: research negative gross margins that get brushed over because there's insane user and ARR growth. Or rather, annualized MRR growth.
The pattern repeats. The narratives change. But the question stays the same: does this business work when conditions normalize?
If the answer is only when the boom is happening, well, Shub and I have some concerns about that.
So: Questions Worth Asking Before Writing The Check
What does this business look like without the current tailwind? If growth depends entirely on cheap capital and hot narratives, that's worth noting.
Does the model actually work at the unit level? Great teams cannot fix broken economics. Stellar founders at Groupon, Fab.com, Homejoy - none of that saved the underlying model.
Is this a one-shot transaction or a repeating relationship? Shub's point about Groupon customers feeling coerced and never returning captures something important. Businesses built on transactions that don't repeat have a ceiling.
Are you investing in the theme or the company? Even if a theme plays out, ninety-five percent of the companies in that theme might still fail. Being in the right company matters.
What does graduation from here look like? The path from unicorn to decacorn is narrow. Compounding requires the right market, the right model, the right defensibility. Boom cycles fund growth. They don't fund compounding.
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