Headwinds on our tail
Reluctant euphoria is a cautiously optimismic publication that looks for the positive in the negative, but also the negative in the positive.
Times of economic crises are often regarded as the perfect time to build. The hype and the distractions are gone, and it’s time for a sober evaluation of the status quo, and a realistic assessment of what lies ahead. I’m sober now, so we might as well start with a look at where we are right now. There’s some significant headwinds companies are facing right now. They touch on the key aspects of a business. It’s time to find new answers to old questions, but also come up with new questions altogether.
Facing headwinds
Capital allocators bet on growth. The riskier the bet, the greater the potential return, but the lower the likelihood of that return manifesting itself. In order to justify taking the bet, the expected return needs to exceed the return of holding capital and earning the risk-free interest rate on it. A higher risk-free rate means the threshold for risky bets is also higher, leading to a broad reassessment of investment decisions. But beyond financial considerations, there are four more general headwinds that the current situation has laid bare.
Headwind 1: how are we making money again?
Tech companies created so much value over the past decade because they built products that could be adopted globally, in markets with strong winner-takes-all dynamics. The high potential return naturally attracted investors, keen to find and fund the next big platform.
To appeal to investors, platforms wildly inflated their total addressable market. They backed their estimates with explosive growth numbers, achieved through unsustainable pricing and handouts. The hope was to establish a quasi-monopoly quickly and figure out profitability later. This worked to great success for some of these companies.
However, for many of the most ambitious of these platforms, the question of the winning business model remains unresolved. What worked well — ads, subscriptions, commission fees — is mostly a translation of traditional monetisation strategies to the digital world. While they work for some, for other businesses it is far less clear how a long-term sustainable business model could look like.
Headwind 2: how big can it get?
Naturally, a lot more people are interested in using a product if it’s free, or unsustainably cheap. But with the pressure on to monetise and turn a profit, many apparently huge markets will probably shrink quite significantly. This will have a direct effect on user numbers, growth outlooks and ultimately valuations.
Companies focused on convenience and non-essential products will be even more heavily affected by this swing in the short term, suffering from cutbacks on unnecessary spending. It might turn out that many of the companies launched with unsustainable plans for “world domination” will ultimately achieve profitability as a healthy niche player. But not every digital platform will automatically become the next super app.
Headwind 3: wait, what are we building?
Becoming a healthy niche player sporting one of the above-mentioned business models works for some, especially in the digital realm. But for others, especially those that are more deeply ingrained with real-world operations and assets, it’s harder to extract enough value or unlock sufficient efficiency gains to profit from a thin digital layer.
There’s a natural limit to disruption when the disruptive force does not touch upon the actual physical elements of the industry it’s setting out to disrupt. Additionally, efficiency gains and ubiquitous access to legacy products and services are not the right response to the next big challenges we are facing. In many ways, it’s not enough to do things differently, but to actually do different things.
For example, we’re not going to solve the climate impact of transportation by just substituting each personally owned vehicle with an EV. Instead, we need to fundamentally reconsider mobility modes and how we move around. D2C brands are not an innovation per se if they sell products no one really needs. We don’t need to rethink only how we sell products, but what kind of products we produce and market.
Inevitably, addressing these challenges requires going beyond digital layering, and actually touching on the infrastructure and systems that underpin the current products and services — even if they are already digitally enabled (I have written about this in the context of mobility before here). The next generation of winning consumer-focused applications will naturally emerge together with, and on top of, new infrastructure and systems.
Headwind 4: well, but what’s the recipe to success here?
Hardware follows different rules than software. Actually disrupting legacy systems follows different rules than merely building software on top of them.
Raw materials and hardware don’t scale. The physical world is bound by the law of physics, making outsize network and scaling effects harder to come by. Margins are, generally speaking, lower, because each unit of output requires the same amount of raw materials. On average, efficiency gains and cost reductions will be competed away and/or passed through to customers. Overall, input (capital, materials, work) is more tightly coupled to output (goods, services), putting an upper bound on growth.
Bringing about systemic change is just as hard — if not even harder. Making the case for hardware innovation can be relatively straightforward, e.g. cheaper unit costs, longer life cycles, improved features. Customers can choose to buy the new item, or stick with their old one. There is a chance for a gradual market entry. Systemic changes are different. It’s simple to outline what is not working at the moment, and how it could work better. But actually getting from current state to a desired future state is not clear cut. I have no trouble outlining issues in this article, for example. This does not mean anything will follow from it.
Systemic change mostly only works at scale, making it hard to accurately assess the benefits. It requires collaboration between different entities leading to a situation riddled with potential dead locks and conflicts of interest. This also raises the question of responsibility. Climate change is a stark example here: everyone would have a strong incentive to change the overall picture, but the incentive to change one’s own modus operandi is significantly lower.
All of this means there is a long period that requires continuous investment to kick off and drive change, but besides a rough plan there is no guarantee the pay-off will eventually manifest itself — and it’s to a great extent outside the control of those actively driving the effort.
Looking ahead
The questions raised above touch on the fundamental elements of each business. They’re even more important to businesses that are just getting started. Many of the answers that worked over the past years are being questioned. But those who manage to find new, promising angles from which to approach the questions, and use the new perspective to come up with innovative answers will be in a strong position to come out swinging — after, or even during, a crisis.
