When it comes to investors there are very few who are as respected or well known as Warren Buffett. It’s not just because he made a lot of money (He is ranked No 3 on Forbes Billionaire’s List, with a net worth of $72.7 billion), or even because he chose to give most of his wealth away. It’s also because his principles are believed to be solid, sustainable and, even, universal — his fans consider him nothing short of a philosopher.
One of his investment philosophies — I would say, it’s the core — illustrate not only the wisdom, but also the subtle sense of humor that he is famous for. It goes like this:
Rule no 1: Never lose money
Rule no 2: Never forget rule no 1.
At one level it simply means that, at end of the day, a business has to make money. The cost at which a company creates value to customers should be less than the price they pay. For Buffett, it was all about the returns on invested capital. Profits. Peter Drucker says it’s profits that give legitimacy to a business.
This might sound a bit at odds with what happens with the start-ups. I am sure you constantly hear conversations about how your colleague and his family, armed with a coupon, had a sumptuous dinner at a restaurant for free, courtesy of some foolish startup. Or, how a friend uses an app to call a cab, riding for free with all the paybacks promised. Or the huge discounts with which one can buy something online. They are all great for customers, in the short term. But surely, none of these can be profitable for the companies. Can they break Buffett’s rules and create a new rule to building long term business value?
And then you have Amazon. It’s one of the most admired companies in the world. Customers love it. Its innovations are adopted as standards. Its founder, Jeff Bezos, is considered a kind of genius businessman. Amazon is valued at whopping $250 billion — a good $100 billion more than IBM. Yet, it has never made any profit. Is Amazon breaking Buffett’s rules? Or is there something else going on here?
In my line of work, I often come across this question from entrepreneurs: What should we focus on — profitability or growth? The underlying assumption is that it’s okay for a startup to focus on acquiring more and more customers, achieve scale, and then look at profitability. It has an intuitive appeal. If the market is huge, make sure you grab it before others do, and then worry about profitability. That’s how Amazon does it — it has pressed the pause button on profits — so it can grow and grab market share.
Well, this kind of analysis misses a crucial point. If your unit economics isn’t right, there might not be any pause button for your losses.
What does it mean? In simple terms, are you the kind of CEO who understands your costs and revenues at a detailed per unit basis.
Let me explain it with an example of one of my favorite apps. Evernote. When I first downloaded and started using Evernote, I was a free user. I didn’t pay a penny to Evernote. Over time however, I found that I liked the product and noticed that premium users got more features — features I wanted, and so I subscribed to a premium account. Though it happened only after many subtle non-intrusive nudges from the App.
Let me put on my VC cap, and look at the transaction. Evernote — even its free version — is a great product. Customers love it. It’s functional, simple, and efficient — and more importantly has no ads.
Evernote premium version can convert a good percentage of its users into paying customers. And as long as they can keep doing that, scaling up with allowing free users makes a lot of sense. The value of the company will grow as they scale up customers who in turn will convert at some point. On the other hand, if they cannot get revenue out of some of their customers — then scaling up will only erode the value of the company.
So, we have two things. How much are you paying to acquire a customer? And what’s the long term value of the customer? If a customer uses the coupon or a discount you give to attract him, and and never comes back then you should be worried when your business scales up. It’s not your business that’s scaling up — but your losses. Your venture capitalist’s losses.
That’s a reason why I pay a lot of attention to unit economics when startups pitch to me.
Understanding unit economics well in practical terms would mean — besides knowing the capital costs — having a clear idea of customer acquisition costs, which includes all the money that you have to spend on spreading the word, enticing your customers to use your products through free trials, discounts, coupons etc — and other marketing costs. It would also mean having a grip on the operational costs — how much you have to spend to keep the lights on. Ultimately, it’s about knowing which levers to pull, if you want to get closer to profitability.
These costs need to be weighed against the perceived value among the customers and the money they are willing to pay for that value. It’s about pricing — but it’s also about sustainability. Will the customer come back, how often will he come back, and how long. Are the assumptions we make about the pricing, frequency and duration realistic? How elastic is the pricing? Can a new entrant disrupt it? Are there ways to lock in the customers?
Most startups, pitch free and discounts, very few say my product can command a premium pricing.
While it would be unrealistic for a VC to expect a startup to make money immediately, credible answers to some of these questions when you are pitching your business will give you better chances at raising money.
So is Buffett right about “Never lose money”? Even in the world of startups, you do have to make money at the end of the day, or sell the company at the right inflection point — once you have proven the market need and your superior product. Exceptions apply, and like lawrence of Arabia-“Truly, for some men nothing is written unless THEY write it”, Occasionally, Amazon — Jeff Bezos, can defy Buffets rule.
My other favourite Buffet Quotes:
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price — I apply this to my startup investing as a VC
We believe that according the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.’ — I look for long term partners when i am co-investing
Diversification is protection against ignorance. It makes little sense if you know what you are doing — I invest in about 2–3 companies a year, invest in few, invest deep
Honesty is a very expensive gift. Don’t expect it from cheap people — While it is not always popular, I try to be honest in my feedback and cherish it being reciprocated
The most important investment you can make is in yourself — Meditate, exercise, eat healthy, sleep well, laugh, read, write, garden, love is how I take care of myself
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