The Rise And Fall Of Blitzscaling!

The race to a $1bn market cap for startup companies has been getting faster and faster over time. It took the average S&P 500 company 20 years to reach a billion-dollar valuation. It took Google eight years, Facebook six years and Uber just three years to surpass this level.

It would appear that there are two basic approaches to growing a company. The first more old fashioned approach is to come up with a good way of making money and then, try to do more of it. The second – more innovative - approach is to find something that loses money, scale it up as much as possible and then eventually try to find a way of making it profitable – I’m not sure if that last step is always necessary though.

If you can grow the business quickly enough, your company might become really valuable long before you ever flip to profitability. The first model is of course boring, and the second model has become the dominant Silicon Valley business model over the last twenty years or so, in fact it was given the name “blitzscaling,” by Reid Hoffman – the founder of LinkedIn. The blitzscaling approach is not applied to every type of business, but mainly to network-effects businesses where you aim to become the dominant player in your industry and then pivot to profitability.

A network effect business is one where the value of the product or service increases when the number of people who use that product or service increases. The big idea is that user acquisition costs should decline as you achieve scale and network effects, and then once you are the dominant player in your sector you can start pushing up prices, and the unprofitable fast-growing subsidized service becomes profitable. One way to think about blitzscaling is as a cold-blooded rational economic calculation: The financial benefits of entrenching your business into everyone’s digital lives are so significant that spending even billions of dollars to get there can maybe be worthwhile.

Especially in an environment where interest rates are very low, and you can raise capital at minimal cost, you can spend an awful lot of money growing a business and even if it takes a really long time to eventually flip to profitability - because of low interest rates, those distant, and hopefully huge profits are worth almost the same (arriving far out in the future) as they would be if they were arriving tomorrow, as you are discounting these future profits at a zero – or close to zero interest rate. If you walk around most urban centers today, most of the firms that you see advertised on the side of buses fit into this category. Deliveroo, Getir, Gopuff are good examples.

These are not necessarily businesses that you would want to own outright, as they are cash flow negative, and there is not a really obvious path to profitability, but their valuations have grown rather quickly. So if you were an investor, you might be up on the trade. We have similarly seen companies dump rental bicycles or electric scooters on the streets of big cities, with the idea of dominating that form of transportation.

Once again, I’m not sure that you would want to do this with your own money, but venture capital firms seem happy to do so. The way Reid Hoffmann explained the term Blitzscaling to The Harvard Business Review is that he took the name from the World War Two German military tactic Blitzkreig. He explains that before blitzkrieg emerged as a military tactic, armies didn’t advance beyond their supply lines, which limited their speed.

The theory of the blitzkrieg was that if you carried only what you absolutely needed, you could move very, very fast, surprise your enemies, and win. Once you got halfway to your destination, you then had to decide whether to turn back or keep going. Once you made the decision to move forward, you were all in.

You either won big or lost big. Blitzscaling adopts the same perspective. If a start-up determines that it needs to move very fast, it can take on far more risk than a company going through the normal process of scaling up.

This kind of speed might be necessary for both offensive and defensive reasons according to Hoffmann. From an offensive perspective, your business may require a certain scale to be valuable. LinkedIn is a good example; it would never be valuable unless millions of people joined the network.

Marketplaces like eBay equally must have both buyers and sellers to operate at scale. Payment businesses like PayPal and e-commerce businesses like Amazon have low margins, so they need to transact very high volumes. From a defensive perspective, Hoffmann argues that your business may need to scale faster than your competitors because the first to reach customers may own them, and the advantages of scale may lead to a winner-takes-most position.

Additionally, Hoffmann argues that in a global environment, you may not necessarily be aware of who your competition really is, as they can appear to materialize out of nowhere very quickly. Now before we discuss the venture capital approach, let me quickly tell you about today’s video sponsor Morning Brew. As most of you know, I’m a big consumer of financial news, and morning brew is an amazing way to get up to speed on what is going on first thing every morning.

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OK, so the Softbank Vision fund is a venture capital fund, founded in 2017, and they are maybe one of the funds we think most of when we think of blitzscaling. With over $100 billion dollars in capital, the vision fund is the world's largest tech focused investment fund. The popular stereotype of what they do is that if there are a handful of startups competing in a new sector.

SoftBank can step in and fund one of them with a huge amount of capital. Having this cash available to spend on customer acquisition gives that company an immediate and insurmountable competitive advantage. It can expand domestically and internationally at great speed, achieve brand name recognition overnight, while its competitors grow slowly or even stagnate, unable to compete in an environment where one well-funded competitor can sustain huge losses in order to grow.

The chosen company can out-compete everyone else by spending hugely on marketing and cutting prices to win customers. With unlimited money to spend they can eliminate the competition altogether and dominate the category. The rapid growth will come at the expense of huge near-term losses, but SoftBank won’t care, as they are playing the long game, and if they own the dominant player in a big global category surely, they can eventually find a way to make it profitable.

You can see how this approach might work, Airbnb being a good example. They were not the first company to come up with the online short-term letting business model. VRBO and a number of other competitors were there before, but Airbnb was able to spend a lot more on growing the business, they kept fees low and sent out professional photographers to photograph every apartment that was listed for example and quickly came to dominate their category.

When Airbnb filed for an IPO in 2020 they warned investors that they might never become profitable. On the day the company went public it hit a valuation of over 100 billion dollars. Another example is UBER, whose move fast and break things approach meant that they could set up in a new city, skirt regulations, and then once the service had become popular, regulators would struggle to shut them down.

Customers were given a $5 ride credit for getting their friends to sign up, allowing Uber to achieve scale at great speed. Had they taken a more cautious approach, consulting with city officials applying for licensing and trying to grow organically, they might not have grown at all? Other taxi hailing apps existed before Uber, but Uber grew quickly, had a good app and dominated the space almost overnight.

Now, in theory, Uber should be a cheap business to run. It doesn’t own vehicles or directly employ drivers, it’s just a platform – a broker arranging deals between buyers and sellers for a fee. For more than a decade, investors accepted billions of dollars of losses, but now, Uber is aiming to balance the books.

Since the start of the pandemic it shed its experimental driverless car and vertical lift-off aircraft units, offloaded bikes and scooters and reduced headcount by around 25 per cent. While the company is valued at $47 billion, it still loses money. Unfortunately for Uber, competition has proved to be relentless.

They are locked in a fight with a variety of competitors globally, both for ride sharing and food delivery. Prices it would seem are a delicate balancing act. Too high and passengers move on, too low and drivers will find other work.

On top of this, Uber has to strike the right balance with the share of fees it takes from its drivers. Whatsapp is another company who spent a lot of money to acquire customers and then sold to facebook. It’s not obvious what the path to profitability is for an app like that.

Users don’t want to give up their privacy and are mostly refusing to accept facebook's updated terms. Silicon Valley wrote the playbook for spending money in pursuit of growth, and the tech industry remains a hotbed of fast-growing yet unprofitable companies. But the smell of burning cash has spread well beyond Silicon Valley over the years.

Spotify, the popular music streaming service based in Sweden, continues to lose money. There are all sorts of delivery and shopping services, meal kit companies, electric scooter rental companies, short term office rental companies worldwide, the list goes on and on… The king of the Blitzscalers is of course, Amazon, which was founded in 1994 and grew hugely over the years, building out their e-commerce infrastructure and jump-starting side efforts like Amazon Web Services and Amazon Prime Video. They turned their first annual profit in 2003 nine years after being founded.

Today Amazon is the fifth most valuable company in the world. While they lost 3. 8 billion dollars in the last quarter, they did make $33 billion in net income last year alone.

Moviepass is possibly the other side of the coin from Amazon. It was a subscription-based movie ticketing service founded in 2011 which went bankrupt in early 2020 – right before the pandemic. MoviePass members could pay $9.

95 for a monthly subscription that allowed them to watch as many movies as they wanted to in movie theaters per month. Since the average cost of a movie ticket in the United States was around $9, going to just two movies per month resulted in a good deal for the customer, and a loss for the company. The one time that their business model might have worked, was during the pandemic, when the movie theatres were closed.

They had that special sort of blitzscaling business where the more customers they had, and the more they used the service, the greater the losses would be. It was a tough business. .

. Moviepass had a creative approach to setting venture capital money aflame to subsidize the movie-going habits of its 3 million customers. The company claimed that it could eventually make money by striking revenue-sharing deals with theater chains, or by charging movie studios to advertise inside its app.

They ended up going bankrupt first. There’s a big difference between blitzscaling a software-based business and a business that requires a lot of physical assets and employees. If you have a working piece of computer software, you can make infinite copies with very limited cost and effort.

The software won’t necessarily sell on its own, but if you compare it to traditional manufacturing, it’s an entirely different business. Blitzscaling might make sense in this case. Companies like WeWork, which was claimed to be a tech company and was allegedly worth 47 billion dollars in 2019, had very different economics, which involved taking long term leases on office buildings, redecorating them, and renting them out on short term leases.

To this day, I’m not really sure what is supposed to be innovative about WeWork. Over the years we have seen that not many companies have been able to repeat Amazon’s success. Just look at the dozens of “Uber for X” start-ups that raised billions of dollars to disrupt industries like laundry, parking and grocery delivery by offering cut-rate promotional deals, only to run out of capital before customers latched on.

The good thing for customers of these businesses is that their lifestyles are being supported by Venture Capital giveaways. But how long can that last for? There is a social cost to the blitzscaling business model, as it can destroy competing businesses and be punishing for workers.

In 2014, New York City Taxi Medallions (the physical certificate required to operate a yellow cab) were worth over a million dollars, today they are worth less than $100,000 due to competition from Uber. Mom and pop bookstores have almost entirely disappeared since the emergence of Amazon. There are all sorts of amusing stories in the world of blitzscaling, like that softbank funded three different ride hailing companies, Uber, Didi and Rappi, who found themselves blowing through softbanks money competing with each other in Latin America, each firm spending softbanks money to undercut the next.

Maybe Softbank should have picked just one of these companies to fund and tried to make it the dominant power globally. Uber is possibly the company most associated with blitzscaling today, and it would seem that they are trying to switch to the first model of doing business. The boring one of coming up with a good way of making money and then trying to do more of it.

Last month Uber’s CEO sent out an email to employees telling them that they are going to try to make money going forward. He said, “We have to make sure our unit economics work before we go big. ” He says that Uber will now focus on achieving profitability on a free cash flow basis rather than adjusted earnings before interest, taxes, depreciation, and amortization.

He says that “It’s clear that the market is experiencing a seismic shift, and we need to react accordingly. ” There is nothing actually surprising about a CEO telling employees that they should try to make money and that if they are doing things that lose money, they should do less of them rather than more. But this is the CEO of Uber after all.

I should note that an economy mostly made up of unprofitable companies does have its risks. These blitzscaling companies can destroy the businesses of competing firms who aim to run at a profit, which distorts economic growth in favor of well-funded unprofitable firms that are seeking monopoly power. Customers of these companies, can do well while collecting freebies – but might later find themselves facing sudden price hikes, disappearing benefits, and meaningless warranties.

For those willing to do their research, this might be a golden age of good consumer deals, where you can reap the benefits of artificially cheap goods and services while investors soak up the losses. The current crop of money-losing companies may not be around forever, but as long as someone is willing to keep funding blitzscaling, there’s little reason for consumers to stop enjoying the fruits of investor optimism. One question we could ask is whether blitzscaling is countercyclical?

When the economy is booming, there might be all sorts of consumer giveaways, but as soon as the economy slows, these firms are pushed to break even or become profitable, meaning that they push up prices exactly at the point where their customer base are struggling to make ends meet. We might see inflation just because companies become less willing to lose money to grow. Once this business model has made it through a full economic cycle, we will see if it generally made money, or if blitzscaled business models look as ridiculous as many of the business models from the dot com bubble twenty three years ago?

Right now it looks like overall more money will be spent on growth than is reaped by the blitzscaling winners. A lot of the leading lights of Silicon Valley are big proponents of universal basic income, where a regular fixed payment is given to everyone in society in order to create a minimum income floor. Universal Basic income might actually be the logical conclusion of blitzscaling.

Afterall, everyone would sign up quickly for the free money being handed out, so growth would be phenomenal, there wouldn’t be all of the fussiness of e scooters, meal kits or movie tickets to deal with. And then, once other competitors stopped handing out money, the winner could focus on working out how to make the deal profitable… If you found this interesting, you should watch my video on the dot com bubble next. Don’t forget to sign up for morning brew using the link in the description below it's totally free so there's no reason not to try it out.

See you again soon, bye.