If they come, I will be successful

by Felipe Arias

In one of our first classes, the issue of when to test the profit formula of a startup’s business model was raised. For me, this debate continued throughout many of our case discussions and guest visits. The issue came to a head when Fred Wilson encouraged startups to focus on the core user experience and adoption over monetization issues early in a lifecycle. With examples such as Facebook and Twitter, an entrepreneur looking for a category defining business could lean on investor backing and big valuations to scale more quickly and then find the right revenue model later. He did temper the recommendation by saying that category defining startups can be as rare as unicorns, and others may need to look for monetization earlier.

Still, I feel that too many startups are leaving the profit formula on the backburner and use “advertising revenue” as a plug on financial projections. As an example, Aardvark projected a $38.48 CPM in order to have a positive operating margin. In contrast, Trip Advisor with its strong conversion rates for expensive products generates CPMs in the mid-teens. Having super premium advertising rates while still providing a large amount of impressions is very difficult.

As a result, companies that lean solely on advertising, including successes such as Facebook, Yelp!, and Cheezburger, see revenue per engaged member from $1 to $3 annually. Getting to a 3:1 ratio of Lifetime Customer Value to Customer Acquisition Cost with those metrics seems very difficult as well. Moreover, as demonstrated in the Mochi Media case, the scale necessary to produce meaningful revenue (let alone profits) from advertising can be immense. Based on these assumptions, an untested profit formula that will rely on advertising revenue in the future seems unlikely to succeed.

Why, then, do very smart investors encourage very smart entrepreneurs to chase “unicorns” that will steal the imagination (and the time) of the user without taking any of their money? The answer, for me, is that success is based on valuations and not profits, at least for the time being. While I do believe that advertising dollars will continue to shift towards higher ROI medium, it has not yet been proven to me that simply having a lot of users and a lot of user data means that an online property has a high ROI on advertising. However, current valuations seem to take spent time as a strong link towards future profits. If there was a “bubble” in tech startups, valuing on users and time spent seems to be the issue for me.

As a result, I look for hope in another of Fred Wilson’s comments wherein he advised to look for a revenue model that makes more people want to use the product. He gave an example of Pinterest potentially providing ecommerce for items that are included in linked photos. Such value creating ecosystems are the perfect example of a business model that aligns the customer value proposition, profit formula, go-to-market plan, and technology and operations management. As I move forward from this class, my search for unicorns will center on finding this perfect alignment and not on finding the perfect user experience. I feel it is only a matter of time before valuations seek alignment over users as well.