Posted by: Will | October 7, 2008

How Startups Can Innovate in a Struggling Economy

Startups, especially web startups, will see one of three fates in this economy:

  1. Bankruptcy due to resource starvation.
  2. Stagnant growth due to a drop in consumer activity or spending.
  3. Financial success when the economy rebounds due to business model innovation.

Bankruptcy due to Resource Starvation

Both large and small companies are susceptible to the risks of habituation. Employees get used to free lunch, analysts get used to unlimited access to market research, and road warriors get used to travel perks. In this economic downturn, companies tighten their belts. Large companies may be able to “trim the fat” more easily than small companies simply because there is likely more excess at a large company. Yet both large and small companies can expect to see lower productivity when cuts are made.

Diagram - Resource Starvation Cycle

Diagram - Resource Starvation Cycle

A drop in productivity after layoffs or resource reduction is a natural consequence. Employees become afraid and lose focus. My former professor Jack Welch wrote about the importance of not cutting service when trimming the fat, but it is hard to avoid.

Lower productivity will result in more hardship which may require further cuts, and the resource starvation cycle continues until the company reaches bankruptcy. [Note: I learned this type of modeling in MIT’s System Dynamics]

At a web startup, this risk is highest for business models based on user acquisition, or “eyeballs.” Unless the startup has recently raised a large venture financing round, its inability to immediately monetize its traffic will be a challenge of the greatest magnitude.

Many startups have followed the path of eyeball acquisition because of role models like YouTube, which was acquired by Google for $1.65 billion in October 2006. But let’s remember that YouTube was burning about $1 million per month with no revenue generation six months before acquisition. In this economic climate, that burn rate would be unsustainable.

Consider a hypothetical early stage social site today that has experienced major growth. It won’t be willing to cut its resources used to serve up videos, photos, and chats, but supporting this usage requires capital that will not come in time from site advertising CPMs. If this startup can’t raise money or get acquired, it will fail.

Stagnant Growth Due to Lower Consumer Activity

Web startups that started to monetize traffic when they reached “critical mass” are in a better position to ride out the economic crisis than those that are still on a trajectory of trying to gather eyeballs.

American consumer spending is expected to drop as fear sets in from the sliding stock market. Therefore, even companies that have revenue-generating business models will suffer over the near-term.

Many of these companies can take measures to survive by ratcheting down their marketing spend and expansion strategies. We might expect to see lower spend on Google AdWords as web startups slow down their customer acquisition engines to respond to the decline in user activity.

Threadless is a great example of a company that will have little trouble riding out this crisis, even though we can expect their revenues to drop. Their business model is brilliant: they source t-shirt designs from their loyal user community of designers and t-shirt aficionados, ask the community to vote on their favorites (thereby expressing demand), and then outsource the production of the t-shirts for orders placed.

Inc.com published a feature on Threadless which praised their innovative crowdsourcing approach and estimated their 2007 revenues to be $30 million, with about 50 employees. Threadless’ revenues and costs are each pegged to user activity, but margins are relatively constant. If user activity decreases, the company won’t see major losses. When users are willing to spend again, this company will fluidly bounce back.

Financial Success by Innovating Now

“Amid the turmoil and tumult of battle, there may
be seeming disorder and yet no real disorder at all;
amid confusion and chaos, your array may be without head
or tail, yet it will be proof against defeat.” — Sun Tsu’s Art of War

The companies that are able to innovate in hardship will be the most successful.

The Wall Street Journal recently discussed how Southwest “surged ahead during the 2001 recession … with a clear cost advantage.” Southwest developed a competitive advantage by leveraging its human resources. Agents who scanned tickets at the gate would then act as flight attendants; pilots would help gate-check luggage. In contrast to organizations where roles and responsibilities were strongly segmented, at Southwest all employees had one goal: get people on the plane and get the plane in the air. This reduced delays and inconvenience, which in turn resulted in lower costs. [Note: Southwest also paid its employees less than industry standard and hedged against rising fuel prices to keep its costs low]

My favorite example from the technology world is Google. Although Google was not facing an economic crisis, it was trying to conquer the world of search and battle incumbents Excite and AltaVista with very limited resources. In fact, Sergey Brin and Larry Page had no money to support their very ambitious task of continuously crawling the web so they “begged and borrowed Google into existence.” Their original hardware would make Frankenstein blush.

By the time Google was funded (to the tune of $25 million), they had proven their concept in scale using commodity computer hardware. If Google had been funded earlier, arguably they might have walked over to Sun and bought expensive workstations. Google’s initial innovation was in building a highly parallelizable crawler that was comparatively lower cost than its incumbents. From a technical paper about Google’s architecture:

Our ultimate selection criterion is cost per query, expressed as the sum of capital expense (with depreciation) and operating costs (hosting, system administration, and repairs) divided by performance.

The example $278,000 rack contains 176 2-GHz Xeon CPUs, 176 Gbytes of RAM, and 7 Tbytes of disk space. In comparison, a typical x86-based server contains eight 2-GHz Xeon CPUs, 64 Gbytes of RAM, and 8 Tbytes of disk space; it costs about $758,000.

In other words, the multiprocessor server is about three times more expensive but has 22 times fewer CPUs, three times less RAM, and slightly more disk space.

When it came time to scale, Google could scale without prohibitive costs. [Note: Later Google innovated by monetizing its search traffic with advertising which sustained its massive growth]

Conclusion

This economic crisis hurts all businesses, but startups are uniquely positioned to weather the storm through innovation. Those that do will find themselves with a sustainable competitive advantage in the next bull market phase of our economic cycle.


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