BackWhat’s the mortality rate for unicorns?
The core issue is that many of these start-ups aren't profitableevery sale they make costs them a bit of their backers' money
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This is not a trick question. Nor is it a query submitted to a fantasy writer’s listserv. It’s a serious issue that is occupying Silicon Valley investors. Privately held tech start-ups worth more than $1 billion are known in the trade as “unicorns". There are a lot of them around these days—so many that people are starting to ask whether this isn’t something of a bubble.
The core issue is that many of these unicorns aren’t profitable. They are huge and they have lots of customers. They are the subject of both glowing write-ups and angry screeds about the “gig economy". But every sale they make costs them a bit of their backers’ money.
Of course, that strategy did work for at least one company: Amazon, which is still just barely bothering to turn a profit as it heads into its third decade. At this point, it’s hard to imagine anyone putting together an operation that could compete with Amazon, because the investment would be colossal.
Unicorns obviously hope to pull off a similar trick: acquire the customers now, and later, having secured a nice cosy monopoly, raise prices to monetize them. There are reasons to be sceptical of this approach, however. A lot of companies tried the Amazon strategy during the dot-com era; exactly one company managed to leverage it into tech-giant status. Many spent a lot of venture capital cash delivering stuff below cost, then abruptly went out of business when money ran out.
Let’s think about the easiest ways to protect an acquired monopoly, or oligopoly:
Barriers to entry. It costs a lot to enter the market (think auto manufacturers) or you have some sort of government-granted protection from competition.
Switching costs. How expensive is it for me to switch to your competitor? For restaurants, the answer is “zero". The only cost is the risk of a less-than-tasty meal. On the other hand, if I want to switch cell phone providers, I need to pay AT&T a lot of money to break my contract. The higher the switching costs, the more likely customers are to stay put.
Network effects. It wouldn’t cost me much money to switch from Facebook to another social media site. But Facebook is where all my friends are. That means that the network with more users will tend to keep them.
Economies of scale. When industries are characterized by large economies of scale, it’s hard for upstarts to compete, because they can’t make the product as cheaply as the incumbents.
None of these strategies makes you invulnerable forever, but if you are going to spend huge sums on customer acquisition in the hopes that you will be able to make money off of those customers later, you will want at least one of these factors on your side. For instance, network effects are most powerful when switching costs are high.
Companies have made this work. Google’s dominance was largely driven by network effects. But Google isn’t trying to get its customers to pay for its services. Instead, the company got the users, and then sold their eyeballs to advertisers. It also invested in creating economies of scale in ad delivery.
Many of the new round of upstarts, on the other hand, are providing services, like transportation, that have a high marginal cost. That means they won’t be able to realize Google-like economies of scale. At the same time, the switching costs of trying a new service are pretty low. At some point, they are going to have to raise prices—and only then will we find out if people are willing to pay enough for it to make the company profitable.
They may be able to sustain large demand at higher prices and revolutionize our lives. Or they may settle into a profitable but not transformational niche with somewhat less usage but better margins. Or many of them may slither out of existence, taking their massive investments with them. Because it’s only in myth that unicorns are immortal. Bloomberg
Megan McArdle is a Bloomberg View columnist.
Comments are welcome at theirviews@livemint.com
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