The Startup Laws of Physics
From Eric Paley @epaley:
Two Laws Of Startup Physics
Section titled “Two Laws Of Startup Physics”Fifteen years into my venture capital career, I’ve come to believe there are two undeniable laws of startup physics: Capital compounds both positive and negative formulas. All positive formulas compound at diminishing rates of return. 1/55
- Capital compounds positive and negative formulas We are fond of saying, “Capital has no insights.” It doesn’t have the answers to your problems and can actually only fund two things for a startup: 2/55
A) Experimentation - which rarely is expensive. B) Scale - which compounds whatever is already happening at the startup, whether compounding toward greater intrinsic value or compounding the startup’s value to zero. 3/55
Capital can scale intrinsic value rapidly if you have an engine that allows it to turn 5 of value. If it has an engine that turns 1 (or even 0.99), capital will ultimately compound the negative value formula to zero. 4/55
- All positive systems compound at diminishing rates of return Sooner or later, the return on each dollar invested will shift to negative. If you’re unaware of the point at which compounding goes into the red, you start compounding negative value. 5/55
Paradoxically, the desire for growth often prematurely drives startups into negative compounding, ultimately leading to failure. In my experience, startups that internalize these rules have done incredibly well. 6/55
Failure to respect the rules of startup physics - capital compounds good and bad, and all positive compounding eventually diminishes - has been the cause of just about every startup failure I’ve seen that can’t, simplistically, be written off as “no one wanted the product.” 7/55
The positive compounding formula Experiment with small amounts of capital until a formula is found that generates a surplus of intrinsic value on each dollar invested. Then, and only then, should you deploy capital in an attempt to scale that specific formula. 8/55
While this may sound obvious, most startups, out of ambition, attempt to skip directly to the scale phase without fully developing a formula that consistently produces positive value. 9/55
Startups that don’t have a working economic engine may be able to raise round after round of capital, even at massive valuations, but will almost always compound to zero over time. It’s nearly impossible to fix a negative formula startup with an abundance of capital. 10/55
Defining intrinsic Value While the easiest way to evaluate a positive value formula is directly financial (we invest 3 back), often intrinsic value is created and isn’t clearly financial at the start. 11/55
This type of intrinsic value presents real complexity because it is difficult to quantify and can be easily rationalized as positive value, even if the compounding of it is actually negative. 12/55
Certainly, many companies create intrinsic value ahead of measurable economics. Still, it can be dangerous to believe you can spend millions with no source of true validation – and venture capital is a poor source of validation. 13/55
For example, having a vast proprietary data set may have value, but not nearly as much as hoped. Likewise, building a massive IP portfolio may be valuable, but not when compared to the $100M invested to create it. 14/55
The signals a startup needs to validate its thesis will vary and are not solely financial, but the key point is that founders should seek out validation in the most inexpensive form possible. 15/55
Some of these experiments will focus on the product, others on the market, but overall, startups should test their assumptions against an unforgiving reality. Without finding a way to test reality, scaling is perilous. 16/55
Although a founder’s confidence in an idea may initially be intuitive, they should balance it with proof of high confidence in ROI for the stakeholders’ sake. 17/55
How diminishing rates of return work in practice When startups attempt to grow, they invest in levers they hope will sustain their positive value formula. These levers inevitably perform at a diminishing rate. New value drivers must be found through experimentation. 18/55
Here are some examples I’ve witnessed many times over of how well-intended scale-up starts to diminish in performance: 19/55
🔔 Adding marginal new features Each feature’s value is usually less than the previous ones, but each addition creates more complexity in engineering overhead, marketing, and customer service. 20/55
👻 Pursuing low-performance customers Customers that fall outside your ICP (Ideal Customer Profile) will be slower to convert, more sensitive about pricing, and churn at higher rates. Thus, they will have lower returns than your core ICP customers. 21/55
💸 “Investing” in marketing High-performance channels saturate rapidly, forcing spend with more expensive and less well-optimized alternatives. The low-hanging marketing fruit is quickly exhausted, but the relentless desire for growth drives toward negative value spend. 22/55
📈 “Scaling up” sales Newer sales hires will typically perform less well because they have little experience with the company and product, stretch the marketing-generated leads, get less focused training, etc. 23/55
Also, when startups scale sales quickly, they are rarely as disciplined about hiring. Therefore, the average sales rep tends to diminish in performance as the company scales. 24/55
🕳️ Customer success missteps Customer service will be less efficient as the product scope and customer profile expands. The same challenge in scaling sales talent is true here - lower performers are more accepted the faster the company is growing. 25/55
🗓️ Putting faith in the mythical person month At a certain point, executives will get into empire-building mode and attempt to add people to accelerate a particular initiative. This extra headcount consumes resources and results in less productivity. 26/55
🌪️ Exec focus Leadership focus is a finite resource that will be spread thinly through expansion. Every system you expand will perform less well, and lower-performing employees will need more assistance. In short, scale dilutes the C-Suite’s attention from key priorities. 27/55
Startups need to invest in all these areas to grow, but how founders make that investment can be the difference between success and failure. 28/55
Why are these rules so hard to follow? 🚆 Capital creates inertia The faster you spend capital, the harder it is to stop. As startups scale, stopping a dollar of spending is harder than deciding to spend it in the first place. 29/55
🏁 Capital demands acceleration Admitting mistakes is hard. It is painful to go from doubling your sales force in one year to stopping it or even cutting it the next. It’s easier to hope that problems will resolve themselves with time – but they usually don’t. 30/55
🙈 It’s easy to rationalize diminishing returns Founders launch companies because they believe in their vision. VCs invest because they want extraordinary results. Diminishing returns are easy to ignore and truth becomes harder and harder to engage. 31/55