How to Spend a Startup’s $ Wisely

What's up, everyone? Welcome back to another episode of Founders Journal. I'm Alex Lieberman, co-founder and executive chairman of Morning Brew. Today I am talking about how to spend your money wisely. Simply put, most startups and their founders don't spend their money well, often using it as a crutch for a suboptimal product or a misguided tool for growing their business too quickly and growing it the wrong way. I'm going to read 2 of the best essays on this topic and then provide my analysis. The first essay is by Elad Gil, who is a successful entrepreneur and arguably the greatest angel investor in the world. The second essay, which is called Default Alive or Default Dead, which you may have heard of, is by Paul Graham, the founder of Y Combinator. Let's hop into it. Okay, so before I start reading this, uh, just to give you the lay of the land, I'm going to start by reading Elad Gil's essay, which is titled Capital Efficient Businesses. And then I'm going to move to Paul Graham's essay for a few minutes after it's mentioned in the first essay. And then finally, I'll come back to Elad's essay to finish it off. And by the end of this episode, you should have a sense of what it looks like to spend thoughtfully on your business versus spending frivolously. So I'm going to take out the essays here, and we're going to start with Elad's. He starts by saying, for the last 5 decades, every wave of technology-driven companies has had amongst them highly capital-efficient businesses. The capital efficiency tends to reflect that A, people really want your product and will pay you for it, and B, the founders are cost conscious and frugal and do not overhire. So there's a few things here I want to pause for a second. First of all, I think it actually may shock some people when they hear me say this and hear me read what Elad is saying, that there are very successful, very large technology-driven companies that are highly capital efficient. Because I think generally people assume to have a very large technology business that ends up IPOing and being a Fortune Fortune 500 business. It required a ton of money, and by nature, it wasn't capital efficient for a long time until it finally got to a point of profitability. And while there are examples of businesses like that, you're gonna see in a minute that there are many businesses, household names, that were actually extremely capital efficient and actually were probably closer to what you would consider to be a bootstrap business than a heavily venture-backed business. And so it's just a really interesting notion that Elad brings up that I think kind of cuts the, the prevailing narrative of how people think about successful And then he goes on to say, indeed, Paul Graham from YC has developed the metric of, quote, default alive to reflect capital efficiency as a core sort of startup metric. So now I'm going to shift to Paul Graham's essay on default alive, since Elad is referring to it. Going to read a little bit there, and then we're going to come back to Elad's essay. Okay, so this essay by Paul Graham, which is titled Default Alive or Default Dead, it's It's one of the top 10 most famous startup essays of all time. It was written in October of 2015, but it's as valuable today as— actually, I would say it's the most valuable it's been in a very long time because of the economic environment and funding environment we're in. So it's potentially more valuable than October of 2015. So I'm going to read kind of what I deem to be the most important excerpts from this essay. He starts by saying, when I talk to a startup that's been operating for more than 8 or 9 months, the first thing I want to know is almost always the same. Assuming their expenses remain constant and their revenue growth is what it has been over the last several months, do they make it to profitability on the money they have left? Or to put it more dramatically, by default, do they live or die? And this is where the concept of default alive or default dead comes from. I want to make a few comments on this before moving on in the essay. What Paul Graham is basically saying here in a very simple way is, can you get your business to be profitable before you run out of cash? So if your business is not profitable today, will Will you be able to get to profitability before you run out of cash, assuming you can never raise another dollar of investors' capital? The other thing that I think is just interesting here is Paul Graham starts by saying, when I talk to a startup that's been operating for more than 8 or 9 months, and then he goes into the definition of default alive or dead. I'm actually very curious on why he picks this timeframe, because to me, you know, it takes startups a long time to get to product-market fit. Sometimes it takes them a number of years. But I actually think that this concept of default alive or dead is as valuable in kind of the pre-product market fit phases of your business before you know that there's a there there as it is in the post-product market fit phases. And so what I would say is, you know, Paul talks about focusing this default alive or dead metric on startups after they've been around for 8 or 9 months. But as I think about in the context of, uh, let's take one of my businesses, StoryArm, which is, you know, a personal branding service for modern executives. We've been around for only 6 months, but I think this is as valuable where we have to be able to ask ourselves if we never got a dollar from investors, would StoryArm Would it be profitable? And the answer is yes. Okay, so continuing on, PG then says the startling thing is how often the founders themselves don't know the answer to the question he just posed, which is would they be default alive or dead if their expenses stayed the same and revenue growth continues what it's been the last several months? Basically saying most founders don't know the answer to whether they're default alive or dead. And what's interesting about this is it feels like a lot of founders, especially those that raise money, especially early on, early on in pre-product market fit have a sort of abstracted relationship with business. It's not steeped in reality. It's steeped in this story that a lot of founders have that someone will keep bankrolling their business. And I think inadvertently, this essay is very much written for founders that just assume, like, the venture capital parade of unlimited money will continue forever. And we, we're in an environment literally right now where that is not the case. Okay, so moving down, PG then says, and he's basically directing this at the founders that don't have the answer to whether they're default alive or dead. He says, I propose the following solution. Instead of starting to ask too late whether you're default alive or default dead, start asking too early. It's hard to say precisely when the question switches polarity, but it's probably not that dangerous to start worrying too early that you're default dead, whereas it's very dangerous to start worrying too late. So I want to just pause there. And what's funny about this section to me is that the point that Paul Graham is making about founders that he's speaking to who don't know the answer to what their default, alive or dead, this to me is where there is the largest difference between bootstrap founders and venture-backed founders. And when I call founders bootstrap founders or venture-backed founders, of course, literally that can mean founders who raise money from venture capitalists and founders that are bootstrapped that literally never raised a dollar, and they use cash flows of the business to continue hiring people and investing in the business. But I also think of it a little bit in a more amorphous way of like a mentality of bootstrapping where you feel like you're always counting your dollar, you're always stretching your dollar, you're extremely frugal versus this mentality of spending a lot, uh, thinking from a place of there's always going to be capital abundance. And by the way, there's trade-offs to both of these ways of thinking. But anyway, my view on this, and this is kind of how I've always been in building Morning Brew, building StoryArc, never raising venture capital. My view is that bootstrap founders must think about being default alive from day one. Like from day one in building Morning Brew, we were thinking about how are we going to stretch every dollar we have to be self-sustaining as a business. For StoryArc, we never raised a dollar. We used our first client who paid us $7,000 upfront. 2, we took the net income of that client to hire our first employee, and we just know that if we never get an investor dollar for StoryYard, which we never plan to raise an investor dollar, we will be profitable and we will be able to use the cash flows of the business to continue to iterate on the business as well as ultimately distribute to shareholders. Now, what I will say is there is a downside to the bootstrap founder mentality, and I've experienced this firsthand. As a bootstrap founder, you're used to being extremely frugal, trying to hoard your capital, um, and being relatively risk-averse in taking big bets. And so the struggle here for a bootstrap founder, which I'll read a section from Elad Gil's essay in a minute which alludes to this, is once you have a business that's working, once you have product market fit, once you have a foundation and it is time to get really ambitious and pour fuel on the fire, it is a very unnatural motion for a bootstrap founder to do that. And so I remember there are points in Morning Brew's history where Austin and I You know, say it was the year where Morning Brew did, say, let's say $13 million in revenue and we had $3 million in profit or $20 million in revenue and we had $7 or $8 million in profit. And let's say we had $10 million in the bank account. Austin and I, our first— our default reaction was like, yeah, just keep it in the bank account. Let's have this slush fund for when there's, you know, some economic event in the future. And it was very hard for us to say, hey, you know what, maybe like the right buffer to have is $2 or $3 million, but let's figure out $5 or $6 million. How do we use that cash to accelerate Morning Brew's growth and get us closer to the point of being the brand that we want to be? Now, on the flip side, venture-backed founders are forced to think about things like growth and product-market fit above all else, because that is how they're going to raise their next round after they raise a pre-seed or seed. The way you get to a Series A is by hitting certain growth metrics. And so The idea of profitability and how judicious are you with your capital becomes a second priority. And that's largely because of the incentive system that is created in the venture capital landscape. Now, that's the negative trade-off. The positive trade-off is I think actually venture-backed founders can be more comfortable with taking risks earlier, um, and they can be more comfortable with capital allocation earlier than bootstrap founders are. But there are also great examples of venture-backed founders who also spend very frivolously. So it's a double-edged sword. Okay. I want to just read a few more passages from the PG essay, and then we're going to move back to Elad Gil. PG then goes on to say, there is another reason founders don't ask themselves whether they're default alive or default dead. They assume it will be easy to raise more money, but that assumption is often false. And worse still, the more you depend on it, it referring to capital, The falser it becomes, and this is such a poignant point, especially for founders who raised capital during 2020, where so much cash was inserted into the financial system when rates were still at zero. And now we're in an environment where rates are higher, where there's a ton of dry powder, where venture capitalists are not deploying capital nearly as easily, and the founders that. PG is referring to here are falling into a big trap. And I'm going to describe exactly what that trap is because PG puts it perfectly. He says, here's a common way that startups die. They make something moderately appealing and have decent initial growth. They raise their first round fairly easy because the founders seem smart and the idea sounds plausible. But be— but because the product is only moderately appealing, growth is okay, but not great. The founders convince themselves that hiring a bunch of people is the way to boost growth. Their investors agree, but because the product is only moderately appealing, the growth never comes. Now they're rapidly running out of runway. They hope further investment will save them, but because they have high expenses and slow growth, they are now unappealing to investors. They're unable to raise more, and the company dies. Now he goes on to say what the company should have done is address the fundamental problem that the product is only moderately appealing. Hiring people is rarely the easy way to fix that. More often than not, it makes it harder. At this early stage, the product needs to evolve more than to be built out, and that's usually easier with fewer people. And so I think, you know, PG just nails it here, basically saying that founders use money as this incredible Band-Aid on a gunshot wound. The gunshot wound being that the product isn't great. It's not solving a really painful problem, or it's not solving it in a great way. And what that leads to is ultimately like kicking the can down the road of the ultimate problem, which is the product isn't good enough. So this said in a different way is your product has to solve a problem exceptionally, and no amount of money is ever going to get you out of that issue. And that's why being default alive is such an important thing, because if you are profitable, you can continue to invest and experiment with your product until you get to a place where there's true product market fit and people love what you're doing. So I just want to read a few quick notes from the end of the PGSA. Then, then I'm going to fill, uh, finish up with what Elad Gil is saying, and then we're going to close out. So 3 interesting notes from like the footnote section of the PGSA. The first is he says startups that don't raise money are saved from hiring too fast because they can't afford to. But that doesn't mean you should avoid raising money in order to avoid this problem any more than that. Total abstinence is the only way to avoid becoming an alcoholic. Basically, he's just saying that just because you avoid the hiring too fast problem by not raising money doesn't mean you shouldn't raise money. There are good reasons to raise money if you're thoughtful about it. The second footnote is I would not be surprised if VCs' tendency to push founders to overhire is not even in their own interest. They don't know how many of the companies that get killed by overspending might have done well if they'd survived. My guess is a significant number. What he's basically saying here is that venture capitalists have an incentive to push founders to spend a lot of money because venture capital is very much a power law game, or it's a game of you want a business to absolutely crush it, and if it doesn't crush it, then you don't care if the business dies, right? Like it's binary to you. What he's basically saying is there are probably a lot of cases where if the venture capitalists didn't have that incentive, uh, system to have a startup either crush it or die, maybe the startup would have spent less. Been a default alive, uh, used that money to make, uh, changes to the product, found a product that actually worked, and then had a good reason to raise a lot of money because now there was a foundation to build on top of. And then the final footnote in this essay is he is— PG says after reading a draft, Sam Altman wrote, I think you should make the hiring point more strongly. I think it's roughly correct to say that YC's most successful companies have never been the fastest to hire. And one of the marks of a great founder is being able to resist this urge. Said differently, fast hiring is often a bad idea, especially in the early days of the business. It— and it becomes something that covers up larger problems like product issues. And also when you end up having a ton of people on your team and you discover those product issues later on, it makes unraveling all these problems significantly harder. Now, just to go back to the Elad Gil essay, I want to read a few more passages. He says capital efficiency has existed in roughly every technology wave. Many of the largest, more important companies in the world started off highly capital efficient. Indeed, capital efficiency tends to reflect an especially strong business model. Examples include— and he goes into 6 or 7 different companies. I'm going to read a few. Microsoft was bootstrapped in the 1970s and did not raise any venture capital until a round right prior to their IPO. Dell was bootstrapped off of cash flow in the 1980s until a similar pre-IPO round. Google raised a single round of traditional venture capital before doing a pre-IPO round with Yahoo and others. He talks about Instagram as well, Midjourney, Yahoo, and eBay. And what's funny about all of this is these are all businesses that were built in the '80s, '90s, and early 2000s. In theory, it actually should be easier today with AWS instead of servers that are on-premise. With AI, it should be easier to be capital efficient as a technology business today than it was in the '70s, '80s, '90s, and 2000s when you also had examples of really capital efficient businesses. And then the final thing I just want to read is basically how Elad Gil defines a capital-efficient business. He says, in general, there tend to be 2 drivers of capital efficiency. One, customers will pay a lot for the product. The capital side of capital efficiency is often a proxy for both product-market fit and an intense customer need. Customers are willing to pay up for a product that is important to them, and there is insufficient competition in the market to commoditize pricing or destroy the category. Pricing is often a proxy for value and differentiation of a product. Same thing said a different way that we've been talking about, which is money is one of the greatest distractions from actually talking to your customers and building a product that is truly worth actually putting money into. And then finally, the second thing that Elad Gil says is a driver of capital efficiency is, quote, the company is run efficiently. During COVID roughly all tech startups lost their way on spending. Capital was flowing freely, and teams often rapidly and dramatically overhired, boosted expenses on things non-crucial for the business, and spent wastefully. The most capital-efficient businesses tend to be frugal and have a low-cost approach to the world. Salaries are lower to help make equity more valuable. The founders and employees of these businesses treat the dollars spent by the business as their own money. They realize that profitability gives them infinite runway and enormous freedom on decision-making and future path optionality. The one thing I just want to say here is this idea of the founders and employees of these businesses treating the dollars spent by the business as their own money has to be baked into your culture and the behaviors of the business. You cannot just expect this will happen. And if you listen to my episode on Jeff Bezos's first Amazon shareholder letter, you'll see how much he talks about the importance of frugality. Because as a customer-obsessed business, the only thing that matters is not making a cushy lifestyle for employees. It's about employees working their asses off to make the best possible product for customers. So at the end of the day, All this said simply is money oftentimes, if spent frivolously, can be a disguise or a bandaid for way larger issues. Those issues being a product that is not nearly good enough to generate significant profits. So you're default alive and a product that is not good enough to deserve, ironically, having money to pour fuel on the fire. And those are thoughts. And I guess my analysis on how to spend wisely from 2 of the greatest startup investors in the world, Elad Gil and Paul Graham. With that, I hope you enjoyed this teardown and analysis of obviously 2 incredible essays on spending your money wisely. And I would love to know if you'd like more episodes like this where I take famous business writings, I summarize them, and I share the most important lessons for entrepreneurs. Shoot me an email to alex@morningbrew.com and let me know what you think. As always, thank you so much for listening to Founders Journal, and I'll catch you next episode.