Why Scaling Up is Like A $50 Cup of CoffeeBy Jorge Combe | Fri, 01/15/2021 - 09:20
Does anyone else realize that a Starbucks coffee can cost up to US$50? That is probably why I don’t have a credit card. I am paranoid about expenses, both in our firm and personally: I even try to avoid the toll roads, which is a tough discussion with my family to explain the benefits of saving US$3 and how much it can generate through reinvestment.
Our human nature is wired with the software of i) hyperbolic discounting for consumption, and ii) a poor understanding of the power of exponential functions and compounding for investments.
Let me explain. While most would prefer US$9 today versus US$10 in a week (implied IRR of 24,000 percent – and this would be the hyperbolic discounting), very few would calculate and consider how much a reinvestment of US$100,000 at 20 percent for 30 years would get your net worth to US$23 million. Doing the same for 50 years would make you a billionaire (exponential growth and compounding).
Making reference to the dangers of hyperbolic consumption and the benefits of exponential returns, Warren Buffet says: “Time is your friend, impulse is your enemy.” Even if you had an excel spreadsheet working all the time in your head and were able to use exponential functions for opportunity costs and for discounting, most of you would continue having a credit card and saving too little. Temptation is unmanageable for most to interchange today’s pleasure and consumption for the promise or expectation of future consumption and benefits. This is wired into our brains. The same happens in business.
Given how difficult it is to think in exponential terms and imagine what can be done in 20-50 years, very few entrepreneurs can establish a barbell strategy that simultaneously focuses on the big picture of solving a long-term problem on a long-term trend while having the ability to trace a road and decide where is the first stone. This ability to zoom in and out of your company’s long-term vision and day-to-day operations is probably the most challenging and difficult skill set an entrepreneur can have. This rare skill would involve: setting a goal; pivoting from that goal as you learn from short-term experiences; and at the same time, making numerous daily decisions that seem irrelevant individually but that constitute the necessary steps to grow and expand.
Once you have a vision, your first step is a minimum variable product. Usually, the launch of this first product is far from perfect, far from your vision and something not to be proud of. But, a “bad plan is better than no plan” (Garry Kasparov). In addition, this fast testing will give you valuable feedback related to the wrong potential roads to your goal. As Thomas Edison said: “I have not failed, I’ve just found 10,000 ways that won’t work.”
When you find something that works, you need to apply as much leverage as possible to grow and reach your goal. Perfection in a business doesn’t exist; you cannot aim to shoot for perfection but only to refine and iterate your model and assumptions constantly until you improve constantly. Perfection is the goal, it is a utopia, it’s the dream that keeps you awake at night. Although it’s never attainable, it is a must in the working of your strategy. You cannot trace a road unless you are going somewhere. Perfection lies in the process of improving yourself and your company on a daily basis. It is not being happy with what you have produced and how it is being produced, taking small and nimble steps that don’t mean anything individually but when put together are the art. It is pointillism art, where each dot does not have any figure, but when you look at it from 15 feet away, all falls into place and all makes sense.
In order to fuel your growth and become an exponential organization, you need to apply leverage, which can come in different forms and scales. As Naval expressed in his famous tweetstorm, “How to Get Rich (without getting lucky),” there are mainly three forms of leverage you can use as part of your toolkit: labor, capital and products with no marginal cost of replication. Exponential growth results from a combination of a growing business with leverage (in its different forms). There are three categories:
Team: Probably the oldest, easiest and lowest-risk form of leverage. Either hire or subcontract people to help you get the job done. But beware: it’s not just throwing people inside a cubicle and expecting a miracle to happen. Our thesis at DD3 is to only hire for core competencies, which we define as the things that we need to control directly and be responsible for, and outsourcing everything else. We have a high-quality, small, flexible team; and at the best time, we hire the top independent talent for all other functions. More labor increases the output that you can produce at your company (whatever you do), and more output can translate to greater growth.
Capital (debt and third-party equity): Throughout the last century, this is probably one of the most efficient ways to get rich (that’s why you see so many hedge-fund managers on the Forbes list). Hedge funds combine both: they apply leverage to capital that is only partially theirs and for which they charge fees. At DD3, we raised capital early on and focused on leveraging our portfolio of products as soon as they became cash-flow positive. We think of debt as the positive spread between what we can generate and the interest rate we pay. Our thesis: Don’t use debt to fund unproven ventures, debt is for accelerating growth but not to fund OPEX.
Technology: Probably the easiest way to increase production while maintaining or reducing costs. A true technological business should have extremely high margins on a unit basis and low marginal production costs.
Exponential growth derives from these complex and volatile short-term structures and distributions but the long-term is the sum of the short terms (or to be consistent: the result of the multiplication of the geometric means of the short-term individual returns).
At our office, we have a big poster with Warren Buffet’s phrase: “Rule No. 1: Never Lose Money. Rule No. 2: Don’t Forget Rule No. 1.” Once you understand and fully assimilate how compounding works, you cannot lose money in a single quarter or a year. The way we implement our barbell strategy of growing exponentially is to focus on the small/chaotic things in the short-term and every now and then, take a pause to raise our head and make sure we are heading in the right direction. Implementation is simple and based on two principles: A) our capital needs to have returns (ROE) of 20-30 percent every year (this is already after applying leverage); and B) whenever possible, we swing for triples or home runs, which risk little capital and that provide asymmetric returns adjusted for risk (e.g. banking advisory). The combination of A + B provides consistent upward trajectory and in every other quarter, we take the elevator instead of the stairs.
Small savings and small wins compound over time. Think “exponential” and stop extrapolating the past into the future. Basing your predictions on the past will most likely make you think linearly, with the risks of large dividends, little reinvestment, and sacrifice the future. Get as fast as you can to having a working product, and once you do and have a positive cash-flow story, apply as much leverage as possible and swing for the fences. Invest and reinvest as much as you can: money, getting knowledge in an industry and building relationships. Focus on the short term, have discipline, be patient and let the magic of compounding work for you.
Next time you go for a coffee, do the math. A 50-buck coffee sometimes is worth it… sometimes it’s not.
(For any of those still wondering how a Starbucks coffee can cost up to US$50 per cup, it is simple: US$3 compounded at 25 percent for 20 years and brought back at the discount rate of 8 percent for those same 20 years, would result in US$55.83 per cup. It has to be a delicious coffee or fabulous setting to make it worth it.)