It’s vital startup founders avoid fairy tale economics in their business model

Like Sleeping Beauty woken after her 100 years slumber, Liz Truss is befuddled as she wipes the sleep from her eyes. Her ‘fairy tale economics’ wish just hasn’t come true. Truss says the remedy for Britain’s economic problems lies in giving the economy an uncalibrated fiscal boost in the form of £45bn of unfunded tax cuts, whatever the consequences for public borrowing. Given the calamitous market reaction and feeble interviews she gave on BBC local radio last Thursday, we will soon see how much staying power her fanciful version of once upon a time has for they all lived happily ever after.

The twenty-give-minute statement from Chancellor Kwasi Kwarteng on September 23 kickstarted a crisis, spooking the financial markets in spectacular fashion. As investors took fright, the Bank of England injected £65bn, and said that it was ready to buy unlimited quantities of long-dated bonds to restore order to financial markets. Earlier, the pound had crashed to its lowest ever exchange rate with the dollar.

Truss is arguing against the economic orthodoxy of the IMF, the Bank of England, the insights of The Economist and The Financial Times, Mark Carney and Gordon Brown, pushing her ideology. Yes there is a global storm, but the rest of the world is sheltering – but Truss seems to have pushed us all outside, stripped all our clothes off and got zapped by lightning.

The Bank of England has resisted pressure for an emergency interest rate rise, but it has signalled unequivocally that a big increase will come in November. That will add to the Government’s own interest payments and harm people with mortgages. Huge tax cuts, the centrepiece of Kwarteng’s budget, were never going to pay for themselves. Never has the gap between rhetoric and reality been so gaping from a Chancellor.

The fact that the budget dodged independent scrutiny from the OBR was a signal of fiscal recklessness. Restoring growth is crucial but you design any economic stimulus carefully so that it is credible, otherwise the whole exercise becomes self-defeating. But not for Truss and Kwarteng. Their recklessness has provoked a reaction building on the disbelief in her previous childlike understanding of ‘Trickle Down’ economics. There is not a scintilla of evidence that tax cuts ‘trickle down’ to impart economic dynamism, extra effort or enterprise.

So how does this inform us in startup founders? Here are some economic fundamentals to add into your startup thinking to ensure there are no ‘fairy tale economics’ in your startup business model.

1 Risk and return With all investment, the higher the risk assumed, the higher the expected return, and there is no riskier enterprise than a startup venture. The cash flows have much more variability than those of established companies, but the highest returns also historically accrue to the small-business investor: the average annual returns of small-company investments have been 17.7% over the past 70 years, compared with 12.5% for quoted companies. To attract capital, founders must weigh the possibilities for economic return, balancing risk in their business model against the higher rate of return that will be achieved if the business succeeds.

2 Supply and demand. Demand is the relationship between quantity of a good and its price, as well as the benefit perceived by customers. The total demand for a good or service is determined by taste and preferences, number of buyers in the market, prices of related goods, customer budget and expectations.

Supply reflects how much of a good is brought to the market within a given time. The cost for the to supply the good is a factor. The total supply is affected by the cost of resources, number of sellers in the market, prices of related goods, technology levels and expectations. A key point is to differentiate between a change in quantity demanded and demand itself, only price will change the relationship between quantity demanded and supplied to individual customers. A host of other factors cause the total demand or supply to change.

3 Opportunity costs Opportunity costs are the invisible cost of the path-not-taken. For example, if you are a developer, you could work in big tech for a salary of £100k+. This £100k is the opportunity cost of working on your venture instead i.e. the salary forgone.

Let’s say that your startup idea has a 50% chance to succeed, and you own 50% of the company. This means that for this to be worthwhile in purely economic terms, you need it to generate at least £400k in profits in a year: £400k multiplied by the chance to succeed give the project expected returns of £200k, from which your share is £100k.

That said, the opportunity cost concept should be used a lot more widely in your startup economics toolbox. An early-stage startup has very few resources to invest, and you need to choose wisely in what activities to put your effort. Everything has an opportunity cost. For example, fundraising is an extremely common process for startups, but if you’re fundraising this means you’re not building and marketing your product to your customers. In that sense, the opportunity cost of fundraising is high.

Equally, before investing in a new product, service, or activity, consider not only the cost of creation but also other ways that money could be invested, and which option provides the greatest opportunity.

4 Sunk costs A sunk cost is simply money that has already been spent and cannot be recovered. This concept goes hand in hand with the sunk cost fallacy, the tendency to continue with a certain project or a certain direction after you’ve already invested in it. It’s a fallacy because if the concept/direction is wrong, the outcome would be negative regardless of your initial investment in it. The sunk cost fallacy only makes it so that you lose much more time and resources on your bad bets than you have to if you quit in time.

However, the sunk cost fallacy is even more important to master for startups, being able to deal with the bad bets is crucial for your success. Very few people strike high on their first attempt, so the ability to quickly discard bad ideas in order to get to the good ones as quickly as possible is essential.

If you work on a bad idea too long, you risk being stuck in the land of the living dead. If there is no indication of growth despite your efforts, should you pivot, or if you should abandon the project altogether, regardless of how much you’ve invested in it.

5 Breakeven This is straightforward economic principle – when will our revenues equal our costs, and we are making neither profit nor a loss? It’s a key target for a startup as it covers all elements in the business model – revenue, price, unit costs, overheads.

This translates into a more vital definition when you consider it in cash burn terms – when will cash inflows equal cash outflows, and we become cash neutral? The calculation for the breakeven point can be done one of two ways. One is to determine the volume of units that need to be sold at a given price, the second is the amount of sales in monetary terms that need to happen. The breakeven point allows a startup to know when overall, or one of its products, it will start to turn the tide on cash outflow. 

6 Marginal benefits and marginal costs A core economic concept. The marginal benefit of an activity is the benefit from choosing to supply an additional amount of that service or good. The marginal cost is the expense for adding that extra amount. When marginal benefits of an activity are greater than or equal to marginal costs, there is profit.

When a new product is being developed, the per-unit cost of production exceeds the marginal benefit. Once mass production lowers the marginal cost, the greater marginal benefit results in profit. This is important – at what volume do we reach a lower unit cost that creates profit? The marginal benefit-cost relationship runs throughout a startup’s operations as cash is a finite resource and requires the founder to accurately analyse what marginal benefits could result from each activity.

7 Elasticity of demand This defines how much demand for your offering changes when price changes. When price increases, quantity demanded generally declines, but by how much? If demand is elastic, it may decline a lot, as it is sensitive to price increases. If demand is inelastic, a price rise doesn’t reduce demand much. The demand for most medical services, for instance, is inelastic, as there are no or few substitutes. The demand for bananas is elastic, as higher prices will lead consumers to other fruit options. Pricing patterns for startups must be based on how much value customers put on the product or service and what substitutes exist.

8 Specialisation Adam Smith, the founding father of economic thought down in his Wealth of Nations treatise of 1776, stated that productivity increases when workers specialise. This insight lead to the development of the notion of division of labor and the assembly-line-led industrial revolution.

For a startup this translates into specialisation: as the economy and technology grow more complex, it becomes impossible to be a jack-of-all-trades. It’s a much better strategy to concentrate your efforts and to become the leading expert in a niche. Whilst this is true for your venture and your offering, this is not entirely true for the founder. As the person leading the enterprise, your job isn’t just to maximise efficiency, but to understand and coordinate the different aspects of the business. in order to be able to take the optimal decisions.

9 Satisficing Economics works on the assumption that consumers are rational actors, whereas behavioural economics challenges this assumption and argues that in the real world people are subject to cognitive biases and are emotional decision makers (i.e. they are subjects to bounded rationality). This gives rise to the concept of satisficing: rather than maximising the cost/utility of your offering and making optimal consumption choices, people on average are following the path of least resistance. In other words – they are satisficing. 

In the world of startups, this translates to the belief that build it and they will come but this is an illusion. Building a better solution (higher utility at lower cost) isn’t enough. You need to make your solution as easy and obvious as possible for your target users, make it a good experience, and reach out with smart marketing, otherwise users will be perfectly happy to ignore you and stick to their existing supplier. Innovation is one of the hardest concepts to get potential users to recognise and give them a reason to switch and overcome the status quo bias.

10 Comparative Advantage David Ricardo, a Scottish economist, had an intuitive insight: a few firms benefit from trading even if one is objectively the best at everything. This is because one of the activities generates the highest returns, which means that all other activities are better left to the other players in the market because of the opportunity cost of not focusing on your highest value-added activity.

This theoretical concept becomes extremely practical for startups. You have very few resources to spare, so it’s better to focus your efforts on your highest value-added activities. This rule of thumb says the way to minimise your opportunity costs and maximise your marginal returns is by investing resources and effort into the activity at which you are the best. Everything else is a waste of money and effort. Avoid distractions, focus on your USP.

The entrepreneur who chooses not to understand economics will commit follies and impede the growth of their company. Yes there are different opinions, politics and underlying economic philosophies, but my takeaway from this week have been the words of John Maynard Keynes: Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone.

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