Have tech companies ditched the lean startup?
Deep dive #001
The lean startup methodology was introduced by Eric Ries in 2008. Interestingly, this was during the period of the great recession. Peter Thiel in his book, Zero to One, described it as a direct reaction if not an overreaction to the excesses of the dot com era and subsequent crash. But it appears that history continues to repeat itself with the boom and bust cycle.
The year 2022 was another unpleasant year for the global tech industry, with multiple rounds of layoffs, high-interest rates, and receding venture funds. The tech industry rode on the back of the pandemic effects and COVID-inspired behavior (such as e-commerce, and streaming), to the mountaintop, stretched valuation multiples to the moon, and hired millions of workers. Unfortunately, the momentum did not last and we are seeing the rubber band snap back. If 2021 was characterized by massive wins in the startup, IPOs, and venture capital world, 2022 was the complete opposite. As of December 2022, there were over 153,000 layoffs, a record-breaking trend that does not seem to be slowing. In Jan 2023, there are already 17,000+ layoffs. Could this be reminiscent of the bust of the internet bubble in 2000? Or is this just a social contagion?
Source: layoffs.fyi
During the 2020 pandemic, the U.S. Federal Reserve pumped a lot of money into the economy. This money had to go somewhere. Growth stocks and tech seem like great opportunities. The VCs were super-high on cash. There was an abundance of capital chasing founders. Between 2020 and 2021, VCs poured almost half a trillion dollars into 30,000 deals. In 2020 alone, $166.6 billion flowed into startups, then in 2021, that number doubled to $330 billion. The number of unicorns soared in 2021, with 586 companies valued at over $1 billion. This drove the costs of equity, engineering talent, advertising, and expansion. For instance, during this period, Amazon doubled its workforce, adding about half a million workers. Meta(Facebook) did the same. 2021 saw a record-breaking number of tech IPOs, but the party abruptly came to an end.
The U.S. Consumer Price Index had a sudden surge in 2022, prompting the Federal Reserve to drastically raise interest rates – six times in eight months, raising it from 0% to 3.75% per annum. With these higher rates, investors found secure assets more appealing than riskier investments. As a result, venture capital firms became less eager to pour money into unprofitable startups and ones with higher risks. The Russian-Ukraine crisis also put pressure on funds being sent to portfolio companies, forcing them to be prepared for a possible downturn. This fear spread quickly and the market responded accordingly – there weren't any tech deals that raised $1 billion in 2022 compared to at least 10 IPOs that raised more in 2021. The African tech ecosystem, which appeared to be initially to be insulated, had its fair share too. There were at least 1,679 layoffs on the continent, and VC funding plummeted in Q3 and Q4 of 2022.
When tech companies experience this level of upheaval, it's inevitable to look back and wonder what went wrong, as well as how these layoffs might impact the industry's culture moving forward. Should companies take the risk of scaling without profitability in mind? Is our product culture not resilient enough to handle difficulties? Are established companies with leveling growth curves seeking out new growth opportunities in the wrong way?
Is growth the enemy of lean startups?
The dot-com bust of 2000 was seen as a consequence of extravagant spending, unsustainable business models, and inflated valuations. As a result, it led to four unwritten rules in the startup world that came to dominate business thinking post the dot-com era.
Make incremental advances — “Grand visions inflated the bubble, so they should not be indulged. Anyone who claims to be able to do something great is suspect, and anyone who wants to change the world should be more humble. Small, incremental steps are the only safe path forward.”
Stay lean and flexible — “All companies must be lean, which is code for unplanned. You should not know what your business will do; planning is arrogant and inflexible. Instead, you should try things out, iterate, and treat entrepreneurship as agnostic experimentation.”
Improve on the competition — “Don’t try to create a new market prematurely. The only way to know that you have a real business is to start with an already existing customer, so you should build your company by improving on recognizable products already offered by successful competitors.”
Focus on product, not sales — “If your product requires advertising or salespeople to sell it, it’s not good enough: technology is primarily about product development, not distribution. Bubble-era advertising was obviously wasteful, so the only sustainable growth is viral growth.”
Is it possible to keep to these guiding principles in the face of oversubscribed funding rounds and the “pressure to move fast and break things''? While Paul Graham argues that a startup is designed for growth, the more you grow and raise additional funds, the more investors expect you to keep growing. Ultimately, startups need to diversify their product verticals or expand into new markets in order to keep the growth momentum. At this point, it may be difficult to operate lean. But in some other people's view, growth is essential, even if the lessons of the dot-com era have to be ignored.
This 1999 interview with Jeff Bezos confirms the prevailing sentiments that startups should be cautious about the future and have an obsessive focus on customer experience. Laying off 15% of its workers in 2001, Amazon must have at least learned its lesson. But, could it be that scaling itself is problematic? Or are some business models difficult to scale?
Amazon during its IPO in 1997 had 256 employees, which could conveniently manage its e-commerce business. As the business expanded, it required much more capacity, focus, and specialization. From marketplaces to cloud computing to streaming and hardware, it needed individual teams to tackle similar issues in various product verticals. Operating costs soared, making it harder to reach scale. Today, Amazon has 1,544,000 employees.
Source: finbox.com
The chart above shows that Amazon has had difficulties scaling revenue with employee count since 2013. A few months ago Amazon also raised its maximum base pay for corporate employees to $350,000 a year from $160,000 in order to fight the talent war. While it is understandable that the lean methodology is great for small startups, who are trying to prove new ways to deliver value, does it also work for big companies? Should companies who want to scale ditch it? Or is it difficult to scale efficiently?
Looking at Apple’s revenue-to-employee ratio, it has stayed consistently above 1.5, an indication that the company might be doing something different.
What about the top 3 companies by earnings?
Source: companiesmarketcap.com
As seen in the above chart, despite being the top 3 most profitable companies in tech, Apple, Microsoft, and Alphabet are not part of the top 5 employers. This could somewhat be a reverse causality. It could be that profitability affects decisions to employ, but the size of employment also affects profitability. Interestingly, none of them announced layoffs in 2022, aside from Microsoft laying off 1000 employees (0.4% of its employee size). Notably, Alibaba, and JD Mall also have high employee counts. This could mean that e-commerce companies are difficult to scale efficiently.
source:macrotrends.net
Amazon's operating expenses climbed rapidly from 2016. While Microsoft, Google, and Apple have leaner expenses and employee count, Amazon has been burning a lot more cash and expanding aggressively into other verticals. Perhaps, scale is not the problem, but how you scale.
The 2022 dark year for the tech industry is a wake-up call to revive the lean startup culture. This is already happening with the multiple rounds of layoffs. R&D, advertising, and marketing are other cost-cutting avenues for many companies. In 2023, most startups will likely focus on surviving and less on growth. We might also see another wave of M&A for startups to consolidate.
Aside from VCs facing challenges to raise their own funds, less money means more due diligence, appreciation for companies with real value and not just relying on future valuations. Overall, companies will need to become leaner, rethink their expenses based on ROI, and intelligently allocate capital.
That’s all for today.
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