Lean vs. Fat Startups

Last week, Ben Horowitz and Fred Wilson debated the “Lean Startup / Fat Startup” discussion at TC Disrupt in New York City (video is available at Fred’s blog).  The debate is actually quite good and both men make good, compelling arguments for the side they are representing.  In fact, I do not disagree with either person’s beliefs, which may seem a strange position to take since the debate, ostensibly, attempted to position them as being in disagreement with each other.  I do, however, think the general debate of this issue deserves a post, not to disagree with either of the debaters, but because I believe many other people taking sides on the debate view it as a black-and-white issue where one investment model (fat or lean) is clearly superior.

A little background on the issue: 

“Fat” startups represent a somewhat older idea around investment.  In the 1990’s, when venture capital boomed as an industry, starting a web-based company often required the entrepreneur to hire a sizable, local development staff and IT personnel, in addition to management, sales, marketing, etc.  In addition, I remember working at a small startup and still needing to rent space at a local server farm as well as having large, expensive computers on site.  Hype was an important driver of startups, so having a nice office space, hosting events, and having hats, laptop bags, and just about anything you could branded with your logo was important.  In short, if you wanted to be successful you needed a lot of money to start off with. 

In the 2000’s, however, the market has changed dramatically.  The barriers to entry for an internet company are low.  Outsourcing development and IT to offshore locations is commonplace.  Few small businesses need to maintain large servers, inexpensively hiring companies to host everything for them.  Most importantly, the hype is gone.  In the wake of the internet bubble bursting, backlash against the extravagance of startups in the 90’s has made startups wary of doing large promotional parties.  The growth of shared office spaces, virtual offices, and cloud computing has made it such that startups need not even have an office until they grow to the point it becomes necessary.  As a result, theorists and investors have begun to promote the idea of the “lean startup.”

The lean startup ideology is that the startup should raise as little money as possible and keep their expenses as low as possible.  The result is better for both the entrepreneur and the investor.  Take as an example ABC Company.  Let’s assume, as a given, that however much money ABC raises, it will be worth $100m in 5 years and has a present valuation of $10m.  Under the fat plan, ABC raises $10m, giving the investor a 50% stake in the company.  Under the lean plan, ABC raises only $5m with the investor taking a 33% stake in the company.  From the entrepreneur’s perspective, under the fat plan they own $50m in stock in 5 years, while under the lean plan they own $67m in stock.  Lean provides a clear advantage.

If the investor holds more of the company under the fat plan, why would they prefer the lean plan?  Investors are less concerned with the absolute dollars returned from an investment than they are in the rate of return on that investment.  Here is how the math works.  Under the fat plan, the company invests $10m to make $50m, a 5x return on their investment.  Under the lean plan, however, they invest $5m and make $33m, a 6.67x return on their investment.  The investor can then use the remaining $5m to invest in another company that it hopes will result in an equally good return.

Looking at this example, then, it is obvious that every company should be lean and that fat startups are a bad idea right?  Why does Ben Horowitz, a venture capitalist who was previously an entrepreneur working at Netscape and Opsware, support this model (you can read his arguments on his blog)?

The choice between lean and fat is not a black-and-white one.  Both are viable models for a business and both are tools to be used.  The key to success is not blindly following one or the other of the ideas, but understanding the value of each and developing a strategy that takes advantage of that fact.  If your strategy is to operate under the radar and you don’t see any major players to compete with on the horizon, going lean is a perfect choice.  If, however, your strategy involves pushing out established players in your market or creating a large presence very quickly to prevent other companies from gaining market share, you may need to spend a lot of money on marketing to create awareness and technology to ensure your product is so far superior to the existing alternatives that even larger, established companies will have difficulty catching up on that front  (Ben Horowitz’s example of LoudCloud from his blog post is a great example of this). 

The key is to consider both options and decide what sort of financing you need to achieve your goals based on your strategy.  Returning to the example above, if the terminal valuation is not fixed, meaning that if you raise more money the value in 5 years is dramatically higher, then raising more money most certainly does make sense.  In particular, if remaining lean dramatically increases the risk of business failure, going fat is likely a better choice.  How better to own a smaller piece of a larger pie, than to own a large piece of no pie at all? 

Unfortunately, those who watch the video of the debate will note that it resulted in a decisive victory (by audience polling) in favor of lean startups.  While this may be simply because the majority of them have businesses where a lean startup is appropriate, I fear it is more likely the herd mentality of following the latest trend, when even the two people leading the discussion would agree that the side they were supporting is not always right.