The Over-Investment Cycle

How too much money can kill companies and industries, and a quick look at Ridesharing

Half the battle in business - entrepreneurship, investing, or even selecting a career - is picking the right industry to compete in. Every industry has certain characteristics that place it somewhere on The Competitive Spectrum (shown below). The further left your industry falls, the smaller the piece of the profit pie you get to eat.

While competing in favorable industries is crucial to success, for a whole host of factors, it sometimes isn’t enough. One reason it might not be enough is, oddly, the risk of too much money.

Over-investment can kill a great industry. Too many dollars all chasing the same customers kills growth efficiency & drains the profit pool for every competitor. A decade-plus of cheap capital has led to an overfunding of ambitious startups fighting for the same markets, creating swaths of structurally unprofitable companies and industries too deeply engrained in their customer base to change their operating models.

The Over-Investment Cycle

When money is abundant and the cost of capital trends to zero, capital becomes a commodity and the amount of funding available vastly outweighs the number of good ideas needing funding. The VC industry becomes bigger than the industries they’re funding.

Companies competing to win a large market will get more than enough funding, and the intense focus on growth-at-all-costs' will blind everyone to profitable growth. They will invest heavily in customer acquisition, spending more and more to acquire each new customer, meanwhile distorting the true economics of their business model. Eric Paley in his 2017 article “Toxic VC and the Marginal-Dollar Problem” calls this the “Marginal Dollar Problem”:

Experiments that previously were returning $1.50 over time for every dollar invested start to return $1 as money is pumped into scale, but everyone agrees that’s okay. It just means that the customer pays back the cost of acquisition more slowly.

As the investment keeps scaling up, soon only $0.80 comes back for every $1 invested. This poor return is upsetting, but growth is the mantra and Fuego’s executives and investors rationalize that this can be fixed later. Eventually, as the company scales further, $0.50 comes back for every $1.

At some point along the way you might get a couple massive companies that have more or less hit their TAM. These companies have high and growing revenues, but mounting losses and minimal runway. To everybody’s surprise, nobody is profitable! So what do we do now? Do we pull back growth spend, raise prices, and hope our competition follows along? No! That would be suicide. Eric’s example above outlines a very important piece of the over-investment cycle: once you’re running you can’t get off it. Getting stuck in the over-investment cycle is akin to running on a hamster wheel. Investors bought into the company with a plan to exit at a price tag much higher than where you currently stand, and the only way out is through higher revenues and a dash of greater fool theory. Eric Paley compares it more aptly to a car with a leaky engine:

Think of your company as a car in a race to cross the country with an engine that’s leaking gasoline. The faster you accelerate the engine, the more the car leaks and the greater the risk of explosion. You have two options. You can slow down the car, pinpoint the problem and fix it; or, you can just keep pouring more gas into the tank, hoping for an infinite supply, and accelerate at maximum speed — all the while praying that the fuel leak doesn’t lead to a catastrophe along the way. So the car goes faster and faster with a decreasing rate of efficiency and an increasing probability of tragedy.

The cycle continues until something inevitably breaks and the procrastination of hard decisions becomes an immediate problem. Typically, the over-funded company will go back to the investor table looking for more money to continue winning share. For one reason or another — increased cost of capital, loss of trust, patience, or belief — the same investors who bid the company up, will pass.

Ride-Sharing: Uber vs Lyft

Ride-sharing is a great example of an industry flooded with capital and thus obscuring its true economics. Uber and Lyft have both raised billions in an attempt to gain share in the massive market; both have been incredibly successful at raising capital and growing revenues, but much less successful at generating profit.

• Since its inception, Uber has raised ~$25 billion, and from 2016-2021 delivered negative $27 billion of Operating Income.

• Lyft has “only” raised ~$5 billion of equity, and during the same period has posted negative $8.0 billion in Operating Income.

• Uber went public at an $82bn valuation and today has a market cap of $55bn.

• Lyft went public at a $22bn valuation and today it is worth $5bn - roughly the same amount of money they’ve raised.

Meanwhile, consumers have made out like a bandit. The growth-at-all-costs mindset has led to floor-level pricing for riders.

[As an aside, I do not blame any operators at either company, I think they really had no other choice in order to effectively compete. It is a symptom of too much money that forces players to play the game.]

How does it end?

It seems likely that Uber and Lyft cannot profitably co-exist.

On the revenue front - the zero-switching costs nature for both drivers and riders makes it incredibly difficult to raise prices. There’s also some game-theory at play where one company’s attempt to raise prices is met with lower prices by the other.
On the cost front - there are few meaningful cost-cutting opportunities when so much of your spending is to maintain and grow your customer base. Additionally, steering a culture to be more cost-consciousness isn’t as easy as flipping a switch - there are organizational headwinds that could make it a long and contentious process, reducing productivity along the way.

To be fair, both companies have made efforts to right-size their financials; Uber’s CEO has come out and mentioned they will begin pulling back on less efficient spend and increasing focus on profitability, saying things like, “ we have to make sure our unit economics work before we go big.” (only took 13 years). However, the competitive constraint that restricts their unit economics from working still exists. This point leads me to my prediction: Only one company can exist in this market and it will be Uber. Lyft, who has always lacked the scale and resources of Uber, will ultimately be a forced seller.

For what it’s worth, I don’t think this is a particularly bold prediction, and it appears to already be playing out. Looking at the charts below, you can see how the two businesses have diverged on almost every important metric over the last few quarters. Uber is growing faster and is marching toward profitability, whereas Lyft is more volatile and showing signs of plateauing.
[Note: this data is of course somewhat obscured by other business segments like eats, scooters, etc.]

The well is running dry at Lyft. With huge losses, weakening fundamentals, and a shrinking balance sheet, they can’t continue to invest as aggressively as they have become accustomed to. This truth, coupled with a tough macro environment, will leave no marginal investors willing to keep the company around. Uber, the larger and better-capitalized competitor, will survive and come out even stronger.

In search of a decent ending with a sprinkle of advice, I’ll leave with one final quote, stolen from a pillow in Carl Icahn’s office: “Happiness is positive cash flow.”

Thanks for reading,
Andrew