July 9, 2020
This is a transcript of the fourth episode of MEDICI Studio's new video interview series "Weekend Wisdom: VCs Debunked & Demystified" led by Aditya Khurjekar, CEO and Founder of MEDICI. In this episode, watch Josh Kuzon, Partner at Reciprocal Ventures, elucidate the concept of "Unit Economics," how it applies to FinTech, and its complexities in general.
Aditya: Welcome to MEDICI Studio. This is Aditya Khurjekar, and my guest today on the Weekend Wisdom series is Josh Kuzon of Reciprocal Ventures. Josh, thank you for being here.
Josh: Thanks for having me. I appreciate it.
Aditya: Thank you to everybody who is watching this on YouTube, LinkedIn, or Twitter Periscope. Most of you will be watching this later on MEDICI Studio, where this will be published. Josh, I’m really happy that we can do this on, and you're doing this on a weekend, so I appreciate it. Our goal with this series is to debunk and demystify venture capital, and we're going to go deep into one topic here with you. Firstly, folks know that I have a number of VC friends in the industry, and Josh is a special one. I have always thought Josh has been a human encyclopedia of everything FinTech. How does it feel, Josh, to carry that big burden? Is it different carrying the big burden of that encyclopedia as an investor versus when you were in a bank?
Josh: Yes, sometimes it feels like there's a bit more pressure to have a clear view of the near and long-term future, and that's just hard to predict. I don’t have all the answers. I have very highly developed thoughts on the financial services industry, and I have a lot of experience in pattern recognition, but I really leave it up to the entrepreneurs. They're the artists. They're the creators. They're reimagining the future, and I'm just here to enable them; I'm along for the ride to just help them achieve long-term success. That's how I see my role.
Aditya: So you've always been a data-driven guy, right? You just talked about pattern recognition. When we decided on this topic, it seemed like it was natural for you to just dig into it. It seemed like you wanted to talk about this, and I'm so happy that we have chosen this topic. “Unit Economics”—people keep throwing that word around. I would love to get, in your words, the definition of that term, and especially as it applies to FinTech. Is there something special about that term for FinTech?
Josh: If you step back for a second, why are we talking about unit economics at all as it relates to startups? Startups or early-stage companies, by design, lose a lot of money for a lot of years in the hopes that one day they reach profitability. So when you approach an investor, you say, “Hey, do you want to invest in my money-losing business?” How do you justify that? Then you say well, intrinsically, my business is profitable if you can look at my unit economics. What does that really mean? At a high level, what are my revenues? What are my sales minus my variable cost to deliver that thing? What is the profit essentially on a unit or a customer basis? And how many of those things or clients do I have to sell to cover my fixed cost such that one day I can make a profit in the future at-scale? So that's how I think of unit economics.
Aditya: Is there something special for FinTech that we should keep in mind? When we talk about that term as it relates to our world, are there more complexities that we should think about?
Josh: I think there are more complexities. For one, in a lot of FinTech areas and FinTech business models, you're using established revenue generation models like interchange or interest income, or something like that. On the cost side, you're also dealing with a lot of fixed costs, whether they're Visa or Mastercard costs or things like that. You might be reliant on the rate environment—you can't just easily push down the prime rate or some base benchmark that your pricing off of. So there are more fixed things that go into the unit economics calculations of financial services companies. You can't just go out there and say, “Alright, my interchange rate is going to be 7%.” That's just not going to happen. So there are some constraints that you have to operate in, which is probably true of a lot of other industries as well, but specifically to FinTech, that's what I see as a unique element of economics in the financial services and the tech space.
Aditya: I think for those constraints, the opposite might also be true. For example, whichever side of the debate you are on, we have 0 MDR for certain transactions in India. Of course, there is a school of thought which says, “That's not sustainable. How can you have any offering with a zero price and stay alive for too long?” But that's exactly what we have. Now, if somebody is building a business with that as an assumption—“Hey, I'm going to innovate on top of this 0 MDR availability, where I can now do other things”—and if you make that decision today, and if tomorrow that 0 becomes a number, it will force you to change the assumptions that you had when you started your company. I think my bigger point here is that unit economics probably isn't a static notion. It’s probably something that is going to evolve. Are there any specific pitfalls here? What are the pitfalls in having the static view of your unit profitability and seeing it change because of things not in your control?
Josh: Competition is high, both on the pricing side and then the cost of acquisition side, and lots of other things in that area. The markets are constantly changing, so you just have to evaluate your unit economics on a frequent basis to understand what levers in your business are changing over time, and work really hard to control them or come up with different strategies to drive towards your ultimate goal. So, yes, you can’t look at these things in a vacuum at all. There are constant market forces at play, so you just have to be very cognizant of that, and be on top of your unit economics as often as possible.
Aditya: Conventional wisdom—as I've heard my investor friends talk about how they look at opportunities—is the usual: we look at the founders, we look at the team, we look at the market, we look at how big the market is, and whether or not you are solving a very specific, important problem in a big market where the solution to that problem is inherently profitable. Typically, these things are said in the same sentence—the market size and the profitability of your proposition to solve a problem. How close is that dependence? Do the TAM and the UE always work in tandem?
Josh: I think more often than not, you really can't separate the two, because how you price your product times the number of people that are going to buy it develops the total revenue opportunity. If you're off by order of magnitude on what you can charge for your product, from a revenue perspective, that market might not look that interesting, and you might have to pivot a little bit to say, “Well, there's still a lot of people out there. How can I find something that fits the demand of that large audience at the price point I want that makes it a big enough market to go after?” So yes, I think so.
Aditya: When we look at all of the different FinTech templates—you have probably been looking at patterns in terms of how companies pitch to you or how you look at them with your framework—is there like one, clear distinction between B2B and B2C—enterprise-centric versus individual-centric propositions—in FinTech as it relates to unit economics?
Josh: Yes. There's always the standard: “Here's what I'm charging for it. Here's what it costs to create it, and here's what it costs to sell it.” You do the calculations on both sides, but in the B2B space, you have the opportunity to sell products & services and software for potentially very large amounts. In that case, in terms of looking at unit economics, sometimes, it’s more of allocation of resources on certain unit bases because there’s just so much cash there that it's easier to make a profit, and you could do that with fewer customers, whereas in the consumer side that does not exist. You typically need hundreds of thousands, if not millions, of customers. I see that as a very big distinction. On the enterprise side, you could have hundreds of customers and become wildly valuable, whereas the equivalent on the consumer side is millions. Naturally, in my head, I think it's easier to find a few hundred people than a few million people, but obviously, there's complexities in both, but that's a big distinction to me.
Aditya: Is there a favorite for you? And has that answer changed since you were a banker? I mean, if you looked at a few things, did you naturally gravitate towards an enterprise platform play or a consumer play as a banker? And has that changed for you as a VC?
Josh: Yeah. I definitely leaned more on the enterprise side, because in my role, I was on the other side of the table from the startup. We were working with these companies on partnerships and different opportunities, so I understood what it took to sell to a financial institution. With respect to the consumer businesses, I do have a lot of experience there, but my orientation might be more towards a focus group of myself versus actually transacting with these enterprise FinTech companies. And that drove me more towards enterprise, where I found I could be more valuable to those types of startups because I had that type of experience. I’ve been through that a lot; I have a lot of friends who have gone through it, and I have a network that could be helpful to entrepreneurs pursuing those types of opportunities and those types of sales and partnerships.
Aditya: It's interesting that most VCs I talk to give me a similar answer: that they prefer enterprise plays. Having said that, most of the startups or the innovations that seem to get airtime are the B2C ones. People will talk much more about a Stripe than a Marqeta. I think that is one of the ironies that has always been fascinating. Almost everyone I talked to—and this was also true in the mobile world—said, “We prefer startups with a B2B enterprise platform play.” But then those always seem to kind of go under the radar. They don't show up on TechCrunch that much. Let me also shift to—I don't want to call it esoteric—but the term “disruption.” That’s one word that gets thrown out a lot, and I'm not a big fan of the word “disruption,” as you know, but I think that the notion of disruption can be explained with numbers. I think that is something you can probably explain much better than I can. Can we explain the concept of disruption with unit economics as the frame?
Josh: Sure. Maybe we all call Square a bit of a “disruptive company”—maybe it created a bigger category, but that's a disruptive event for the merchant services market.
Going back to when Square started, what’s interesting is that many folks at the time didn’t have the right cost infrastructure or payments factory to profitably attract those really small merchant accounts. Square retooled the factory and took a very tech-heavy approach, and they were able to drive down those costs considerably. It was a market that could endure a higher price point. That all made sense and worked—they were able to drag down the cost of getting those merchants onboarded, and that was really disruptive. So I guess you could say they really dropped the cost of operating a merchant services business such that they could deliver to these little merchants who might be swiping like a thousand bucks a year.
Aditya: I remember the stuff from B-school. They talk about “judo economics,” where a small player with a low-cost structure can come in. It also reminds me of playing poker with my boys—it was apparent that when somebody had a pile of chips, it was easy for him to wipe the other two players out by forcing them to pay a premium just to stay in the game. Do we see that here? If Square was not very well funded, would it have just collapsed?
Josh: I think it would have been a slower growth story. You would have probably seen more competitors come into the market faster. Who knows where the market would have gone? It could have potentially not gone anywhere.
Aditya: And this is probably a different topic, but it does seem related—it’s not enough just to have great unit economics. That is not sufficient for a good pitch to someone like you. Obviously, you also need the TAM to go with it, and you also need to have the ability to sustain yourself. It is also true today: every startup—big or small—needs to deal with cash constraints because revenue is under pressure this quarter. And if you don’t have the ability to keep raising enough money to make use of that unit economics story you may have sold in earlier stages, what’s the point? You have to have deep pockets.
Josh: Generally, yes, you need to have deep pockets. But you ultimately need some way to drive growth. I have seen some very special companies that are very capital efficient and have some great strategies. They create tons of growth out of low resources, but those are few and far between. Generally, creating big things requires a bit of capital—not too much, but a significant amount. I think certain things do take off, but those are few and far between.
Aditya: Are there any other dimensions or facets here that I may not have asked you about? Because I feel that we could talk about this for a long time, but at the same time, you live this every day. Are there any other facets of unit economics that you could share with our audience for them to get a little wiser this weekend?
Josh: I think early on in your development, most companies don’t have very strong unit economics. Especially in financial services, these companies are subscale. They might have one product, and they are getting terrible pricing and interchange rates, so that’s just the brutal reality of being a really early-stage company in the FinTech space. At face value, I look at that stuff and say. “That looks incredibly reasonable. What are they going to do about it?” What I want to understand is—when you’ve done the work and research—to prove how you actually can get to positive unit economics and a really honest assessment of the assumptions that you’re using to get there. For example, in the card business, when you’re going after a certain segment, initially, they’re going to spend $500 a month on a card, but in year five, they’re going to spend $5000 a month—that is not going to happen. If you are wildly optimistic about giving a commercial card product to a consumer, I just want to see that you’ve done the work and research, and we can then all get confident that as you grow the business over time, you can start generating positive unit economics. So day one or day two—it’s totally okay. It’s just understanding that you need a well-thought-out plan to get to those milestones.
Aditya: To summarize what we’ve discussed so far, in terms of the different dimensions: one, we’ve talked about how this is a little bit more complicated for FinTech because we have to deal with a few more constraints. We deal with the regulatory pieces where we are not able to change some things, which market forces alone cannot change.
Josh: Yeah. We didn’t even talk about that. Certain elements of the regulatory framework limit your ability to market. So there are tons of constraints here. It’s something I was thinking about yesterday—there’s just a lot that goes into FinTech startups. And let’s not forget that you also have these large financial institutions sitting here. Like trying to out-Chase Chase—good luck! Like I had someone I used to work with who said, “Don’t out-Visa Visa.”
Aditya: Yeah, exactly. And then we also talked about how it’s not a static thing—the calculation that you make in your seed stage will be different when you raise Series A or B; it’s going to evolve. It is also tied to the rest of the math, which is the market sizing, and to your point, doing the research and having an assessment of how things are changing around you is important because competition will change, and things are not static in that calculation. And in B2B vs. B2C, obviously, there are pros and cons, but it seems that more investors prefer the enterprise platform play as you do. We also learned from Josh how it directly ties into the notion of disruption. I think we covered some good ground here, Josh. Thank you for that. Before you go, I’ll ask you one last question that relates to the current situation. So we are still tracking a number of new investments being made in FinTech in early stages, but most of those conversations most likely started last year before the pandemic. Do you think we should expect a slowdown? Are conversations slowing down? Are you slowing down? Are your LPs telling you to slow down, so that in six months, we will have a lull? Is there anything different that is affecting your deal flow and initiatives because of the pandemic?
Josh: I think things across the landscape have slowed down. There were some existing trends going on in the early-stage market in terms of fewer seed financings happening. So because we can’t meet in person and work the way we used to, I feel like things have slowed down. However, I think everyone is trying to be as active as possible. We are very active in looking to invest in companies right now. Getting adjusted to this new environment took a few months. Who knows what happens going forward with the economy? I tend to think we are going to continue to see lots of interesting activity. This asset class and sector is a very exciting one. If anything, the current environment has accelerated a lot of trends, and it has also caused a lot of issues in the market. From all of that, there’s going to be many interesting opportunities. I’m also thinking about what this does to drive new entrepreneurs and new ideas, and that’s the thing I’m most excited about. What are they going to come up with next? Especially if you were just laid off from a large tech company, and you have a lot of time on your hands at home. I’m very excited to see what these folks are going to dream up. I do think the activity is going to pick up considerably. We’re still in an adjustment period, but we’ve ramped up. I’m seeing many of my colleagues at other firms ramp up as well. I think this isn’t going to stop the FinTech space—I don’t think it’s going to stop interest in it. I think we’ve got a multi-decade transformational opportunity here. This is just a little bit of a challenging bump in the road, but we’re going to get past that really quickly.
Aditya: That’s great. On that optimistic note that this will just be a blip, I want to thank you again. I can think of only two things to do when you have so much time on your hands: one, start a new company in FinTech, and two, continue binge-watching MEDICI Studio—things like Weekend Wisdom with Josh Kuzon. Josh, thank you again.
Josh Kuzon: Thank you. Take care.
Watch the video interview on MEDICI Studio here