Tren’s Advice for Twitter

Jack Dorsey very recently asked for feedback on Twitter. The focus of nearly all of the comments he received was on ways to make Twitter’s service qualitatively better for consumers. If Twitter does not have a great product for consumers, nothing else matters. But having a great product for just one side of a three-sided market is not enough to make Twitter into a successful business.

In a deeper analysis below I will argue that Twitter needs to become more of a platform and not less. Twitter’s drive to become a media company reminds me of this joke:

Late one night a police officer found a drunk man crawling around on his hands and knees under a streetlight. The drunk told the police officer that he was looking for his keys. When the police officer asked if he was sure this is where he dropped his keys, the drunk man replied that he believed he dropped his keys across the street. The police officer asked: “Then why are you looking over here?” The drunk explained: “Because the light’s better here.”

Twitter devoting resources to offerings like Moments in an attempt to become a media business is like the drunk looking for his keys under the streetlight, when his keys are across the street where the building blocks of a much better platform business can be found. In short, it is easier for Twitter to try to be like Yahoo than it is to be a better platform. It is also easier to open a bakery or bar than it is to maintain and expand a platform. But because it is easy to do does not mean it is the right thing for Twitter to do.

I will argue below that to be a better platform Twitter must let go of its worship of the monthly average user (MAU) metric and go full speed ahead on ending abuse, bots and spam. MAU will drop for a while, but will emerge will be a more genuine MAU and better advertising targeting and user data.

In terms of suggestions to make the Twitter consumer offering better, why not focus on doing more things for existing Twitter creators?  The best creators on Twitter get paid zip to make Twitter more valuable. They don’t get *any* love from Twitter whatsoever. The best thing about Twitter are the people who create Tweets. Twitter should do a far better job of making these people more discoverable and happy. For example, why don’t they reach out and offer a blue check mark to the most valuable creators on Twitter. If you ask to get the check mark and you are not Beyonce, Twitter more or less treats you like a possible criminal. The blue check mark rejection letter, which makes you feel like you have been rejected by Harvard Divinity school for questionable character, is a missed opportunity. YouTube has taken advantage of the opportunity to create a far more positive relationship with its creators. Instead of giving some attention and love to the people on Twitter who create the value for Twitter, Twitter is hiring more people to write first party content about the Kardashians on Moments?  That. Is. Just. NUTS.

Blue check marks are just one idea for making the service more valuable for Twitter’s most important creators. Medium has this same problem, but it is even more important for them. In a Tweet his week about Medium I said: “Content can only be consistently good if its creators can make a living from it.”  Twitter creators don’t need to make a living on the service, but they will do more work and contribute more if there are greater incentives to do so.

Twitter is a poster child for a critical point that many people do not understand about innovation. Many businesses like Twitter deliver huge amounts of value to consumers via innovation but do not generate a corresponding amount of profit for shareholders from that innovation. That Twitter is a very important innovation for society does not necessarily mean it will deliver a significant profit. That Twitter may have a moat from network effects is a different point than the size and value of the market that the moat protects. Moats are far from generic. Some moats protect very valuable markets and some don’t. Twitter’s objective should be to expand the value of what its moat protects. If it does not expand the value of what its moat protects, it will not grow into its cost structure.

More detailed analysis:

Twitter is a multi-sided platform linking advertisers on the first “side” of the market with people like me on the second side who use Twitter to communicate. Another third side of the platform is composed of businesses which pay for access to a Twitter API that gives them access to data that Twitter collects about interactions on the platform.


The key to delivering value to Twitter’s advertiser customers (Side 1) is having highly relevant data about potential buyers on Side 2 so the advertisers can generate a high and measurable return on investment (ROI) on their Twitter advertising. Advertisers on Side 1 will compare their Twitter ROI to the ROI they can achieve on other social media platforms. This of course is capitalism at work. Every advertiser and buyer of access to the Twitter API must do an opportunity cost analysis.


Twitter must capture a much bigger share of this:


One important objective for Twitter is to make targeted advertising so valuable that when consumers want to buy something that the advertisements are considered by consumers to be valuable information rather than spam. Delivering advertising to consumers as close as possible to the time they are ready to buy is the optimal result for Twitter.  How is Twitter doing in targeting is advertising? When you see an advertisement in your Twitter feed is it highly relevant to you? Have you ever clicked on a Twitter Advertisement? Or does a Twitter ad usually make you say: “this is annoying. Why are they sending this to me” The magic of search advertising is that when you are using a search engine you are often in the mood to buy. When you are on Twitter reading a post on a sporting event are you really in the mood to buy just anything? Is an advertisement for anti-itching cream valuable then?

To make the targeted advertisement valuable Twitter must “know you” in a deep way. What are the impediments to that? That should be the focus of work at Twitter.

Understanding the urgency of what Twitter must do is bought into focus by looking at the unit economics of Twitter. We may not have enough data to do the type of LTV calculation that I have written about recently on this blog, but Twitter does. We do know enough to make some educated guesses about Twitter’s Unit Economics. As always, especially for an investor, it is better to be roughly right than precisely wrong.  Of course, Twitter can be far more than roughly right. They have the nonpublic data. They can do the math and use the math to create key performance indicators.

Most people who look at Twitter’s numbers focus on the need for more user growth. The cry from analysts is usually some form of: “Twitter must increase MAU and DAU!” This results in thinking and products like the awful Twitter Moments, which is essentially trying to recreate Yahoo’s declining business model and diverts resources that can be better deployed elsewhere.  Is it a good thing is MAU and DAU grow? Sure.  But the more important question is: what is the highest ROI for Twitter on new investments?


Over-fixation on growing MAU and DAU also makes Twitter fearful of fixing important but broken aspects of the service like abuse, spam and bots since that would result in user count drops and less “activity.”  Unfortunately, that confuses genuine real consumers with counts inflated by fake users.  Twitter needs to fix the abuse problem regardless of what it does to negatively impact fake MAU. Spammers and bots must go. No one is going to be fooled about MAU claims when the company can’t generate a profit. The clock is ticking.

Some people argue that this focus on growth MAU makes the Twitter usage data less useful too both in targeting advertising and for buying of access to the Twitter API. Trip Chowdry of Global Equities Research argues:

“If data quality is bad, Ad targeting is bad, and if Ad targeting is bad, Advertisers are not happy, and hence monetization will remain challenging for TWTR. If data quality is bad, then performing prediction on these data sets will also be wrong, hence 10% of revenues that TWTR gets from selling its data will also suffer.”

In my post on Chamath Palihapitiya he makes clear that the for key Facebook in the early days wasn’t MAU and DAU.

“After all the testing, all the iterating, all of this stuff, you know what the single biggest thing we realized [at Facebook]? Get any individual to seven friends in 10 days. That was it. You want a keystone? That was our keystone. There’s not much more complexity than that. It’s not just top-line growth. It’s acquisition, engagement, ongoing product value. It’s understanding the core value and convincing people that may not want to use it.”

What’s the core value of Twitter? What key performance indicator (KPI) drives that value best? It isn’t activity generated by abuse, bots and spam. I suspect the right KPI is something that captures real users sharing and creating content. Something like more than X Tweets shared or created over period of time Y.

Anil Dash in a thoughtful post on Medium argues that Twitter has made a mistake by focusing on the wrong metrics:

“Your relationship with Wall Street investors (and, to some degree, with advertisers) is fundamentally broken because you’ve gotten trapped into using the wrong metrics to measure the success or progress of Twitter. New signups are flat, and they’re going to stay flat, and every desperate flailing attempt to change that just reminds engaged users that they’re not seeing any progress and they don’t believe you can ship features they care about. Meanwhile, do you know how many new video creators joined YouTube this quarter? Me neither! You know why? Because all the good videos are on YouTube! What percentage of people who visit YouTube each month are logged in? What percentage ever uploaded a video? Answer: Nobody gives a shit. Because YouTube inarguably drives culture, and people (and advertisers!) want to be part of that.”

The more important tasks for Twitter and other platforms are less fun than writing Kanye entries in Moments. The focus of Twitter should be on increasing average revenue per user (ARPU) which is driven by the ability to better target users.

As I said, it is useful to look at unit economics

  1. ARPU:

Twitter’s total most recent quarterly revenue:  $616 million a quarter or $205 million a month

Monthly active users:


There are also ~500 million monthly average users (MAUs) who are not logged in, but let’s ignore them since it would make Twitter’s ARPU per user even worse.

Monthly ARPU: 317 million logged in users are generating $205 million a month or 64 cents per user per month.

  1. Gross Margin (revenue less cost of goods sold or COGS):


The problem with the new “we are a media company” approach being adopted by Twitter is that even if they do grow users it is not a high gross margin path. Being a “media company” has significantly worse margins that a platform business and it scales far less well.

  1. Churn (customers lost):

This variable and the next are the hardest to know if you are not Twitter. What is Twitter’s customer retention rate? Twitter knows but we must make an educated guess. We know net growth is 1-4% (including bots, etc.). Within that envelope there can be a lot of churn that is killing growth or not.

Survey Monkey has some rough data that should be viewed with caution.


This chart looks at weekly churn, which refers to people who used the app one week, but didn’t use it again in the following week. Some of those churned users will probably return to the app in the future, but generally speaking, Twitter retention rates do not look very good at all, especially when compared to Facebook’s apps.

I’m going to make an educated guess Twitter’s real churn is 4% a month since that is typical in a consumer business with no annual contract. How did I make that guess? Well I know what their loss is as a company, I know gross margin and ARPU and I see their income statement which generally reflects sales and marketing costs. And I know many churn “comparables” from other companies over a period of decades. With that data, you use pattern recognition and make your educated guess.

  1. CAC (customer acquisition cost):

CAC is also a hard one. In the case of a company like Twitter, a lot of the COGs is really CAC. I use the same reverse engineering process I used with churn to come up with my educated guess. Twitter, as I said, does not need to guess.

Looking at Twitter’s SG&A and the losses (see below)  I, going to guess based on losses and SG&A that Twitter’s  direct and indirect CAC is about $8.

So how does this net out? Well, Twitter’s  unit economics might look roughly like this:


Unlike me Twitter does not need to guess what the inputs variables into the unit economics calculation are. But we do know that if Twitter can get ARPU up to $3 a month the operating leverage gets lots better. Adding a lot of new COGS to the math makes things worse.

There is some urgency if you look at the financials:




Twitter Investor relations slide deck:

Survey Monkey

Anil Dash:


A Half-Dozen Ways to Look at the Unit Economics of a Business


McCaw Cellular Communications sold to AT&T for $12.6 billion in September 1994. And yet the business did not show an accounting profit on its income statement until the second quarter of that year (after the deal was announced on August 17, 1993). The McCaw  Cellular example shows that you can create a tremendous amount of value for shareholders without showing any profit on an income statement. Or not. Here below is a picture of a real letter from Craig McCaw sent in July of 1994 which documents what I said above.


Amazon and Netflix are examples of the same value creation phenomenon as are many businesses that John Malone has created over the years. This post will try to help people understand why this is true.

The drumbeat of people (especially reporters) saying a that a business is “losing money” and is therefore doomed is constant. People with a political axe to grind on a platform company like Uber to make this sort of statement.  What these people are usually claiming is that they learned from sources that the current income statement of a business reflects a loss. The reality is that a loss on the income statement can reflect bad news or good news, depending on other variables, as I noted in my post on CAC. Weirdly, these people  will also say that a business is great because they are “making money” when all they know is that revenue is rising.

Working through some examples usually helps people understand these issues. Every business on Earth, from a huge company to a hot dog stand, can be analyzed in this same way. No matter what your business may be, this unit economics method of analysis is relevant to you!

Assume you have a business that sells a streamed film collection. Looking at comparable movie streaming (OTT) services like Netflix (there are over 110 businesses doing this), the key inputs into the unit economics of the business might look like this:

Monthly Churn                                                                                                       4%

Monthly ARPU                                                                                                      $10

Gross Margin                                                                                                         30%

Cost Per Gross Addition (CPGA sometimes called SAC or CAC)            $30

A screen shot of the unit economics calculation might look like this:


Note what happens up front: $30 immediately is spent to acquire the customer (see the red number).  But in month one the net cash flow coming in is only $3. That means $27 in cash has been consumed in the first month ($30 out and $3 in). If the customer stays a customer for a long enough time and keeps generate $3 in net cash flow, shareholder  value can be created. Without knowing churn you don’t know if the business is sound. You do know that the business is “losing money” in the aggregate, but that is not enough.

In this screen shot above I cut off the picture at 10 months to make it fit the page. The reality of the screen shot below is that at 4% churn the implied user life is 25 months (i.e., cash will be coming in for that long on average).


Value is being created in my first example but it is deferred value. Why does anyone defer consumption to create or invest in a business? They do so if they believe delaying gratification will allow them to consume more in the future. In deciding whether to defer consumption people know that a dollar delivered tomorrow is worth less than a dollar today and therefore the dollar delivered tomorrow must be discounted to a lower value in order to determine its value today (10% annually is chosen at the discount rate in the example).

The cost per gross addition (CPGA) is assumed to be relatively low in my first example because customer value is high versus alternatives and customers are able to terminate service with 30 days’ notice (which lowers sales resistance). But the absence of an annual or longer contract means higher churn is possible.

Gross margins are assisted in this case because the business only pays the credit card merchant fees one time per month versus many credit card charges for à la carte movie buying services.

The important point to understand about the unit economics in this example above is that the variables are assumptions, they feed back on each other and inevitably change with an evolving business climate. If the business asks customers to commit for a year of service in a contract instead of paying month to month, CPGA would rise. Let’s assume CPGA would rise to $70 with that change to a yearly contract. If CPGA is now $70, the unit economics of this business look like this (red is not good):


In this business a $70 CPGA kills shareholder value. But in an alternative scenario that shareholder value killing input could have instead been higher churn or lower gross margin.

As another example, if the business encountered 10% churn the unit economics also get uglier than the first example:


Making all of this work financially for the business is tricky and some people spend their entire careers working on just one aspect of lifetime value problems like this. There is a lot of art rather than science in this work since these people are dealing with human behavior, which fluctuates and is unpredictable.

Investors often need to make guesses about these numbers since business do not real the data. For example, many businesses do not like reporting CPGA or whatever the customer acquisition cost metric is called in their industry (e.g., CAC or SAC). As an example, Netflix no longer reports SAC, but when it did:


Reports in 2016 indicate the Netflix has substantially reduced CPGA/SAC and churn since 2008 through changes like original first party content (which can increase COGs, but at an acceptable cost say many people), but that is a topic for another post. Your business can also die because it runs out of cash and that is another post too.

The most important “take away” from this blog post is that looking at an income statement alone is not enough to determine whether a business is creating value. You must also understand the unit economics of the business.

When someone says a business is “making money” or “losing money” be skeptical about either claim until you get enough data to apply math like I explain above.

Think for yourself. Be a learning machine.


What You Can Learn about Business from a Dozen Lines in the Godfather


1. Michael Corleone:  “I have always believed helping your fellow man is profitable in every sense, personally and bottom-line.” Michael seems to be claiming that he agrees with Charlie Munger who once said: “You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich–who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich–in money–not just in reputation.”   You may, of course question, whether Michael was being sincere in making this statement to some assembled reporters. But perhaps he agrees with the sentiment of Munger here:

“Ben Franklin said: ‘I’m not moral because it’s the right thing to do – but because it’s the best policy.’ We  knew early how advantageous it would be to get a reputation for doing the right thing and it’s worked out well for us. My friend Peter Kaufman, said ‘if the rascals really knew how well honor worked they would come to it.’ People make contracts with Berkshire all the time because they trust us to behave well where we have the power and they don’t. There is an old expression on this subject, which is really an expression on moral theory: ‘How nice it is to have a tyrant’s strength and how wrong it is to use it like a tyrant.’ It’s such a simple idea, but it’s a correct idea.”

2. Michael Corleone:  “One thing I learned from my father is to try to think as the people around you think. On that basis, anything is possible.” Michael appears to  be advocating speculation in the manner of a Keynesian beauty contest which may explain his poor performance investing in public markets. Keynes explains the problem this way:

“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole, not those faces which he himself finds prettiest, but those which he thinks likeliest to match the fancy of the other competitors, all of whom are looking at the problem from the same point of view. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

By guessing what others are guessing what others are guessing [repeat] you will not beat the market. This is speculation rather than investing.

  1. Don Vito Corleone:  “Someday, and that day may never come, I’ll call upon you to do a service for me.” Reciprocity is a powerful human emotion. Professor Cialdini has made this point in his ground breaking book Influence. Compliance professionals know how to exploit this tendency. For example, when the stock broker gives away the “free” salmon dinner he or she is expecting you to reciprocate by allowing them to manage your wealth. The salesman who wants you to buy his goods in return for the football tickets is no different in his or her motivation. One weird thing about the reciprocity tendency is that you are so influenced by it that what is asked for by the compliance professional can be of far greater value that what is given to you. For example, the Hare Krishna member in the airport who gives away the flower can ask for something much more valuable and yet the people being solicited will still tend to feel the compulsion created by reciprocity. The key defensive move against reciprocity is to not accept the gift in the first place. I would rather stab myself in the thigh with a sharp fork than accept a free weekend condominium stay offered by a time share salesperson. One technique that is useful when engaging in a negotiation is to politely refuse to accept or at least immediately reciprocate when hospitality is offered. Lavish hospitality given to the employees of a business is often intended to create obligation at a personal level, which they hope will cause the employee to offer reciprocal benefits to the generous compliance professional. One problem, however, is that some studies have shown that there is also a bias toward receiving a gift: “Although the obligation to repay constitutes the essence of the reciprocity rule, it is the obligation to receive that makes the rule so easy to exploit.”
  1. Clemenza:  “Leave the gun. Take the cannolis.” Professor Michael Porter believes that “The essence of strategy is choosing what not to do.” One of the hardest things for many people in business is to not do something. One common example is the restaurant with a nearly endless menu. They often serve everything poorly and unprofitably.   Allocating resources  to a sub-optimal use is a misallocation of capital. As an example, if you are a startup founder and you are buying expensive chairs for your conference room the same process should apply. Is that your best opportunity to deploy capital? Those chairs can potentially be some of the most expensive chairs ever purchased on an opportunity cost basis. If you drive an expensive sports car Buffett can calculated in his head what your opportunity cost is in buying that car versus investing.
  1. Michael Corleone: “Never hate your enemies. It affects your judgment.” It is hard to overemphasize the importance of temperament to success. Most mistakes are psychological or emotional. Munger believes that he and Buffett have an advantage that is based more on temperament than IQ. If you can’t handle mistakes, Munger suggests that you buy a diversified portfolio of low cost index funds. Unfortunately, even if you do select an index-based approach you still must make some investing decisions such as asset allocation, fund selection and asset re-balancing periods. Humans tend to make so many psychological and emotional mistakes and that “compliance professionals” are able to milk that tendency to manipulate your actions. Be careful.
  1. Sonny Corleone: “Whatcha go to college? To get stupid? You’re really stupid!” Charlie Munger makes the point that high IQ does not mean you have high rationality quotient (RQ).  Temperament is far more important than IQ. Warren Buffett has said about Charlie Munger: “He lives a very rational life. I’ve never heard him say a word that expressed envy of anyone. He doesn’t waste time on senseless emotions.”  Warren Buffett suggests that some of this aspect of human nature may be innate: “A lot of people don’t have that. I don’t know why it is. I’ve been asked a lot of times whether that was something that you’re born with or something you learn. I’m not sure I know the answer. Temperament’s important.” High IQ can be problematic. What you want is to have a high IQ but think it is less than it actually is. That gap between actual and perceived IQ creates valuable humility and protects against mistakes caused by hubris. It is the person who thinks their IQ is something like 40 points higher than it actually is who creates the most havoc in life.
  1. Michael Corleone: “Well, when Johnny was first starting out, he was signed to a personal services contract with this big-band leader. And as his career got better and better, he wanted to get out of it. But the band leader wouldn’t let him.” Johnny Fontaine was locked up in this services contract to lower his transfer pricing power. Wholesale transfer pricing =  the bargaining power of A that supplies a unique product or service XYZ to which may enable A to take the profits of company B by increasing the wholesale price of that product or service. The term “wholesale transfer pricing power” is similar to, but not the same as, a “hold up problem.” The best lens to look at the wholesale transfer pricing power/supplier hold up set of issues is Michael Porter’s “Five Forces” analysis, specifically “bargaining power of suppliers.”  To solve this problem Don Vito Corleone famously said: “I’m going to make him an offer he can’t refuse.”
  1. Hyman Roth:  “The best deal you’re ever going to make is the one you can walk away from.” This is a statement about the importance of having what Roger Fisher Calls a BATNA (best alternative to a negotiated agreement) in his book Getting to Yes. Negotiating leverage is determined by what is essentially an opportunity cost process. If you have only one supplier of an essential component at any point in your value chain (like the music streaming business does), then may God have mercy on your business. Hopefully God will have mercy because suppliers (for example, music owners) will not.  At one in the Godfather the bodyguard Mosca made another point related to BATNA when he said: “Tell me what to do. Then I will tell you my price.” Never agree to buy and then negotiate price. Do the reverse.
  1. Michael Corleone: “All my people are businessmen; their loyalty is based on that.” The best CEOs are “master delegators, running highly decentralized organizations and pushing operating decisions down to the lowest most local levels in their organizations.” They push down decision-making on everything but capital allocation and choosing and compensating senior executives. They “delegate to the point of anarchy” using incentive to get the behavior they desire. There are many examples of this in the Godfather. Tessio at one point said to Tom: “Tell Mike it was only business. I always liked him.” Michael Corleone famously said: “It’s not personal, Sonny. It’s strictly business.” Sonny forgot the lesson and was ambushed as a result. This is the famous exchange the preceded the ambush:

Tom Hagen: “Your father would want to hear this. This is business, not personal.”

Sonny: “They shot my father? It’s business, your ass.”

Tom Hagen: “Even the shooting of your father was business, not personal, Sonny!”

Sonny: “Well then, business will have to suffer, all right?”

10. Sollozzo: “I don’t like violence, Tom. I’m a businessman. Blood is a big expense.” Keeping costs low is a fundamentally important business skill and is consistent with lean startup principles.  As Chamath Palihapitiya has said:

“It’s fine to fail. But if you fail because you didn’t have the courage to move to Oakland and instead you burned 30 percent of your cash on Kind bars and exposed brick walls in the office, you’re a fucking moron….The company builders are just cheap, they’re just grimy, and just, shitty office space, and they’ve got to keep it under 8 or 9% of their total burn, and they find people who really really believe in the thing they’re making, and they decide to just live in Oakland and pay for Lyft, and it’s still cheaper. They do all kinds of creative things that deserve capital so they can build. So it forces us to ask those questions, ‘How are you really company building?’ And that’s how we get the truth on who’s going to stand the test of time.” “We’re trying to coach our C.E.O.s that the window dressing is both expensive from a cash perspective and tremendously expensive from a culture perspective. It distracts the team from building what they need to build. Don’t waste money on things that get away from your mission, which confuse employees about why they’re actually there. Meaning, the quality of the office and the quality of the food are all part and parcel of a lack of discipline, which speaks to the fact that the mission isn’t compelling enough.”

Every penny not spent on achieving the objectives of the business goal is not only wasted but a potentially a contributor to a cash gap that can kill the business. The only unforgivable sin in business is to run out of cash. People who are driven to build a business (missionaries) won’t trade off things like free Kind bars if it increases the risk that they will not achieve their goals. Of course, wasting money is still stupid if a founder is more of a mercenary. As noted above, if a business spends $2,000 on an expensive office chair at seed stage, that chair becomes very expensive indeed if the business eventually has a financial exit at 100X that seed stage valuation.

11. Frankie Pentangeli: “Your father did business with Hyman Roth, he respected Hyman Roth. But he never trusted Hyman Roth!” Charlie Munger has said:

“The highest form a civilization can reach is a seamless web of deserved trust.” “The right culture, the highest and best culture, is a seamless web of deserved trust.” “Not much procedure, just totally reliable people correctly trusting one another. That’s the way an operating room works at the Mayo Clinic.” “One solution fits all is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution.”

The culture of a business is more than the sum of its parts. The totality of the vision, values, norms, systems, symbols, language, assumptions, beliefs, and habits of a business is what creates the culture of a business. Munger and Buffett are huge proponents of creating a strong organizational culture: “Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts. Cultures self-propagate.” Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior.”

12. Hyman Roth: “Good health is the most important thing. More than success, more than money, more than power.” “I’d give four million just to be able to take a piss without it hurting.” Buffett has talked about the challenges of growing older by using this joke as a set up at annual meetings: “I’m Warren, he’s Charlie. He can hear and I can see. We work well together.” Buffett also tells this story:

“I get a little worried about Charlie. I probably shouldn’t say this, but I’m worried about Charlie’s hearing. Buffett then tells about talking to a doctor about his concern. To test the extent of any potential hearing loss Buffett yells from across the room, “Charlie, what do you think about buying General Motors at $35?” Nothing. Mr. Buffett moved closer. “Charlie, what do you think about buying General Motors at $35?” Nothing. Buffett stood right next to Munger and said directly into his ear, “Charlie, what do you think about buying General Motors at $35?” Munger turned to him and said, “For the third time, I said yes.”


Don Vito Corleone: “Never get angry. Never make a threat. Reason with people.”

Don Vito Corleone: “Friendship is everything. Friendship is more than talent. It is more than the government. It is almost the equal of family.”

Don Altobello: “The richest man is the one with the most powerful friends.”

Licio Lucchesi: “Our ships must all sail in the same direction. Otherwise, who can say how long your stay with us will last. It’s not personal, it’s only business. You should know, Godfather”

Hyman Roth: Michael: “We’re bigger than U.S. Steel.”

Hyman Roth: “The $2 million you have in a bag in your room. I’m going in to take a nap. When I wake, if the money’s on the table, I’ll know I have a partner. If it isn’t, I’ll know I don’t”.

Don Vito Corleone: “Whatsa matter with you? I think your brain’s goin’ soft. Never tell anybody outside the family what you’re thinking again.”

Hyman Roth: “This is the business we’ve chosen; I didn’t ask who gave the order, because it had nothing to do with business!”

Archbishop Gilday:  “It seems in today’s world, the power to absolve debt is greater than the power of forgiveness.”

Michael Corleone: “I knew it was you, Fredo. You broke my heart.”

Michael Corleone: “Keep your friends close, but your enemies closer.”

Hyman Roth: “I loved baseball ever since Arnold Rothstien fixed the World Series in 1919.”

Michael Corleone : “Politics and crime – they’re the same thing.”

Hyman Roth: “This is the business we’ve chosen!”

Michael Corleone: “Friendship and money. Oil and water.”

Michael Corleone “I hoped we could come here and reason together. And, as a reasonable man, I’m willing to do whatever’s necessary to find a peaceful solution to these problems.”

We Have Not “Reached an Innovation Plateau”

The economist Robert Gordon is the author of a book entitled “The Rise and Fall of American Growth.” I have yet to read a review that does not like most of Gordon’s book. For example, Bill Gates writes in his review of the book “Gordon does a phenomenal job illustrating just how different life was in 1870 than it was in 1970, through both an economic analysis and engaging narrative descriptions. Most reviews have focused on the “fall” indicated in the title: the last hundred pages or so, in which Gordon predicts that the future won’t live up to the past in terms of economic growth. I strongly disagree with him on that point.” I agree with Gates’ review of the book so I won’t write my own review and will instead focus the argument made by Gordon that Gates refers to toward the end of the book. I have had a hard time writing a blog post since I want to be respectful of Gordon and his work but disagree with him on this point. I don’t recall rewriting a post as many times as I have this one. While it has not been easy to write I feel compelled to do so since I believe that failure to understand why this alleged innovation plateau may result in serious policy and other mistakes.

The strangest thing about Gordon’s assertion about an innovation plateau starting in 1971 is identified by Diane Coyle. In her review of Gordon’s book she writes: “Throughout the first two parts of the book, Gordon repeatedly explains why it is not possible to evaluate the impact of inventions through the GDP and price statistics, and therefore through the total factor productivity figures based on them.” What Coyle is pointing out is that the early pages of Gordon’s book include statements like: “This book … focuses on the aspects of improvements of human life that are missing from GDP altogether.” Despite the problems with GDP and price statistics identified on the book, Gordon uses these metrics to conclude that “there are just so many dimensions of human life where we seem to have reached a plateau in innovation.”  Gordon’s pessimism about the impact of innovation is typified by the dreary title of his paper: “US Economic Growth is Over.” When it comes to the impact of innovation on productivity and human welfare going forward, Gordon’s views on the impact of innovation make Eeyore seem positively cheerful.

Gordon relies heavily on the assertions and concepts described below in making his argument that the impact of innovation has plateaued:

“Our best measure of the pace of innovation and technical progress is total factor productivity (hereafter TFP), a measure of how quickly output is growing relative to the growth of labor and capital inputs.”

“Growth in total factor productivity (the metric that captures innovation) was much faster between 1920 and 1970 than either before 1920 or since 1970. From 1970–1994, it was only 0.57 percent a year, less than a third the 1.89 percent rate of 1920-1970. Total factor productivity growth, or TFP, was notably faster from 1994–2004 than in other post-1970 intervals, but that brief revival was an aberration: It was much shorter lived and smaller in magnitude.”


Gordon’s reliance on the TFP to reach his conclusion about the impact of innovation concept is unfortunate. Bill Gates explains the TFP concept and its problems in a way that is easy for anyone to understand:

“As Gordon acknowledges many times, we don’t have a good tool for measuring the impact of innovation on people’s lives. Like other economists, Gordon uses something called Total Factor Productivity (TFP), which is meant to capture efficiency due to innovation. TFP is based on GDP but takes into account the hours we work and the equipment we use. The truth is, while economic measurements like TFP can be useful for understanding the impact of a tractor or a refrigerator, they are much less useful for understanding the impact of Wikipedia or Airbnb. GDP may not grow as fast as it did in the past, but that alone doesn’t tell you whether people’s lives are going to get better. How do you calculate the value of millions of pages of free information at your fingertips? How do you calculate the impact of the entire hospitality industry flipped on its head?”

University of California at Berkeley economist Bradford DeLong expands on the same point made by Gates:

“Northwestern University economist Robert J. Gordon maintains that all of the true “game-changing” innovations that have fueled past economic growth – electric power, flight, modern sanitation, and so forth – have already been exhausted, and that we should not expect growth to continue indefinitely. But Gordon is almost surely wrong: game-changing inventions fundamentally transform or redefine lived experience, which means that they often fall outside the scope of conventional measurements of economic growth. If anything, we should expect to see only more game changers, given the current pace of innovation. Measures of productivity growth or technology’s added value include only market-based production and consumption. But one’s material wealth is not synonymous with one’s true wealth, which is to say, one’s freedom and ability to lead a fulfilling life. Much of our true wealth is constituted within the household, where we can combine non-market temporal, informational, and social inputs with market goods and services to accomplish various ends of our own choosing. While standard measures show productivity growth falling, all other indicators suggest that true productivity growth is leaping ahead, owing to synergies between market goods and services and emerging information and communication technologies.”–bradford-delong-2016-11

Another reason why TFP is not a good measure of the impact of innovation is that it is based on GDP which is also flawed. The Economist magazine has written a helpful survey  of the problems with the GDP concept, including (1) a bias for activities that involve manufacturing (which is declining as a share of the economy) and (2) measuring only what is bought and sold. The Economist’s survey also points out that the nature of output has rapidly changed in ways that make the GDP concept less useful:

“It is not just that many new services are now given away free; so are some that used to be paid for, such as long-distance phone calls. Some physical products have become digital services, the value of which is harder to track. It seems likely, for instance, that more recorded music is being listened to than ever before, but music-industry revenue has shrunk by a third from its peak. Consumers once bought newspapers and maps. They paid middlemen to book them holidays. Now they do much more themselves, an effort which doesn’t show up in GDP. As commerce goes online, less is spent on bricks-and-mortar shops, which again means less GDP. Just as rebuilding after an earthquake (which boosts GDP) does not make people wealthier than they were before, building fewer shops does not make them poorer.”

Making these metrics even less useful is the fact that TFP is based on other flawed assumptions, such as assuming that there are no returns to scale in an economy and that the economy reflects a state of perfect competition. The economics of software in particular are driven by returns to scale, and as the impact of software grows over time that makes TFP even more inaccurate.

You may be thinking: Gordon has written a really long book, surely it must contain data that supports his claim that the impact of innovation has plateaued. The answer to this question is: no. It is true that TFP is not climbing like it once did but as has been previously explained TFP is very flawed as a measure of innovation’s impact (as is the GDP metric it is based on). Are there easy to understand metrics that can easily replace TFP and GDP? Not really. But that does not mean making policy decisions based on TFP makes any sense. Relying on TFP to gauge the impact of innovation is like using a pickle to change a car tire. It may be fun for people with mathematical gifts to calculate TFP, but eating a pickle is also fun.

What about data to support the “innovation has not reached a plateau” story?  Well, we can look at a range of trends that show that actual human welfare based on things we can actually measure did not stop having significant impact starting in 1971. Measuring real impact is superior to a broken formulas based on fake assumptions. For example, in the real world there is the example of the falling price of solar power:



There are many other metrics as well that refute the idea that there was innovation impact plateau starting in 1971. You can see more data supporting my view at the end of this post.  The TFP formula utterly fails the “does the result map to reality” test.

Understanding why Gordon feels the way he does about the impact of innovation is put into context by looking a few of his public statements on technology and innovation:

“Everywhere I go, I see technology doing almost exactly what it was doing 10 years ago. Receptionists sitting in front of flat screens, making appointments, just identical to what was happening 10 years ago.”

“When you check out in the supermarket, you have bar-code scanning, and you have instant credit card authorization. When you get money, you get it out of the cash machine, which is a form of robot that makes it unnecessary to walk inside a bank.”

“The entire decade of the rollout of the smartphone and all the applications have not caused productivity growth to budge.”

“This book was written the old-fashioned way. It was written with stacks of books taken out of the library. The only modern invention that was involved in writing this book, besides the word processor, was Post-Its stuffed in the books to flag important passages. There was very little reliance on the Internet in the writing of the book.”

To say that I disagree with everything Gordon said above is a huge understatement. Few receptionists today just “make appointments” and many receptionist jobs have been eliminated by automation. Supermarkets use very different technology today and are far more productive that their predecessors, especially the new one created by Amazon that will have no checkers or self-serve check out process. In this Amazon store:

“you scan in with an app on your phone as you walk into the store, grab whatever you want — and leave. “Computer vision,” “deep learning algorithms” and “sensor fusion” figure out what you’ve taken and charge you for it.

Anyone who has visited a developing country knows how smartphones have boosted productivity in a huge way, let alone what they have done in the US. I use the Internet extensively for example in writing and researching and often on my smartphone. Having GPS functionality built into a supercomputer in your pocket did not exist 78 years ago when Gordon was born nor did it exist in 1971 that year Gordon says technology plateaued. I will say that there is less smartphone use and technology use in general in people above the age of 75, but that is a small slice of total users with usage that does not reflect usage of other age groups:


The absence of accurate metrics about the impact of innovation means that people are going to tell stories about that topic. Someone like Gordon who makes “good old days” statements about innovation’s impact from the past being better that inventions since 1970 is going to tell a different sort of story about the impact of technology than someone like me. The good old days crowd might make an argument like Gordon does here:

Gordon “flashes a photo of a smartphone and a toilet on a screen and asks his audience what they would do if they had only two options: Keep everything invented up until 2002, or keep everything invented up until today—but give up running water and toilets. The answer to him is obvious: Indoor plumbing changed how people live, he says, smartphones are just a handier form of what already exists.”

Gordon is telling a story based on anecdotes which reflects his view that the “Great Inventions” from the past can’t be replicated. Part of this story includes a claim that nothing happening today compares to ending diseases like polio during the pre-1971 period. My view is that this story is the result of the same “availability bias” that makes people fear shark attacks or believe that plane crashes kill more people than auto accidents. Innovation today is far more distributed and effects many more people. Thomas Edison working as a lone inventor in his lab is not how innovation happens in today’s economy. The more credible alternative story to Gordon’s is that the collective value of innovation today from technologies like falling solar prices, personal computers, mobile phones, mobile apps or modern medical advances like CRISPR are bigger not smaller than in the pre-1971 period. Cars from three different companies are driving around San Francisco without drivers right now.  You can say well that is destroying jobs. We can argue about that. But you can’t say that innovation’s impact plateaued in 1971 and at the same time say automation is increasingly eliminating jobs.  Select any one argument but not both.

When Gordon claims that what is being created as innovation today are just incremental improvements on what came before 1971, Gordon is essentially making an argument that is similar to someone arguing that electric lighting is just an improvement on a campfire or that a modern automobile is just an improvement on a horse. That human needs are often persistent does not mean that the impact of innovation plateaued starting in 1971.

A far more plausible story than Gordon’s about what happened to TFP and GDP after 1971 is: (1) the economy has shifted rapidly from manufacturing to services; and (2) more of the benefits of innovation are consumer surplus (i.e., not something producers can monetize). These two developments and others mean innovations is increasingly poorly measured in both GDP and TFP.  The fundamental nature of the output of the economy, consumption and welfare has changed and will continue to change. You may call my explanation a story too, but it is a far more plausible story than Gordon’s to anyone paying attention to the advance of technology today and the ways in which the economy is changing. Is academia struggling to increase productivity? Sure. Baumol’s cost disease is a significant problem for academia.  But just about anyone involved in business on a daily basis knows that innovation’s impact is increasing rapidly. Innovation in business today is relentless. Ask Motorola or Nortel or HTC or Blackberry.

In telling my story I’m not going to explain in detail what consumer surplus is (since most of you will stop reading) other than to say that is calculated by analyzing the difference between what consumers are willing to pay for a good or service relative to its market price. Roughly: “Total economic welfare = consumer surplus + producer surplus.” The measurement problem with consumer surplus comes from that fact that it is not possible to estimate the shape of demand for products when there is no measurable price. For example, what is the consumer surplus from WhatsApp or Wikipedia which has a price of zero? If you ask this question about WhatsApp to someone arguing that the impact of innovation has plateaued, they inevitably change the subject.

Brad DeLong describes why a software-driven economy is fundamentally different:

The key difference is between “Smithian” commodities–where it is a safe rule of thumb that the consumer surplus generated is about equal to the producer cost, so that GDP accounts that value goods and services at real producer cost will capture a more-or-less stable fraction equal to half of true standards of living–and… I might as well call them “Andreesenian” commodities, where consumer surplus is a much larger proportion of monetized value because what is monetized is merely an ancillary good or service to what actually promotes societal welfare. What is the proportion? 5-1? 10-1? Somewhere in that range, I think–at least.

DeLong wrote that pointing to an article by Tim Worstall. In that article Worstall wrote: “the gap between ‘real living standards’ and “recorded living standards” is growing simply because so much more of the value of the new technologies is not in fact monetized.” Worstall explains:

“‘consumer surplus’ is the value that we consumers derive from whatever it is over and above the price we’ve got to pay to get it. A general assumption is that we derive a consumer surplus from absolutely everything that we do buy: if we didn’t gain more value than it cost us then we wouldn’t buy it, would we? Brad Delong once pointed out (or perhaps pointed to someone who pointed out) that one way of looking at rising living standards in the 20th century was a factor of about 8. Rich world people in 2000 were 8 times better off than rich world people in 1900. Roughly true by those standard measures of GDP and so on. But if we than added what people could do, the improvements in quality, all something analagous to that consumer surplus. it might be more true to say that people were 100 times better off. That’s how I would explain (some of) that productivity puzzle. A larger than normal portion of the output of the new technologies is not monetised so we’re just not counting it as output at all.”

That the level of consumer surplus is hard to quantify does not mean that economists don’t try to do so. The economist William Nordhaus writes:

“We conclude that only a minuscule fraction of the social returns from technological advances over the 1948-2001 period was captured by producers, indicating that most of the benefits of technological change are passed on to consumers rather than captured by producers.”

Nordhaus estimates that an innovator’s ability to capture the benefits of their innovation is in the low single digits and that the benefits that consumer’s get can be 25-50 times higher than the innovator. Why? The Economist magazine explains:

“Nordhaus, an economist at Yale University, looked at two ways of measuring the price of light over the past two centuries. You could do it the way someone calculating GDP would do: by adding up the change over time in the prices of the things people bought to make light. On this basis, he reckoned, the price of light rose by a factor of between three and five between 1800 and 1992. But each innovation in lighting, from candles to tungsten light bulbs, was far more efficient than the last. If you measured the price of light in the way a cost-conscious physicist might, in cents per lumen-hour, it plummeted more than a hundredfold.”

Do I believe the calculations of Nordhaus on consumer surplus are precisely accurate, especially when he calculates a figure to the right of the decimal point? Certainly not. But I do believe Nordhaus is at least directionally correct.

Today’s technology advances are often producing efficiency improvements which in turn produce lower costs, which translates into lower spending and measured GDP even though actual GDP is higher.  For example, the percentage of firms reporting what is effectively zero inventory levels has increased to more than 20% from less than 5%. This reduction in inventory levels is unprecedented. More is being done with less and yet traditional measurements say that productivity is decreasing since less money is being spent. The key to understanding this change and how it confounds traditional approaches to measuring progress is made clear by example: If an economy doubles output, but competition halves the price, GDP is unchanged but real productivity has doubled.

Another major reason why many people underestimate the impact of innovation is that most innovation has no moat!  Many people assume that innovation always creates more producer surplus and profit. The equate the wealth of a few exceptional innovators with what is happening as a whole (availability bias). Charlie Munger describes the reality for any business person best:

“The great lesson in microeconomics is to discriminate between when technology is going to help you and when it’s going to kill you. And most people do not get this straight in their heads. There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.”

The point Munger just made so clearly is counter-intuitive for many people, but essential to understand. Moat creation is incredibly hard and rare. It is a massive mistake to confuse a moat shortage with an “impactful” innovation shortage. Some innovation does not produce any profit and in fact can destroy profit. For every firm creating disruption some other firms are being disrupted. Munger is saying that sometimes both the disrupting businesses and the disrupted businesses generate only losses from an innovation and consumers are the only beneficiaries. Moat creation is so hard that Munger and Buffett don’t even try to create moats and instead focus on buying them. Other people do try to create new moats and that is essential for the economy. Most venture capital investments fail but a few succeed spectacularly enough to make the investment system very profitable for some venture capitalists and highly beneficial for society. Lots of failure is essential for capitalism to work properly since it is experimentation based on trial and error that drives innovation.

If you are feeling confused at the state of the world as you read this in 2016 it is because your brain is operating normally. Charlie Munger makes that point below in the context of monetary policy, but he just as easily could have been referring to how technology is changing the world:

“I think something so strange and so important [as current central bank policies]  is likely to have consequences. I think it’s highly likely that the people who confidently think they know the consequences – none of whom predicted this – now they know what’s going to happen next? Again, the witch doctors. You ask me what’s going to happen? Hell, I don’t know what’s going to happen. I regard it all as very weird. If interest rates go to zero and all the governments in the world print money like crazy and prices go down – of course I’m confused. Anybody who is intelligent who is not confused doesn’t understand the situation very well. If you find it puzzling, your brain is working correctly.”

Why is the period since 1970 such a confusing time? If Gordon gets to tell a story, people like me should get to tell our story too, especially since ours is a lot more credible. My story begins when Intel began selling the 4004 semiconductor in 1971, the exact same year that Gordon claims innovation plateaued.


This semiconductor and others that followed famously caused Bill Gates to dropped out of Harvard and start Microsoft with Paul Allen. They moved to Albuquerque to write software for the Altair computer they first saw in a Popular Electronics magazine at a newsstand in Harvard Square. The price of the computer in 1975 was $397. It was primitive and lacked easy-to-use software, but even then they could see the potential for this device since they experienced how valuable having access to a computer could be. Despite their youth, especially in the context of how business was conducted at that time, Gates and Allen realized that if their business was not formed immediately they would miss the opportunity. They also realized that what the hardware enabled and where the bulk of the value would accrue was software. Gates recalls: “When we saw [the Altair], panic set in. ‘Oh no! It’s happening without us! People are going to write real software for this chip!’” Gates captured the key factor in driving the rise of software as a driver of business value many years later in a famous 1994 interview with Playboy magazine: “When you have the microprocessor doubling in power every two years, in a sense you can think of computer power as almost free. So you ask: Why be in the business of making something that’s almost free? What is the scarce resource? What is it that limits being able to get value out of that infinite computing power? Software.” He has also pointed out that “software is so inexpensive to duplicate that substituting it for costly hardware reduces system costs. At Microsoft, our only ‘hammer’ is software…. It’s all about scale economics and market share. You can afford to spend $300 million a year improving it and still sell it at a low price.” That productivity statistics started changing in 1971 the year the 4004 chips appeared is not a coincidence.

This point made by Gates is critical to understanding the unique economics of software. Also important is that the dollars spent creating the software are what an accountant calls “sunk.” Ben Thompson writes: “What makes the software market so fascinating from an economic perspective is that the marginal cost of software is $0. After all, software is simply bits on a drive, replicated at the blink of an eye. Again, it doesn’t matter how much effort was needed to create said software; that’s a sunk cost. All that matters is how much it costs to make one more copy: $0. The implication for apps is clear: any undifferentiated software product, such as your garden variety app, will inevitably be free. This is why the market for paid apps has largely evaporated. Over time substitutes have entered the market at ever lower prices, ultimately landing at their marginal cost of production: $0.” Software has unique economics since it is a public good and that creates new challenges for the economy.

All businesses and occupations are being impacted by the software revolution. The phrase “software business” is now as redundant as the term “technology business.” Every business is being impacted by technology, most importantly software. This transformation is not a completely new phenomenon, but the pace of change is. John Naughton has pointed out: “In 1999, Andy Grove, then the CEO of Intel, was widely ridiculed for declaring that ‘in five years’ time there won’t be any internet companies. All companies will be internet companies or they will be dead.’ What he meant was that anybody who aspired to be in business in 2004 would have to deal with the internet in one way or another, just as they relied on electricity. And he was right.” What is different a decade later is that the pace of change driven by this software revolution has accelerated because the change is happening on multiple dimensions that feed back on each other. As just one example, the speed at which the operations of business are moving to the cloud and the implications of that one change alone are staggering.

The 4004 chip was the first of many products sold by chipmakers that unleashed exponential change. Since few aspects of life are exponential when humans do have such an experience it almost seems like magic, especially at first. People are simply not good at understanding exponential change. Bill Gates once put it this way: “When things are improving so rapidly, how do you create a model in your head? Computers are doubling in power, relative to the price, about every 18 months. Most humans don’t have a situation where something doubles in power that fast.” Except for a virus or bacteria increasing in number inside your body, few things in a human’s life are nonlinear.

These are confusing times, but that is no reason to adopt a pessimistic outlook on the potential of innovation to create enormously beneficial impacts. There is no question that today’s economy and the technological changes that power the economy have created a significant number of new problems that we must solve. We must discover new solutions to these new problems and this will require innovations of many kinds.  Economic growth is far from “over.” The impact of innovation has not plateaued.

P.s.,  More support for my view is set out below. There are too many other example to mention here, but this is a start:





Why is Customer Acquisition Cost (CAC) like a Belly Button?

Every business owner has customer acquisition cost (CAC). And a belly button. If that business owner does not know their CAC they are essentially the equivalent of a blindfolded poker player. Every shareholder is a partial owner of the business in which they own shares. If they want to make intelligent decisions about the value of that partial ownership interest in the business, they must understand CAC.

CAC is a key element in the unit economics of a business, which can tell the owner whether the business is healthy. Unit economics are determined by understanding the direct revenues and costs associated with a business model expressed on a per unit basis.

Looking at a few CAC examples is helpful in understanding the concept. As an aside, in a subscription business CAC is often called SAC (subscriber acquisition cost), but the terms are essentially interchangeable.  Another term you may see is CPGA (cost per gross addition). None of these terms is defined under generally accepted accounting principles (GAAP)and definitions may vary from company to company and over time.  That GAAP is way behind the times on issues like defining CAC and customer churn is an understatement.

Satellite TV is a good example of a business that has high CAC. Here are some numbers for DISH:


The high CAC of DISH is only financially supportable with a multi-year contract since the potential for losing customers (churn) before that CAC is recovered exists. CAC and churn are reflexive. For example, if you require a a customer to sign a contract for months or years, CAC rises since customers must forgo opportunity to cancel if circumstances change (long term contracts requires customers to incur opportunity cost). If you do not require customers to sign and contract and they can cancel at any time CAC is lower but you risk not recovering CAC due to churn.

There are many other examples of real world CAC. For example, magazines, restaurants, credit cards, health clubs all have well-known CAC. People have created many entire new products to deal with the impact of CAC and churn over the years. As another example, prepaid cellular was created to lower CAC and to deal with the fact that many people can’t pass a credit check.

Buying keywords is another way to incur CAC.  A sample calculation is:

“Assume a cost “per click of 50 cents, and the resulting website visitors converting to a trial at the rate of 5%. Those trials are then shown converting to paid customers at the rate of 10%. What the sheet shows is that each customer is costing you $100 in just lead generation expense. For many consumer facing web sites, it can be hard to get the consumer to pay more than $100 for the service. And this cost does not factor in the marketing staff, web site costs, etc.”

If 10% of leads turn into a sale, CAC is at least $1,000 since there will be other expenses.

Someone may say about the concepts discussed in this post: “This is too complex. I don’t like math.” If that is the case, it is wise to buy a diversified portfolio of low cost index funds.  Investing requires some math. The good news is that it is not complex math. Operating a business also requires math, but in both cases no more than high school algebra is required.

Is there any way to reduce CAC?  Yes. Some people spend their entire working lives trying to make this happen. One way to lower CAC is to have people spread the word via viral invitations sent by existing customers. This can happen, but it takes an existing customers to get a new customer by word of mouth. Something must kick start the process. The other way to reduce CAC is via cross selling or selling new services or products to existing customers. It is easier and less expensive to sell to customers who are already using your products than to sell something to a completely new customer. Wells Fargo recently took this approach cross selling way too far and created some serious problems as a result. Another way to reduce CAC is to use the “freemium” business model, which is about getting people to use products or services and then trying to create a upsell opportunity.

Companies do not generally like reporting CAC or SAC for reasons that will be explained below. As an example, Netflix no longer reports SAC, but when it did:


Another example of SAC is the mobile phone business. The pink line shows the SAC for a mobile business expressed in Euros in this case (contract not prepaidcustomer):


Bill Gurley has an excellent explanation of how CAC can be used in a lifetime value model, with emphasis on how it can be misused. When looking at LTV is is wise to remember that all models are wrong, but some models are useful. The LTV model must be used carefully and is only as good as the assumptions in the model. Gutley writes:

“Lifetime value is the net present value of the profit stream of a customer. This concept, which appears on the surface to be quite benign, is typically used to compare the costs of acquiring a customer (often referred to as SAC, which stands for Subscriber Acquisition Costs) with the discounted positive cash flows that will come from that customer over time. As long as the sum of the discounted future cash flows are significantly higher than the SAC, then people will argue it is warranted to “push the accelerator,” which typically means burning capital by aggressively spending on marketing.

This is a simplified version of the formula:


The key statistics are as follows:

  • ARPU (average revenue per user)
  • Avg. Cust. Lifetime, n (This is the inverse of the churn, n=1/[annual churn])
  • WACC (weighted average cost of capital)
  • Costs (annual costs to support the user in a given period)
  • SAC (subscriber acquisition costs, sometimes referred to as CAC)

The LTV formula, when used correctly, can be a good tactical tool for monitoring and comparing like-minded variable market programs, especially across channels. But like any model, its proper use is entirely dependent on the assumptions used in that model.

Something unprecedented is impacting all business models right now and it is causing people a great deal of confusion and angst. Central bank policies have taken the cost of capital (WACC) down to levels we have never seen before at a time that is technologically unlike any we have ever seen before. When WACC falls precipitously and platform businesses see the opportunity to generate network effects and critical mass they can get very aggressive on customer acquisition spending since the tape measure grand slam home run potential of doing so has never been higher. Bill Gurley noted this past week that this phenomenon has resulted in: “a massive increase in speculative behavior. If you can make low prob/high outcome bets with OPP [other people’s property], why not?” Understanding why this is happening is made clearer when you consider Warren Buffett’s suggested formula: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.” Wagers in platform businesses are being made at a time when outcomes are highly convex (massive upside potential and limited downside potential). Magnitude not frequency of success matters. Some people are swinging for the fences right now given the low cost of capital and the magnitude of a potential win. If your competitor does this you need to decide whether you play the game that is on the field. Or not.

CAC is a particularly important part of a lifetime value computation for a business since it is paid up front and that means cash going out the door in month one of the customer relationship.  David Skok explains the cash flow issue here:

“To illustrate the problem, we built a simple Excel model which can be found here.  In that model, we are spending $6,000 to acquire the customer, and billing them at the rate of $500 per month. Take a look at these two graphs from that model:



To compute its CAC a business takes its entire cost of sales and marketing over a given period, including salaries and other headcount related expenses and divides it by the number of customers acquired during that period. If a business spent a total of $1,000 on sales and marketing in a month and acquired 100 customers in the same month CAC is $10.00. This calculation of CAC is done on a “gross” customer acquisition basis since customers lost during the period (churn) is considered separately in the LTV formula.

In calculating CAC, everything that is a cost of customer acquisition must be considered or CAC is not fully loaded. Some costs that go into CAC are more obvious like any wages and commissions paid related to marketing and sales, the cost of all marketing and sales software and additional related professional services. Other elements in CAC are more subtle and sometimes hidden.

“The following list includes time and/or other items that you may be ignoring as part of your acquisition costs:

  • The time you spend on getting people onto your sales pipeline – typically may become the job of a sales person down the road
  • The time you spend on Social Media outreach
  • The time you spend Networking at Events
  • The time you spend converting a customer from warm to paying – typically may become the job of a sales person down the road
  • The time you spend on support or install calls to help a customer roll out the product within their network – might become the job of a sales engineer down the road
  • Integration work to include your product into their system or data flow – might become the job of a consultant, or sales engineer down the road
  • Supplier calls or deals (with minimums to help provide you with the necessary inventory to sell onto your new customers.
  • Sales Channel calls or deals – do you need to spend time setting these up or actually even splitting revenues? “

Other additions to CAC may look like cost of goods sold or COGS but are actually a part of CAC. The amount a company pays for a retail store lease near a popular street location is in part CAC. The cost of “loss leader” goods and services offered to potential and actual customers is also part of CAC. “Free” X for customers as a loss leader may look like COGS but it is CAC. In some situations the loss leader business model is called freemium. Sometimes the product or service is actually free and sometimes it is offered at a subsidized price. In other words, sometimes COGS is disguised CAC.

This analysis of Amazon Prime by Cowen is a good example of an all in LTV calculation that includes SAC of $312 and a lifetime value of $2,960:


Sometimes you will hear someone say: “I don’t spend anything on marketing. It’s all word of mouth.” The reality is that word of mouth does not happen by accident and inevitably a lot of time and energy was expended to create viral customer acquisition. Creating product virality requires work and most always some money.

Sometimes you will also hear people talk about what Sam Altman talks about below:

“There are now more businesses than I ever remember before that struggle to explain how their unit economics are ever going to make sense.  It usually requires an explanation on the order of infinite retention (“yes, our sales and marketing costs are really high and our annual profit margins per user are thin, but we’re going to keep the customer forever”), a massive reduction in costs (“we’re going to replace all our human labor with robots”), a claim that eventually the company can stop buying users (“we acquire users for more than they’re worth for now just to get the flywheel spinning”), or something even less plausible. Most great companies historically have had good unit economics soon after they began monetizing, even if the company as a whole lost money for a long period of time. Silicon Valley has always been willing to invest in money-losing companies that may eventually make lots of money.  That’s great.  I have never seen Silicon Valley so willing to invest in companies that have well-understood financials showing they will probably always lose money.  Low-margin businesses have never been more fashionable here than they are right now. Burn rates by themselves are not scary.  Burn rates are scary when you scale the business up and the model doesn’t look any better.  Burn rates are also scary when runway is short (i.e., burning $2M a month with $100M in the bank is fine; burning $1M a month with $3M in the bank is really bad) even if the unit economics look great.”

Recently we have seen a number of writers talk about businesses “losing money” based on information that sources have given them from an income statement. This is not surprising since many growing business may be incurring a loss on their income statement because CAC happens in month one. That loss may be acceptable if the acquisition of the revenue from the customer creates value. Or not. Without more data than just the income statement you just don’t know.Would you accept a $40 cash outflow in month one if a credit worthy customer agreed to pay you $10 a month for a year? If you had enough cash that return is attractive over the long term.

One key to wise growth is making sure what Warren Buffett wrote in his 1992 letter is true:

“Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous… Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value.  In the case of a low-return business requiring incremental funds, growth hurts the investor. In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here:  The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds.  Even so, there is an important, and difficult to deal with, difference between the two:  A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.”  Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended.  In contrast, the ability of management can dramatically affect the equity “coupons.”

Rules of thumb have emerged regarding the “right” level of CAC in relation to LTV.  David Skok lays out the current conventional wisdom:


“Over the last two years, I have had the chance to validate these guidelines with many SaaS businesses, and it turns out that these early guesses have held up well. The best SaaS businesses have a LTV to CAC ratio that is higher than 3, sometimes as high as 7 or 8. And many of the best SaaS businesses are able to recover their CAC in 5-7 months. However many healthy SaaS businesses don’t meet the guidelines in the early days, but can see how they can improve the business over time to get there. The second guideline (Months to Recover CAC)  is all about time to profitability and cash flow. Larger businesses, such as wireless carriers and credit card companies, can afford to have a longer time to recover CAC, as they have access to tons of cheap capital. Startups, on the other hand, typically find that capital is expensive in the early days.  However even if capital is cheap, it turns out that Months to recover CAC is a very good predictor of how well a SaaS business will perform. Take a look at the graph below, which comes from the same model used earlier. It shows how the profitability is anemic if the time to recover CAC extends beyond 12 months. I should stress that these are only guidelines, there are always situations where it makes sense to break them.”

People often under-rate the importance of great distribution and specifically organic customer acquisition. It is often the case that CAC early in the life of a business is very high and that it can trend down over time if the right approaches are taken. Sirius Satellite radio is an example of a business that has seen its CAC drop significantly over time from very painful levels. Founders of startups often make wild claims about their ability to reduce CAC. Marc Andreessen said once: “Many entrepreneurs who build great products simply don’t have a good distribution strategy. Even worse is when they insist that they don’t need one, or call no distribution strategy a ‘viral marketing strategy’ … a16z is a sucker for people who have sales and marketing figured out.”  Just hoping that an offering will go viral is not going to lead a company to success since something going viral is rarely an accident.  Acquiring customers cost effectively is the essence of business.  Almost always the best way to acquire customers cost effectively is with an organic customer acquisition strategy.  In contrast, formulating a strategy based on buying advertising is unlikely to be successful. 

The final point related to the inherently connected nature of CAC. Bill Gurley helped me improve my metaphor when he wrote this:

“Tren Griffin, a close friend that has worked for both Craig McCaw and Bill Gates refers to the five variables of the LTV formula as the five horsemen. What he envisions is that a rope connects them all, and they are all facing different directions. When one horse pulls one way, it makes it more difficult for the other horse to go his direction. Tren’s view is that the variables of the LTV formula are interdependent not independent, and are an overly simplified abstraction of reality. If you try to raise ARPU (price) you will naturally increase churn. If you try to grow faster by spending more on marketing, your SAC will rise (assuming a finite amount of opportunities to buy customers, which is true). Churn may rise also, as a more aggressive program will likely capture customers of a lower quality. As another example, if you beef up customer service to improve churn, you directly impact future costs, and therefore deteriorate the potential cash flow contribution. Ironically, many company presentations show all metrics improving as you head into the future. This is unlikely to play out in reality.”

It is always wise to be be careful out there in running or owning a stake in a business since CAC can be a stone cold killer.


Bill Gurley on LTV:

David Skok:

Sam Altman on Unit Economics:

Buffett 1992 letter:

Recode quoting Cowen on Amazon Prime:

Seed Camp:

A Dozen Things I’ve Learned About Negotiation

Once upon a time I wrote a book on negotiation with my friend Russell Daggatt. The book is mostly a collection of real stories about our experiences working and living abroad. I lived in Seoul for four years and for a year in Sydney. Russell lived in Tokyo.  The book was published by Harper Collins, but few years after the paperback was on the market we bought back the copyright. It is available to read for free on my web site If you want a paper copy of The Global Negotiator, try Amazon.

1. Establish Trust



2. Do Research about the other Negotiator


3. Be Creative:


4. Be Humble About Your Skill Level


5. Some Days are better Than Others



6. Get the Other side to Make the First Offer



7. Build relationships. Don’t do Deals.


8. Keep the Relationship Mutually Beneficial by Sharing value


9. Counter Gamesmanship


10. Focus on Interests, Not Positions



11. Create and Claim value


12. Know Yourself and the Other Negotiator


A Dozen Things Warren Buffett and Charlie Munger Learned From See’s Candies

This is my 200th blog post. I thought it would be most fitting given the milestone to write about a topic related to Munger and Buffett.

One of the most important decisions in the history of Berkshire was the acquisition of See’s Candies in 1972. Buffett has called See’s Candies “the prototype of a dream business.”  Berkshire’s purchase of a boxed candy business founded by the See family in California fundamentally changed the investing world because it changed the way Buffett and Munger thought about investing. While you may never have the chance to own a business like See’s Candies, by better understanding the nature of a dream business you can more easily find a business to invest in that shares some of its positive attributes.

For anyone not familiar with the company, Bloomberg provides a helpful summary: “See’s Candies produces and retails boxed chocolates. The company was founded in 1921 and has store locations in the United States and internationally. See’s Candies operates as a subsidiary of Berkshire Hathaway.”

1. Buffett: “It’s one thing to own stock in a Coca-Cola or something, but when you’re actually in the business of making determinations about opening stores and pricing decisions, you learn from it. We have made a lot more money out of See’s than shows from the earnings of See’s, just by the fact that it’s educated me.” “If we hadn’t bought See’s, we wouldn’t have bought Coke. So thank See’s for the $12 billion. We had the luck to buy the whole business and that taught us a whole lot.” Munger: “We’ve learned that the ways you think and operate must involve time-tested values. Those lessons have made us buy more wisely elsewhere and make many decisions a lot better. So we’ve gained enormously from our relationship with See’s.”

What Buffett is saying is that the more you know about business the better investor you will be (and vice versa). The best way to learn about business is to actually run one or at least work in one. As Will Rogers once said: “Good judgment comes from experience, and a lot of that comes from bad judgment.” It is the feedback loop between success and failure and various decisions and actions that are part of operating a business that gives the business executive or investor the best education. Reading about X, Y or Z aspects of business is helpful but there is nothing quite like the education that comes from being in the driver’s seat and having personal responsibility for actual business outcomes.

2. Munger: “If we’d stayed with the classic Graham, the way Ben Graham did it, we would never have had the record we have. And that’s because Graham wasn’t trying to do what we did.” “See’s was the first high-quality business we ever bought.” “After nearly making a terrible mistake not buying See’s, we’ve made this mistake many times. We are apparently slow learners.” “If See’s had asked $100,000 more, Warren and I would have walked — that’s how dumb we were. [Munger’s friend] Ira Marshall said you guys are crazy — there are some things you should pay up for, like quality businesses and people. You are underestimating quality. We listened to the criticism and changed our mind. This is a good lesson for anyone: the ability to take criticism constructively and learn from it. If you take the indirect lessons we learned from See’s, you could say Berkshire was built on constructive criticism.” “The main contribution of [buying See’s Candies] was ignorance removal. If we weren’t good at removing ignorance, we’d be nothing today. We were pretty damn stupid when we bought See’s – just a little less stupid enough to buy it. The best things about Berkshire is that we have removed a lot of ignorance. The nice thing is we still have a lot more ignorance left. Another trick is scrambling out of your mistakes, which is enormously useful. We have a sure to fail department store. A trading stamp business sure to fold and a textile mill. Out of that comes Berkshire. Think about how we would have done if we had a better start.” “See’s Candies was acquired at a premium over book (value) and it worked. Hochschild, Kohn, the department store chain (in Baltimore), was bought at a discount from book and liquidating value. It didn’t work. Those two things together helped shift our thinking to the idea of paying higher prices for better businesses.”

What Munger is talking about above (in addition to the importance of humility) is the idea that a business with superior quality bought at the right price can still be a bargain consistent with the principles of value investing. This evolution of the value investing system to consider quality in valuing a business is arguably Munger’s greatest contribution to Berkshire. Munger knew that value investing had to evolve since the “cigar butt” types of businesses that Graham liked to buy started to disappear as years passed since the Great Depression. Munger recognized that “Grahamites … realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses.” For Munger, not considering the quality of the underlying business when buying an asset is far too limiting:  “The investment game always involves considering both quality and price, and the trick is to get more quality than you pay for in price. It’s just that simple.” “We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.” “If you can buy the best companies, over time the pricing takes care of itself.”

3. Buffett: “Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars. Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.”

How do Munger and Buffett assess quality? This passage from the 1992 Berkshire Chairman’s letter set out the key test: “Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.”  A recent presentation from Broyhill Asset Management points out:

“See’s sold 16 million pounds of candy in 1972. In 2007, it sold 31 million pounds.  That’s a growth rate of about 2% annually.  Yet the business created tremendous value. How? Because it generated high returns on invested capital and required little incremental investment.  Growth creates value only when a business can invest at incremental returns higher than its cost of capital. The higher return a business can earn on its capital, the more cash it can produce, the more Value is created.  Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.”

4. Munger: “There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies. At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have.” Buffett: “We bought See’s Candy in 1972, See’s Candy was then selling 16 million pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine.”

Buffett believes: “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” Buffett and Munger found an asset in the form of See’s that has retained tremendous pricing power over the years. That means See’s has a moat. It is not an unlimited moat geographically as will be discussed below, but where the moat exists it is very strong.

5. Buffett: “Buy commodities, sell brands has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891. On a smaller scale, we have enjoyed good fortune with this approach at See’s Candy since we purchased it 40 years ago.”  “When we bought See’s Candies, we didn’t know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.” “Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of chocolates by the time we get through with them on our radio ads. So that Valentine’s Day is the biggest day. Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, ‘Honey, this year I took the low bid.’ And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent.” “What we did know was that they had share of mind in California. There was something special. Every person in California has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine‘s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn‘t take any capital. And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas.

The See’s acquisition taught Munger and Buffet about the power of a brand to create a moat. Munger has pointed out:

“The informational advantage of brands is hard to beat.  And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is $.40 and the other is $.30, am I going to take something I don’t know and put it in my mouth – which is a pretty personal place, after all – for a lousy dime? So, in effect, Wrigley, simply by being so well-known, has advantages of scale – what you might call an informational advantage. Everyone is influenced by what others do and approve.  Another advantage of scale comes from psychology. The psychologists use the term ‘social proof’. We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step. Again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, ‘Gee, I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?’ All told, your advantages can add up to one tough moat.”

One question relevant right now is whether the power of national brands versus local brands is decreasing due to transparency created by the Internet. In any event, over the years the power of a brand when combined with commodity inputs has created a powerful combination. “In 1972, See’s sold 16 million pounds of candy, and 35 years later, it stood at 32 million, meaning it gained just 2% a year, but it’s profit rose by 9% a year”:




Source: Motley Fool Berkshire Hathaway Annual Letters.

6. Buffett: “The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.” “You cannot destroy the brand of See’s Candies. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don’t see See’s candy sponsoring the local funeral home. We are at the Thanksgiving Day Parades though.” “In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor. In fact, we believe most lovers of chocolate prefer it to candy costing two or three times as much. (In candy, as in stocks, price and value can differ; price is what you give, value is what you get.)”

If you grew up in a home that bought See’s Candies (mostly on the West Coast, especially in California) and your experiences around that candy have very favorable associations, you will pay more for a box bearing the See’s Candies brand. By contrast, someone who grew up in the east cost of the United States will not attribute as much value to that brand since they do not have those same experiences. For this reason, See’s Candies has found it hard to expand regionally and has done so very slowly. What See’s Candies sells is not just food, but rather an experience that is usually offered in the form of a gift.” A perceptive writer in an Israeli newspaper points out:

“Warren suggests getting your brand into the “gift market” because people don’t give second-class gifts. If you price your new whiskey brand at 5 percent less than the leading brand, you’ll have a hard time gaining customers. “The higher-priced one is both better known and more expensive,” reasons the customer. “Why get something inferior just to save a few dollars?” This is especially true when the product will be a gift; no one wants to be seen as second class. The new whiskey would actually market itself more successfully in Grey Goose style: as a premium brand with a matching package that helps the potential buyer overcome much of his hesitancy. “Even though I’ve never had it before, it looks elegant and costs just a bit more than the brand I was planning to buy. It makes an impressive-looking gift that my host would enjoy. I’ll give it a try,” the thinking goes.”

That See’s Candies sells boxed candy mostly bought as gifts is a fundamental way that is business differs from other businesses that sell something that people eat. Buffet points out:

“Most people do not buy boxed chocolate to consume themselves, they buy them as gifts—somebody’s birthday or more likely it is a holiday.  Valentine’s Day is the single biggest day of the year.  Christmas is the biggest season by far.  Women buy for Christmas and they plan ahead and buy over a two or three week period.   Men buy on Valentine’s Day.  They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of Chocolates by the time we get through with them on our radio ads.  So that Valentine’s Day is the biggest day. Can you imagine going home on Valentine’s Day—our See’s Candies is now $11 a pound thanks to my brilliance.  And let’s say there is candy available at $6 a pound.  Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candies over the years—and say, “Honey, this year I took the low bid.” And hand her a box of candy.  It just isn’t going to work.   So in a sense, there is untapped pricing power—it is not price dependent.

If you are See’s Candies, you want to do everything in the world to make sure that the experience basically of giving that gift leads to a favorable reaction.  It means what is in the box, it means the person who sells it to you, because all of our business is done when we are terribly busy. People come in during those weeks before Christmas, Valentine’s Day and there are long lines.  So at five o’clock in the afternoon some woman is selling someone the last box candy and that person has been waiting in line for maybe 20 or 30 customers.  And if the salesperson smiles at that last customer, our moat has widened and if she snarls at ‘em, our moat has narrowed. We can’t see it, but it is going on every day.  But it is the key to it. It is the total part of the product delivery.  It is having everything associated with it say, See’s Candies and something pleasant happening.   That is what business is all about.” 

7. Buffett: “The ideal business is one that takes no capital, and yet grows. And there are a few businesses like that, and we own some.” Buffett [in 2007]: “Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip).”  “We’ve tried 50 different ways to put money into See’s. If we knew a way to put additional money into See’s and produce returns a quarter of what we’re getting out of the existing business, we would do it in a second. We love it. We play around with different ideas, but we don’t know how to do it.” Munger: “By the way, we really shouldn’t complain about this because we’ve carefully selected a bunch of businesses that just drown in money every year.”

Some businesses just can’t profitably put more cash or capital to work even though their underlying business at its existing scale is sound. This is why Buffet insists that all cash is allocated by him to the highest and best use within Berkshire. This avoids what Buffett calls the “institutional imperative” about which Buffett writes:

“Rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”

8. Buffett: “After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to ‘be fruitful and multiply’ is one we take seriously at Berkshire.)” 

When a given Berkshire portfolio company (for example, See’s Candies) generates cash, that cash is rarely invested in more See’s Candies stores, manufacturing plants or acquisitions since the return on capital would be lower than other alternatives within Berkshire. Because of Berkshire’s corporate structure, Buffett is able to move that cash from See’s Candies to the greatest opportunity on a tax efficient basis (without paying the tax that would be imposed if See’s Candies paid a dividend or See’s shares were sold and the money the reinvested). Buffett elaborates: “because we still have this ability to redistribute money in a tax-efficient way within the company, we can reallocate it to where it will earn a higher return than shareholders may on their own.” Sometimes the best way to appreciate a business like see’s is to contrast it with the opposite example, as Munger does here: “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.”

9. Munger: “It takes almost no capital to open a new See’s candy store. We’re drowning in capital of our own that has almost no cost. It would be crazy to franchise stores like some capital-starved pancake house. We like owning our own stores as a matter of quality control.”

Wesley Gray and Tobias Carlisle write in their book Quantitative Value:  Finding a genuine franchise is as worthwhile as it is difficult. As the See’s Candies example demonstrates, franchises are valuable because they can pay out capital to owners without affecting their ability to grow, or they can compound the capita; of the business by reinvesting it year after year. Sustainable, high return business like See’s Candies are forgiving investments. They throw off a great deal of capital every year.” Munger believes: “There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash — and I don’t want to go back.”

10. Buffett: “We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.”

Charlie Munger is also not a fan of consultants. He is famous for saying: “I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: ‘What this situation really needs is more management consulting.’ Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires one.” Munger has offended just about everyone at some point so consultants are part of a large club. Having said that, cold calling Buffett or Munger in an attempt to sell them consulting services is unwise.

11. Munger: “Some great businesses have very volatile returns – for example, See’s usually loses money in two quarters of each year – and some terrible businesses can have steady results.” Buffett: ‘Our company song is: ―What a friend we have in Jesus.”

If you are willing to buy a business that has volatile profits from quarter you may find the purchase price to be a bargain since others may be frightened by what they deem as “risk.” Munger has said this is a considerable willingness to accept volatile results from quarter to quarter is a considerable advantage in investing.

12.  Munger: “We wrote a one-page deal with Chuck Huggins when we bought See’s and it’s never been touched. We have never hired a compensation consultant.” “I’d rather throw a viper down my shirt front than hire a compensation consultant.”

The most important task in capital allocation for Buffett and Munger is to take cash generated by a company like See’s Candies and deploy it to the very best opportunity at Berkshire. Buffett’s view on the importance of capital allocation easily stated:

“Charles T. Munger, Berkshire Hathaway’s vice-chairman, and I really have only two jobs… One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.”

Occasionally Munger and Buffett find a person on who has such superior talent that they really don’t need much of a moat. This situation is rare, but it does happen.

“Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t. I would argue that Simon Marks – who was second generation in Marks & Spencer of England – was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man. These people do come along – and in many cases, they’re not all that hard to identity. If they’ve got a reasonable hand – with the fanaticism and intelligence and so on that these people generally bring to the party – then management can matter much. However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.”

Sometimes you have both a moat and a great manager, and as Mae West once said: “Too much of a good thing can be wonderful.”

Finally, here is Janet Lowe quoting Munger talking about See’s in her book Damn Right (the best step-by-step account of the See’s acquisition is in Lowe’s book). She quotes Munger talking at a See’s company event as follows:



The Investments blog:

Don’t Confuse Cheap with Value:

The Secrets of See’s Candies:

Warren Buffett Bought This Company for $25M: 

Warren Buffett basks in sweet success of See’s Candies, Bank of America deals:

Here’s why Buffett and Munger love companies like See’s Candies:

Greg Speicher:

Hurricane Capital:

Buffett at the University of Florida:

CS Investing:

Tips from a Billionaire

Quantitative Value, Wesley R. Gray, Tobias E. Carlisle

Damn Right, Janet Lowe

Why Moats are Essential for Profitability (Restaurant Edition)


Investing is about owning a partial stake in a real business. You must understand whether the actual businesses in which you own stock earns a return on capital to be a successful investor. The more different types of businesses you understand in this way, the more skill you will acquire in understanding another new business. The point I am making explains why Warren Buffett says: “I am a better investor because I am a businessman, and a better businessman because I am an investor.”  The reason why Charlie Munger has what Buffett calls “the best 30 second mind in business” is in no small part because of the many different types of businesses he has examined as potential investments. In contrast, most people spend more time selecting a refrigerator than they do selecting a business to invest in. When you buy a stock without digging in and understanding that business deeply, the odds that you have made a mistake go up significantly. Investing is so competitive that you simply can’t afford to give way that competitive edge and succeed as an active investor.

Buffett explains why some businesses are profitable and not others:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Why do only some businesses have pricing power? Charlie Munger describes the answer succinctly: “We have to have a business with some inherent characteristics that give it a durable competitive advantage.” Buffett puts it this way: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

I’ve been thinking about what might be the best example to use to try to explain the nature of the work an investor must do to determine whether a business might have a moat protecting an attractive business. The example must be narrow since people will read only so much in a blog post. Since just about everyone reading this post has at least thought about opening a restaurant at some time in their life I have created this hypothetical scenario: Two of your friends have asked you to invest in their restaurant. How should you analyze this request? What factors might create a moat for an individual restaurant? To find the answer to this question Warren Buffett recently said that when you are thinking about buying stock in a company or making an investment you should: “assign yourself a story.” Your task in doing the research is to assemble the relevant facts, talk to experts and create a model of the microeconomics of the business. Please note that this is not a post about investing in a chain of restaurants like McDonalds to keep the discussion simple.

People can and do start with as little as a food cart and from that small beginning build a successful restaurant with hard work and some luck. This aspect of the restaurant business is both good and bad. It is good since it presents a way for people with little capital to get a financial start in life. It is unfortunately also bad since there are few barriers to entering the restaurant business, which limits profitability.

Here are some illustrative facts about competition levels in the restaurant business:

In spring 2016, there were 624,301 restaurants in the US.

Between 2006 and the industry’s peak in 2014, the number of restaurants in the U.S. grew 7.3% to more than 638,000—outpacing the population 6.9% growth rate.

“New York, New Jersey, and Connecticut — have more restaurants than anywhere else in the United States; 16.9 restaurants per 10k people.  In 2013 there were 232,611 establishments in the U.S. fast food industry.



The primary reason why restaurants fail so often and have low profitability is that there are too many of them. This is true in any business. Supply is the killer of value. Adding to that oversupply problem are people who stray out of their circle of competence, since risk comes from not knowing what you are doing. Even worse, some people are in the restaurant business for non-economic reasons and that makes the economics worse for people who desire to make an actual profit. A famous Ohio State study revealed that 26.16%  of independent restaurants failed during the first year of operation. That is consistent with other studies that show:  “Over three years, that number [of failures] rises to three in five. While a 60% failure rate may still sound high, that’s on par with the cross-industry average for new businesses, according to statistics from the Small Business Administration and the Bureau of Labor Statistics.”

What is overall demand for restaurants? This brings up the top-down constraint on revenue that is caused by disposable income limits: people have only so much money to spend.

William Wheaton, a professor at MIT has identified: “an incredible regularity in what they spend on eating out: $1,200 to $1,400 per person” on average annually.  Americans tend to visit restaurants of any type, from fast food to fine dining, about 190 times a year according to NPD’s food service division. In the past 10 years, older millennials have made 50 fewer restaurant visits per capita, according to NPD.

The other factor that can adversely impact a restaurant’s profits are alternative sources of supply (like buying groceries and eating at home).  The total number of supermarkets in the United States amounted to 37,716 in 2014. What about profit of that restaurant substitute? “Grocery is among the thinnest margins out there in retail. The average grocer probably gets a 2-3% operating margin. That’s a very slim margin, and that’s before interest and taxes.”

You will sometimes hear people say that that restaurant profits are down because food costs are up. Food costs rising are not a good thing for a restaurant. When food cost go up it does suppress overall demand due to limits on what people can spend. And customers  who see higher restaurant prices will tend to seek out alternative sources of supply like buying groceries and cooking at home. But the most fundamental problem with restaurant profitability is a lack of pricing power because there are too many restaurants.

What about the flip side, when something happens like food costs dropping? Food costs going down are only an opportunity for a restaurant if competitors don’t lower their prices. Competition tends to cause the restaurants to either cut prices or use more expensive ingredients, which takes costs higher again. Competition between restaurants will tend to cause retail prices to drop to a point where there is no long term industry profit greater than the cost of capital, despite the drop in wholesale food costs. This is not just true in the restaurant business and applies to any business.

What are the economics of a full service restaurant? Well, they typically they look like this:

   San Francisco restaurants

Cost of food – 24%

Cost of alcohol sold – 5%

Wages and salaries – 32%

Employee benefit – 7%

Restaurant occupancy costs – 10%

Other – 15%

Pretax profit – 2.5%

  U.S. restaurants

Cost of food – 27%

Cost of alcohol sold – 7%

Wages and salaries – 31%

Employee benefits – 4%

Restaurant occupancy costs – 6%

Other – 19%

Pretax profit – 6%

Does 2% or even 6% pretax profit sound like a significant moat to you?

Of course, there are many types of restaurants. A food truck is not fine dining and the actual microeconomics of each business type will vary, but here is another example of the full service category from California:

“The 220-seat restaurant serves about 1,300 to 1,400 diners a week, with an average per-person check of about $40. After adding in revenues from private parties and people who just have drinks in the bar, it had 2003 sales of $3.2 million and is on track to do $4 million this year, said Chief Executive Officer Bruce McDonald.  Foreign Cinema is cash-flow positive, but it won’t realize a genuine profit for at least five years, because it carries $2 million in debt. Its earnings before interest, depreciation and amortization were $86,000 last year. With higher sales and a tight grip on operating expenses this year, they may hit $400,000, McDonald said. “[The chefs] start out most days seeking out what’s fresh and inspirational at Monterey Market, a produce dealer blocks from their Berkeley home. They spend more than $1,000 a week there. Their food and beverage costs average about $21,000 a week, or 30 percent of their weekly revenue of $70,000. That lines up closely with other full-service restaurants, which follow a remarkably similar economic formula.  Of every dollar a full-service restaurant brings in, it spends roughly a third on food and alcohol; another third on salaries, wages and benefits; up to 10 cents on rent; and up to 20 cents on other costs such as marketing, according to studies by restaurant associations. That leaves about 4 cents of pretax profit.” As with all restaurants, alcohol is far more profitable than food. “We pay $25 for a bottle of booze and sell it for $100,” McDonald said. (Beer and wine have slightly lower markups.) “Many people who start out in the restaurant business end up owning bars or in real estate.”

Here’s the situation in New York:

As the chef David Chang howled earlier this year, “Food’s too cheap, tipping makes no sense, cooks are broke, and it’s damn near impossible to earn a living in this effed-up business.”) Second, that three dollars or so in operating income isn’t even really profits. Operating income is needed to pay back the costs to build out the restaurant. Paying those costs was supposed to take about three years in the case of our restaurant. (It never happened.) Only after that come profits. The harsh bottom line: three per cent operating income isn’t that short of the definition of success in New York City restaurants of five to ten per cent operating income, depending on whom you ask. And even that piddling percentage, achieved by few restaurants, is under assault from all sides. There are rising New York rents: if our restaurant’s rent, which was twenty thousand dollars per month for about twelve hundred square feet, had consumed only ten per cent of revenue—a restaurant’s target, per the conventional wisdom—its operating income would have tripled.

There are restaurateurs who claim they are more profitable, but restaurant people I know roll their eyes when they hear a claim of 20% profit like this:

“The key to success in the business, Mr. Bastianich says, is a basic understanding of restaurant math—and “restaurant math is easy.” Appetizers cost only a small part of what customers are charged; desserts are almost pure profit. Linen is enemy No. 1 because buying and cleaning tablecloths and napkins is expensive and customers don’t pay for it, just as they don’t foot any of the bill for bread and butter. “Übermeats” such as dry-aged steaks (“the King Lear of menu items”) and veal chops are the bane of every restaurant because the initial food cost is high. As for wine, when sold by the glass the price is usually four times the actual cost, although at Babbo, the author says, the price of a small carafe called a quartino is sometimes only double.” “For Babbo, a “nice little $2.5- or $3-million-a-year operation,” the annual net is at least a half-million dollars. Not bad for a casual Italian restaurant in Greenwich Village.”

Babbo has the Mario Batali brand, but this claim of 20% profit is not normal. It helps (and can even be essential) to own the building as I explained in my post on “wholesale transfer pricing.”

The owners of Wild Ginger started their wonderful restaurant in a rented space on Western Avenue in Seattle.  The restaurant  was a huge success.  When lease renewal time came up for Wild Ginger the landlord wanted a massive rent increase. The ability of the landlord to demand that increase is wholesale pricing power.  It was not absolute, but wholesale transfer pricing power in that case was significant. The owners of Wild Ginger had a lot of brand and other value tied up in that location. The rent increase request was so big that the Wild Ginger owners brought in  up investors and bought their new building in a new location and did the huge investment required to refurbish it.  The restaurant owners had to completely change their business model by bringing in the outside money from investors.  The owners of Wild Ginger are is now in the restaurant business and the real estate business. The whole thing was kicked off by the wholesale providing power of the original landlord.   Another restaurant moved into the old Wild Ginger space on Western Avenue and went bust, probably because the rent was too high compared to the many other restaurants in Seattle. Now that restaurant space on Western Avenue sits empty. As yet another example, Anthony Bourdain in his former TV show “No Reservations” did a profile of old school restaurants in one episode on “Lost Manhattan” and pointed out that the old school restaurants that are left own their own buildings.  They are able to stay “old school” in the restaurant business only because they are their own landlords.  If they had just been tenants, they would have been priced out of business in Manhattan long ago.

In a recent Bloomberg podcast a restaurant owner said: “the lease is everything in our business.” His approach to the wholesale transfer pricing problem by having the landlord be his partner. The restaurateur said “the golden number is rent at 8% of revenue but he said achieving that is usually impossible in a place like Manhattan. One side note is important to consider here: sometimes building owners will give a restaurant with a strong brand below market rent to entice other tenants to lease space in their building. If your competitors have this lower rent and you do not, that is a problem for your business. You are not Mario Batali.

Avoid rents by having a food truck you say? Here is an accounts of food truck economics:

“These numbers do not paint a pretty picture—nor do they support the notion that there’s a ton of savings to be passed on to the consumer because they operate out of a truck. Essentially, after you sink 50-100 grand into your truck/kitchen/home, you now work 10-plus hour days and hope to hell that you can turn 150 covers in 3 hours or less of service. You read that right—150 covers in 180 minutes, or 1.2 covers per minute every day for 250 days a year. If you’re lucky enough to average that level of business every day of the year (including those dreary days in winter), then you may just walk home with enough profit to pay yourself minimum wage. All three food-truck owners agreed that most of the successful trucks are also doing catering. Edison pointed out that some owners have evolved their businesses into brick-and-mortar spaces due to the profit constraints presented by the truck model. “There’s not a single truck from the ‘old guard’ that hasn’t expanded to brick-and-mortar. Why? If we could sit back and retire on a single truck, we’d roll with that. But it’s just not possible. It’s a pretty honest way to make a dollar—but nobody’s getting rich off a single truck.”

Here’s Anthony Bourdain talking with Thrillist about the current state of the fine-dining business:

“It’s more and more difficult to even run a fine-dining restaurant. The profit margins are not getting bigger; they will probably get smaller. That space, that part of the market, will probably continue to shrink. As it is now, most restaurant people cannot afford to eat in their own restaurants.”

This short essay on restaurant economics is intended to be illustrative of the sort of research that must be done when investing in any stock. It is only a start of the actual research that should be done in any given case. As you can probably tell, I think investing in a restaurant opened by two friends belongs in the “too hard” pile at the very least. In short, there are far more attractive opportunities. Charlie Munger says it best: “Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other. And that’s the way we filter out buying opportunities”

I’m going to stop writing now since this post is up to ~3,500 words and research tells me that most people have stopped reading already. What you see above in terms of research is only the beginning of the sort of work that a person should do before buying a share of a business or investing in a business. Risk comes from “not knowing what you are doing” says Buffett. Researching the business before you buy a stock lowers risk. If you don’t want to or can’t do the research on the businesses in which you buy stock you should instead buy a low cost diversified portfolio of index funds. The choice is that simple. There is no shame in saying: “researching a business bores me.” But it is a shame if people buy individual stocks anyway.

P.s., Understanding the previous discussion of the restaurant microeconomics depends on the reader understanding these points which I raised in my post on Michael Porter (his quotes are in bold and mine are in plain text as is usual):

“If there are no barriers to entry… you won’t be very profitable.” If there is no impediment to new supply of what you sell competition among suppliers will cause price to drop to a point where there is no long term industry profit greater than the cost of capital.  Michael Porter calls a company’s barriers to entry a “sustainable competitive advantage.” Warren Buffett calls it a “moat.”  The two terms are essentially identical.  The principle is so simple and yet so many people think only about customers and not competitors as well.  Yes, innovate and deliver exceptional value for customers.  No, that is not necessarily enough for sustainable profitability. “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.”  If you deliver the same product or service as your competitor you by definition don’t have a moat.  Competition will in that case be based on price and price-based competition inevitably degrades to a point where profit disappears. Porter teaches: “if customers have all the power, and if rivalry is based on price… you won’t be very profitable.”  He adds: “Produc[ing] the highest-quality products at the lowest cost or consolidate[ing] their industry [is] trying to improve on best practices. That’s not a strategy.”

The five primary factors which can help create a moat, either alone or in combination with other factors, are as follows:

  1. Supply-Side Economies of Scale and Scope;
  2. Demand-side Economies of Scale (Network Effects);
  3. Brand;
  4. Regulation; and
  5. Patents and Intellectual Property.

When might a restaurant be deemed to have moat? The test is always quantitative: does the restaurant generate a return on investment that is significantly above the opportunity cost of capital and does that last for a significant number of years? If a restaurant meets that mathematical test, it has a moat even if precisely what created the moat is not clear. The task at that point is to determine what factor or factors created the moat so they can be reinforced by the owner of the business. Sometime a bit of research will reveal clues. For example, chain restaurants can create distribution networks and systems that take advantage of supply side economies of scale. Their moat is similar to a business like Costco in that way. Other factors can create moats and sometime it is the combination of factors that produces the barrier to entry. Sometimes a famous chef’s brand acquired from television appearances can help create a moat. Sometimes a location can be helpful as can longevity (the comfort food effect) and historical significance.

P.s., This is a fun chart below explaining aspects of a how different restaurant items bring in different profits. As I said above I know people who think his view on profit levels is not realistic. “Shrinkage” is a problem for many restaurants. I find this story told by Joe Bastianich humorous: “At 11 he was washing dishes. One of his jobs was to salt the wine. ‘If I didn’t put two tablespoons of salt into every gallon of cooking wine, everyone in the kitchen would be completely s—faced.’”



A Dozen Things You can Learn from Biggie Smalls (The Notorious B.I.G.) About Business

During a recent lunch meeting with a few friends I used the phrase “mo money, mo problems.” One of my friends responded by challenging me to do a Dozen Things post on Biggie Smalls similar to the one I wrote on Rza. My response to the throw down is the blog post for this week. I have made the point repeatedly on this blog that you can learn something from just about anyone. I have written posts on Bill MurrayLouis CK and comedians generally to make this same point. The other point relevant to this post is to not take yourself too seriously. Having fun is under-rated.

1.“If y’all love the music, y’all gonna buy the music.” In my post on Jessica Livingston I quoted her as saying: “Our motto is to make something that people want. If you create something and no one uses it, you’re dead. Nothing else you do is going to matter if people don’t like your product.” Biggie is making the same point as Livingston. The importance of making products people want to buy seems obvious. Unfortunately, too often people get wrapped up in other aspects of startups and can lose track of that basic truth. A founder who is focused on making products people want to buy will succeed far more often than founders who are mostly concerned with things like getting prime speaking slots at major industry conferences or having a hip office with exposed brick walls and water views.

2.“Only make moves when your heart’s in it.”    My blog post last week was about how important it is for the founder of a business to be a missionary rather than a mercenary. Biggie believed that a great business founder or performer needs heart, which includes attributes like passion, determination and grit. Missionaries are far more likely to succeed in business than mercenaries since they have the qualities it takes to overcome hard problems. People with a mission in life “passionately persevere” in the face of adversity when a mercenary would bail out to do something else.

3.“Stay far from timid … and live the phrase the sky’s the limit.”   My interpretation of Biggie’s statement is that he was stressing the importance of making convex bets in life and in business. What you ideally want when making a wager are bets with a big upside and a small downside (convexity). When you find a mispriced convex bet, Biggie’s advice is to “be far from timid.” My post on Nassim Taleb discussed Biggie’s point on mispriced convex wagers more extensively.

4.“Never let them know your next move.” Biggie in this quote is making a point similar to Doug Leone: “Little companies have really two advantages: stealth and speed. The best thing for little companies do is to stay away from the cocktail circuit.” This piece of advice is a bit tricky and controversial since there is another view that it is wise to get feed back early and often. My view is that one can seek early product feedback and yet still follow Biggie’s admonition that there is no need to reveal your next move.

5.“I learn from the other people’s mistakes. I know when to say no.” Biggie’s view here is aligned with the view of Charlie Munger that the best way to learn not to do something that is the equivalent of peeing on an electric fence is to watch other people do it and learn vicariously. In short, it is wise to learn from other people’s mistakes! Like Charlie Munger, Biggie put a lot of effort into when to say “no.” Putting significant resources into a few mispriced bets is a far better approach to business and investing than saying “yes” to too many things. Be patient, but aggressive when it is time.

6.“I’m living every day like a hustle.”  Biggie knew that there is no substitute for hard work and hustle. Other successful people invariably think the same way not matter what career they have chosen. Writers, for example. need to hustle too. Anais Nin put it this way: “Good things happen to those who hustle.” Stephen King has similarly expressed his view that: “Talent is cheaper than table salt. What separates the talented individual from the successful one is a lot of hard work.” Biggie himself once said:“I can’t never stop nobody, can’t knock nobody hustle. They feel like they can come into it dissing Big and dissing Puff and doing they little thing. If that’s what they choose to do, that’s what they choose to do. Only thing I gotta do is feed [my daughter] Tianna and take care of Ms. Wallace. That’s my only job.”

7.“Your style is played out, Like Arnold and that, what you talkin’ bout Willis.” Biggie is referring to the need for genuine 0 to 1 innovation, which I discussed in my post on Peter Thiel who believes: “Maybe we focus so much on going from 1 to n because that’s easier to do. There’s little doubt that going from 0 to 1 is qualitatively different, and almost always harder, than copying something n times.”  In other words, a person or business should avoid just repeating what others have done if they want to produce a substantial and valuable innovation. The cultural reference in the Biggie quote is to a Garry Coleman (AKA Arnold) tagline from the TV show Different Strokes that repeated itself perhaps a bit too often.

8.“Watchin’ the stash grow, clockin the cash flow.”  Biggie knew that the only unforgivable sin in business is to run out of cash.  Biggie once quoted the sage Rza on this point: “Cash Rules Everything Around Me.” Cash can provide its holder with significant optionality. It is likely that Biggie had similar beliefs to Warren Buffett on cash:

“Ms. Schroeder argues that to Mr. Buffett, cash is not just an asset class that is returning next to nothing. It is a call option that can be priced. When he thinks that option is cheap, relative to the ability of cash to buy assets, he is willing to put up with super-low interest rates, said Ms. Schroeder, who followed Mr. Buffett for years before she became his biographer. “He thinks of cash differently than conventional investors,” Ms. Schroeder says. “This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”

9.”That goddamn credit? Dead it.”   Biggie, like many other great investors and business people, was not a fan of debt. Charlie Munger has a view that is similar to Biggie’s: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.”

10. “Never let no one know how much dough you hold.”   Biggie was pointing out that certain metrics do not need to be made publicly available if you are a private business. This is one of the advantages of not going public.

11. “Never get high on your own supply.”   I prefer to think of this statement as an admonition from Biggie that people should be more humble so they avoid mistakes. Of course, what this advice actually represents is Biggie warning people about the dangers of consuming the inventory of your own business.  Either way, the advice is sound.

12. “Consignment is not for freshmen.” “If you ain’t got the clientele say ‘hell no’ — ’cause they gon want they money rain, sleet, hail, snow.”   Biggie is saying that there are dangers associated with taking on a lot of inventory risk, especially from suppliers who have not yet been paid. If a business ends up with products on a shelf that it can’t sell, the suppliers will want to be paid. Biggie knew that business is business. You must get the basics right to be successful. Managing inventory risk is a core skill in many businesses. You never want to get into a situation where someone says, “Leave the gun. Take the cannoli.”


A Half Dozen Reasons Why Venture Capitalists Prefer Missionaries to Mercenaries


1.Mark Cuban: “Don’t start a company unless it’s an obsession and something you love. If you have an exit strategy, it’s not an obsession.”

No one should start a business if they are not obsessively committed to the mission of that business. Genuine obsession and passion are highly valuable since making the business a success will require overcoming significant obstacles. My most interesting experience with being obsessively committed to the mission of a business started in 1994. It was the most intense five years of my professional life. The business was a global broadband non geostationary satellite system known as Teledesic. My obsession with making that startup a success consumed me. My family and health all paid a serious price for this obsession. As much as I loved that business, by 1999 I knew that it was time to move on and do other things. It wasn’t easy to cut the cord, but it was necessary. Teledesic was valued at $3 billion in its last round of funding and we raised close to $1 billion in capital. The story of Teledesic has never properly been told and perhaps it is my responsibility to do so one day.  Until I write that book, you can read the blog post I have written about my experience at Teledesic that is part of this “Dozen Things” series if you are interested.

Missionary joke #1: Two cannibals met each other on a path in the jungle one day. The first cannibal said: “I just can’t seem to prepare a tender Missionary. I’ve baked ’em, I’ve roasted ’em, I’ve stewed ’em, I’ve barbequed ’em, I’ve even tried every sort of marinade. I just cannot seem to get them tender.” The second cannibal asked, “What kind of Missionary do you use?” The first cannibal replied, “You know, the ones that hang out at that place at the bend of the river. They wear brown cloaks with a rope around their waist ” “Ah ha!” the second cannibal replied. “No wonder. Those Missionaries are friars!”

2. John Doerr:  “Mercenaries are driven by paranoia; missionaries are driven by passion. Mercenaries think opportunistically; missionaries think strategically. Mercenaries go for the sprint; missionaries go for the marathon. Mercenaries focus on their competitors and financial statements; missionaries focus on their customers and value statements. Mercenaries are bosses of wolf packs; missionaries are mentors or coaches of teams. Mercenaries worry about entitlements; missionaries are obsessed with making a contribution. Mercenaries are motivated by the lust for making money; missionaries, while recognizing the importance of money, are fundamentally driven by the desire to make meaning.”

A venture capitalist I know recalls Doerr using the “missionary versus mercenary” metaphor as early as 1998 at a Stewart Alsop Agenda conference. Doerr has repeated this idea often over the years and it has essentially become a meme in the venture capital industry.  In short, mercenaries are motivated primarily by money. Missionaries are driven by a cause. Elon Musk is a classic missionary as was Steve Jobs. My advice is: don’t start a business because you want to have it on your resume or because you think it is glamorous. And don’t do so to fill a bucket list unless you feel the obsessive passion Cuban and Doerr are talking about. Here’s the slide Doerr uses when talking about this concept:


Doerr’s list is largely self explanatory. There are a couple of YouTube videos of him making his case about missionaries cited in the notes below. In one video Doerr refers people to a book by Randy Komisar entitled: “The Monk and the Riddle: The Art of Creating a Life While Making a Living” for further inspiration on this topic.

Missionary joke #2: A missionary was walking in Africa when he heard the unmistakable sound of a pride of lions behind him. He immediately started praying: “Oh Lord, please make these lions into good Christians.”  The Missionary thought his prayer was being answered when heard the lions also start to pray. But then he heard the lions say in unison: “Bless us oh Lord, for this thy food, which we are about to consume…”

3. Andy Rachleff:  “Mercenaries, whose primary goal is money, fall somewhere on the middle of the entrepreneur bell curve. They seldom have the desire to change the world that is required for a really big outcome, or the patience to see their idea through. I don’t begrudge them their early payouts. They’re just not the best entrepreneurs.”

Missionaries are far more likely to work to keep their business independent – which is more likely to produce “tape measure financial home runs.” They think bigger in terms of what the business can accomplish. Missionaries with huge ambition for their business are rarer than most people imagine. Mark Zuckerberg is a classic example of a missionary:

“At the time, Facebook was just two years old. It was a college site with roughly eight or nine million people on it. And, though it was making $30 million in revenue, it was not profitable. “And we received an acquisition offer from Yahoo for $1 billion,” Thiel said. The three-person Facebook board at the time–Zuckerberg, Thiel, and venture capitalist Jim Breyer–met on a Monday morning. “Both Breyer and myself on balance thought we probably should take the money,” recalled Thiel. “But Zuckerberg started the meeting like, ‘This is kind of a formality, just a quick board meeting, it shouldn’t take more than 10 minutes. We’re obviously not going to sell here’.” At the time, Zuckerberg was 22 years old. Thiel said he remembered saying, “We should probably talk about this. A billion dollars is a lot of money.” They hashed out the conversation. Thiel said he and Breyer pointed out: “You own 25 percent. There’s so much you could do with the money.” Thiel recalled Zuckerberg said, in a nutshell: “I don’t know what I could do with the money. I’d just start another social networking site. I kind of like the one I already have.”

Founders who “flip the business” early or even in midstream usually don’t last long enough to do this. Rachleff is pointing out that mercenaries don’t always fail, but also that success is less frequent and payoffs are smaller on a relative basis for mercenaries.

Some cities have more missionaries than others. Seattle is a great example of a city with a mostly missionary culture. People in Seattle create businesses and they grow them passionately. The best examples are Bill Gates, Jeff Bezos and Howard Schultz.  This creates lasting businesses and healthy job growth. Other cities have a mostly a mercenary culture- the founders grab any early money that becomes available and move on.

Missionary joke #3: One day the African chief’s wife gave birth to a white child and the chief was stunned. He suspected some hanky panky and went to visit a white Missionary who lived nearly. “You have been having sex with my wife,” the chief said to the Missionary. The Missionary tried to escape from the difficult situation by explaining Mendel’s laws of genetics to the angry chief. “You see that herd of sheep,” he said pointing to the chief’s herd, “Most of them are white; but you will also notice two black lambs among them.” “OK! OK!” said the chief. “You keep your mouth shut, and so will I.”

4. Jim Goetz: “I am looking for unknowns, who are passionate and mission-based.” “We try hard to make that unknown underdog comfortable in our ecosystem.”

As an example of what Goetz is talking about here, he said once about WhatsApp: “It was mission-based and very different than what everyone else was doing at the time.”  Goetz calls the WhatsApp founders “talented underdogs whose unshakeable beliefs and maverick natures epitomize the spirit of Silicon Valley.” Passion is something you can’t fake. Making a better auto insurance product is a passion for some people, but it may not be for you. What’s your passion?  Sometimes I will meet a founder who has created a startup to do X and it is clear that he or she does not particularly like X, let alone has passion for it.  When I ask why he or she started that business the story is usually that they wanted to create a startup. While that may be true in some cases it sometimes seems clear that the founder is instead overwhelmingly motivated by a desire to be wealthy. The irony is that the more you are focused on a mission rather that money the higher the odds that you will become financially successful. The other point made by Goetz above relates to how underdogs have a particularity strong form of motivation that can be very helpful in creating a successful startup. People with something to prove often have a stronger motivation to succeed.

Missionary joke #4: A man became separated from his group of explorers and found himself lost in the desert. Fortunately he eventually encountered the home of a Missionary. Tired and weak, he crawled up to the house and collapsed on the doorstep. The Missionary found him and nursed him back to health. Feeling better, the man asked the Missionary for directions to the nearest town and if he could borrow his horse. The Missionary said, “Sure but there is a special thing about this horse. You have to say ‘Thank God’ to make it go and ‘Amen’ to make it stop.” Not paying much attention, the man said, “Sure, ok.” So he mounted the horse and said, “Thank God” and the horse started walking. Then he said, “Thank God, thank God,” and the horse started trotting. Feeling really brave, the man said, “Thank God, thank God, thank God, thank God, thank God” and the horse just took off. Pretty soon the man saw that the path lead to a cliff and he started doing everything he could to make the horse stop, yelling:  “Whoa, stop, hold on!” Finally the man remembered, “Amen!” The horse stopped just four inches from the edge of the cliff. The man then leaned back in the saddle and said, “Thank God.”

5. Dan Levitan: “We can find a great sector or business, but we’re investing so early that unless there’s this tenacious grit, determination, resourcefulness, ability to evolve, it won’t work.”

Levitan is pointing out a key aspect of early stage investing: it is called an early stage business because it is an early stage business. Many unknowns will be encountered along the path of any business and a team with the qualities Levitan describes is far more likely to find success than a team who is just in it for the money. People with grit determination, resourcefulness, ability to evolve don’t give up easily. Ev Williams story is a classic example of how things can evolve in very different ways and how grit is critical to success. This is from a Harvard Business School case from 2008:

“The Blogger experiences had included a major blow-up with his co-founder that had resulted in legal proceedings, a brush with near-bankruptcy, and the laying off of his entire team, Williams has become even more disillusioned with his current venture, Odeo.  Odeo, a podcasting pioneer, had debuted almost two years before and had gotten off to a very strong start, with a high-profile debut at a prominent industry conference, coverage on the front page of the New York Times’ Business section, and the raising of a large round of financing from a top-tier venture capital firm. His attempts to find an acquirer have failed, layoffs have begun, and he is now facing a meeting with an increasingly hostile board of directors. At that meeting, he is very tempted to resign so he can move on to his next project and regain the thrill of being an entrepreneur.”

Odeo would evolve to become Twitter.

“One day in September 2006, Odeo’s CEO Evan Williams wrote a letter to Odeo’s investors. In it, Williams told them that the company was going nowhere, that he felt bad about that, and that he would like to buy back their shares so they wouldn’t take a loss. In his letter to Odeo’s investors, Williams wrote this about Twitter:

By the way, Twitter, which you may have read about, is one of the pieces of value that I see in Odeo, but it’s much too early to tell what’s there. Almost two months after launch, Twitter has less than 5,000 registered users. I will continue to invest in Twitter, but it’s hard to say it justifies the venture investment Odeo certainly holds — especially since that investment was for a different market altogether.

Evan proposed buying back Odeo investors’ stock, and, eventually, the investors agreed to the buyback. So Evan bought the company — and Twitter. The amount he paid has never been reported. Multiple investors, who had combined to put $5 million into Odeo, say Evan made them whole.”

Missionary joke #5:  “A Missionary travelled to what he thought was an totally uninhabited island. He discovered that there were indeed people there, but the inhabitants of the island knew nothing of Western culture. The missionary decided that it would be in the locals best interest if he could teach them about civilization. He created small schools in huts and taught the natives how to read and write and do mathematics. Part of his teaching was to take the locals one by one around the island, and teach them the correct English words for objects that they would see. One day, the Missionary was walking around the island with one of the locals. When they walked past a tree, the Missionary pointed and said: “Tree”.  The local would repeat, “Tree”. They continued further and saw a bush. The Missionary pointed to it and said, “Bush”. The native repeated the word, “Bush”. They walked around the bush – and lying on the ground behind it, were two locals making  whoopi. The Missionary hoped that the local would not ask about it, but he did: “What is that? What are they doing?” Missionary replied, “Riding a bicycle. Those two people are riding a bicycle!” The man pulled out his poison dart gun and killed the couple. The Missionary was incredulous. Angered, he yelled: “Why did you kill those two people? I told you that they were riding a bicycle! “The local answered, “He was riding MY bicycle!”

6. Jessica Livingston:  “Resilience keeps you from being pushed backwards. Drive moves you forwards.”

Livingston is pointing to one of the qualities discussed on sectin 5 as being particularly important. Dr. Angela Duckworth defines “grit” as “perseverance and passion for long-term goals.” As an example, some people I know describe Uber’s Travis Kalanick as being off the charts on grit. Steve Jobs said once: “I’m convinced that about half of what separates the successful entrepreneurs from the non-successful ones is pure perseverance…. Unless you have a lot of passion about this, you’re not going to survive. You’re going to give it up. So you’ve got to have an idea, or a problem or a wrong that you want to right that you’re passionate about; otherwise, you’re not going to have the perseverance to stick it through.”

Missionary joke #6: A cannibal was walking through the jungle and discovered a new restaurant operated by a fellow cannibal. Feeling somewhat hungry, he sat down and looked over the menu. Broiled Missionary: $25.00 Fried Explorer: $35.00 Baked Politician: $100.00. The cannibal called the waiter over and asked: “Why such a big price difference for the politician?” The waiter replied “Have you ever tried to clean one of them?”


John Doerr Video

John Doerr Video

John Doerr Video

The Monk and the Riddle

Dan Levitan 25IQ 

Jim Goetz 25IQ

Andy Rachleff 25IQ

Elon Musk 25IQ

John Doerr 25IQ 

Fred Smith:

HBR case study: