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New Investor Mandate: Profits Over Discounts

The discounts and freebies many tech startups have used to lure customers—free lunch delivery, $3 beauty products and bargain taxi rides—have fallen out of favor with investors who are losing patience with the failure of these companies to turn a profit. New Investor Mandate: Profits Over Discounts

Uber, DoorDash and others are urged to focus more on making money than luring customers.

The proliferation of subsidized products and services from venture-capital-backed startups over the past decade reflected a rush by investors to fund the next behemoth consumer-tech company. The thesis: Create a market leader with loyal customers hooked by attractive deals delivered at the touch of a smartphone app. Once the company got big enough, profits would flow and the subsidies could end.

Startup investors are re-evaluating that approach. Following a year of dismal performances from companies that were heavily subsidized by venture capital, investors and board members are pressuring companies to figure out a more profitable business model, tech deal makers and startup founders say.

Investors want startups to become less dependent on using raised capital to cover the cost of customer discounts, such as e-commerce startup Brandless Inc. selling home and beauty products for a fraction of the cost of shipping them, ride-hailing companies Uber Technologies Inc. and Lyft Inc. discounting the cost of their rides, and meal-delivery service Postmates Inc. offering coupons for $100 off delivery fees.

“The subsidy bubble for raising new money is over,’’ said Wesley Chan, managing director at Felicis Ventures. “What you are seeing is a realization that subsidies often lead to disaster for startups that rely on them.”

Meal-delivery service DoorDash, Uber, Lyft and We Co., the parent of the office-renting company WeWork, this year will lose well over $13 billion combined. All became top industry players after raising billions of dollars from investors who subsidized the companies’ costs, but none is profitable.

“You can manufacture growth, and you can’t manufacture profit,” said Ryan Kulp, who formerly worked in venture capital and now runs a marketing startup, Fomo.

Battle For Market Share

Many companies in the transportation and delivery sectors used billions of dollars in venture capital to subsidize their businesses. They now face pressure to prove their business model is profitable and can survive without the help of outside investment.

San Francisco-based DoorDash raised in the past two years nearly $2 billion, cash it used to grow to more than 4,000 markets this year from 600 markets in 2018, said a person familiar with the matter. About three-quarters of its markets aren’t profitable, the person said.

DoorDash leads the U.S. meal-delivery market with a 37% market share, the data firm Second Measure said. DoorDash provides free delivery to a low- single-digit percentage of its orders, the person said, and its restaurant partners cover part or most of the losses from other freebies.

The growth in markets came despite encouragement from some board members to focus on turning a profit from each customer, according to another person familiar with the matter. DoorDash is projected to lose about $450 million this year, before factoring in certain expenses, that person said. In a 2015 presentation to investors reviewed by The Wall Street Journal, the company projected that it would have gross annual profits of $450 million at the end of 2018.

“Four years ago—more than half of our life as a company—we had approximately 100 employees and were operating in fewer than five states,” a company spokesperson said. “Since then, we’ve helped hundreds of thousands of merchants reach millions of customers.”

DoorDash plans to have an initial public offering in 2020, according to people familiar with the company’s IPO plans. The public markets have been less than friendly to some of its peers, including Grubhub Inc., whose stock price is down about 30% from a year ago. President and Chief Financial Officer Adam DeWitt blames the rampant subsidies by competitors that “appear explicitly and implicitly all over the place” and have pushed Grubhub to adopt less-profitable strategies, such as partnerships with restaurants that don’t pay to be on the Grubhub app.

“At the end of the day, the diner is seeing a price that is not sustainable,” Mr. DeWitt said of his competitors.

The delivery service Postmates Inc. has filed for an IPO that was expected in the first half of this year, but it has delayed those plans amid a price war with competitors.

The majority of Postmates’ deliveries are profitable, the result of having more restaurants pay a commission to use its service, according to the company. Those fees often cover the cost of the delivery driver and allow Postmates to keep customer delivery fees as low as 99 cents, the company said.

Share Now, a car service, announced this month that it would shut down its operations in the U.S. and some European cities in February, ending 30-cent-per-minute car rentals in those markets. Share Now will focus on those European markets where it sees the best potential for profitable growth, said Michael Kuhn, a senior manager at Daimler Mobility AG. Daimler AG and BMW AG are co-owners of Share Now.

This fall the car-subscription app Fair increased the down payment on its leases to a few thousand dollars from a couple of hundred dollars after the company, according to former employees, overpaid for cars and then leased them out at a discount.

Fair was able to offer customers such deals thanks to investors including SoftBank Group Corp. , which led a more than $380 million funding round in late 2018, most of which Fair spent in less than a year, according to former employees.

A Fair spokesperson said the company is purposely discouraging customers with high prices as it restructures its business to find a more profitable model. It expects to relaunch its leasing program with lower down-payment prices early next year.

Even with more investor scrutiny, subsidies aren’t going away. The venture-capital industry has a record amount of money to invest, and with interest rates staying historically low, many investors will be attracted to private tech companies even when they rely on private funding to pay their bills and dole out big discounts.

Investors had been eager to subsidize companies because of what Prof. Emeritus Brad Cornell of the University of California, Los Angeles, and New York University Prof. Aswath Damodaran refer to in an unpublished paper as “the big market delusion.”

Uber’s chief executive, Dara Khosrowshahi, has publicly compared the company with Inc., saying it will be the go-to provider of all forms of transportation. Lyft’s president, John Zimmer, has said publicly his company would take majority U.S. market share by creating a transportation “superapp.”

In its IPO filings, Uber described its market opportunity as $6 trillion—the mileage value of all personal cars and public transportation services globally. WeWork touted a $3 trillion market opportunity. DoorDash, in its 2015 investor presentation, gave its total addressable market as $275 billion, an estimate of the U.S. restaurant takeout industry.

But such market estimates don’t account for regulatory backlash and competitors’ offering nearly identical products. Another problem: Adding more customers to an already-unprofitable business model doesn’t mean profit suddenly appears.

“You can theoretically have an infinite number of customers and never, ever be profitable,” said Daniel McCarthy, assistant professor of marketing at Emory University and co-founder of the research firm Theta Equity Partners.

Uber is a decade-old company, but in each of the first three quarters this year it spent more on excess driver incentives—where the cost of promotions to attract a driver is greater than revenue from the ride—than it did the year prior. However, the company is starting to clamp down on those costs.

Uber and Lyft have said they would become profitable in 2021 before factoring in interest, taxes, depreciation and amortization. The companies have for about the past year shown quarter-over-quarter improvements in how much money they make per ride sold. While both companies have called for more-rational pricing in the industry, they have been slow to raise prices and eliminate coupons.

“As the subsidy bubble pops, prices start to go up,” said Jawad Mian, who writes Stray Reflections, an investment publication for hedge funds and asset managers. “A lot of these companies are not going to be able to achieve their milestones necessary for the next round of funding at a higher valuation.”

Brandless, a San Francisco-based online shopping startup backed by nearly $300 million in venture capital, offers everything from organic coconut oil to dinner plates and lavender hand soap for $4 or less apiece. A Brandless spokesman said the company is moving to higher-margin products, such as a $180 blender, and over the summer suspended its spending on marketing. Its sales volume as of August had fallen by about half from a year earlier.

“Just because people can afford it doesn’t mean people will pay it,” Mr. Kulp of Fomo said.


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