Why So Many Ventures Never Become Profitable and Keep Drowning?
Some businesses seem doomed from the start. You don’t need to wait a decade to see if a business will succeed. Just by looking at its cost structure, you can tell that no matter how big the business gets or how hard it tries to cut costs, it’s never going to turn a profit. This is a fundamental problem baked into the business design from the very beginning.
So, what’s my advice? If you’re not in this kind of business, stay away! And if you are? Well, I have two words for you: loss cut. Sometimes, the best thing you can do is recognize when it’s time to move on.
A Real-World Example: The Fall of 2U
Let’s look at a real example to understand what kind of business is doomed from the start. Have you heard of 2U? It was an American company that partnered with universities to offer online graduate degrees. Think online MBA courses with actual degrees from prestigious schools like Harvard.
Here’s how it worked: 2U would charge around $100,000 for a two-year MBA course. They’d keep about 50% as their fee, and the other 50% would go to the university. Sounds like a good deal, right? $50,000 per student should be enough to make a profit, shouldn’t it?
Well, on July 25, 2024, 2U filed for Chapter 11 bankruptcy protection. So what went wrong?
The Cost Structure Trap
The problem was simple but deadly: 2U’s costs always exceeded its sales. Even as 2U grew, their cost rate stubbornly hovered around 110% of sales. In other words, for every $100 they made, they spent $110. You don’t need to be a math whiz to see the problem here.
The answer lies in the nature of 2U’s costs. Almost all of their expenses were variable costs. These are costs that change in proportion to sales volume. Think of it like selling soda on the street: if you buy a can for 50 cents and sell it for a dollar, your costs go up with each sale.
Now, most companies have a mix of variable costs and fixed costs. Fixed costs stay the same regardless of sales volume, like rent for a shop. Whether you sell 100 sodas or 1,000, the rent doesn’t change.
But 2U’s main business activities – acquiring students through sales and marketing, and then supporting those students – were almost entirely variable costs. They spent money on ads, salaries for salespeople, and support staff. All of these costs scaled up as the business grew.
Advertising costs vary based on the method used. Direct response ads are usually variable costs that closely relate to sales volume. For example, if 100 ads lead to 200 sales, 200 ads might result in 400 sales. TV ads, however, often represent fixed costs. More ads don’t always lead to a proportional increase in sales and their impact is less predictable.
Salaries can be either fixed or variable costs, depending on the business model. In service industries, salaries are often variable costs that increase with workload. If an employee serves 100 customers, they’re paid for 100 units of work. If they serve 200, they’re paid for 200 units.
In contrast, some businesses have employees design products for a fixed salary, which customers consume over time. Here, the salary is a fixed cost. Even if sales double, the salary stays the same.
The High Cost of Student Acquisition
Here’s a shocking number: 2U’s sales and marketing costs were always more than 50% of revenue. That’s incredibly high! But it makes sense when you consider how competitive the online graduate school market is. After all, who wouldn’t want to start a business where you can earn $50,000 just by enrolling a student?
The result? 2U’s cost rate was always more than 110% of sales, and this rate never really changed because the major costs were variable. They increased in lock-step with sales. This meant the company was always making a loss.
The One-Time Customer Problem
But wait, it gets worse. The fundamental characteristic of 2U’s business model was that they couldn’t get repeat customers. Once a student gets their degree, that’s it. They’re not likely to come back for another one. It’s a one-time sale, and then bye-bye.
This means the high cost of acquiring students never goes down. In businesses where customers make repeat purchases, the cost of acquisition can be spread out over multiple sales. But aiming at degree-seeking students is a one-shot deal.
Could This Business Ever Work?
When a company has high sales and marketing costs, there are usually a few ways to try to fix things:
- Increase sales price
2U’s online MBA was already expensive, costing over $100,000. Some real-world MBA programs are actually cheaper! - Reduce sales and marketing costs
Cutting sales and marketing costs would likely just reduce the number of students they could enroll. - Increase spending per customer
This is where things get interesting. There are three common strategies:- Cross-selling: This is like when McDonald’s offers fries and a drink with your burger. 2U could have explored offering recruiting services targeting graduates with master’s and doctorate degrees, earning fees from employers hiring new talent. However, this would have required expertise they lacked, and many online graduates struggle to land top-tier jobs. Source. If there’s limited demand for online degree holders, it would be difficult to earn fees from employers.
- Repeat selling: Not really an option. Most people don’t pursue multiple MBAs or switch fields, like going from business to medical school.
- Upselling: This involves starting with cheaper products and then offering more expensive ones to the same customers. 2U actually tried this strategy in its final years.
The EdX Gamble
In a last-ditch effort to turn things around, 2U bought EdX, a free online course provider, for $800 million in late 2021. EdX had a staggering 80 million users who were paying nothing because it was a non-profit organization.
2U’s plan was to grow these free learners into paid short course customers, then boot camp students, and finally degree program students. It seemed like a smart move. They could potentially reduce marketing costs significantly by tapping into this huge pool of 80 million users.
But it turned out to be a total failure. Those free users didn’t contribute to 2U’s revenue at all. Why? Because the motivations of free course takers and degree students are very different. It’s like growing oranges and expecting apples—the Motivation Mismatch.
Degree students typically want high-income jobs. Short course learners, on the other hand, often want something very different. Many short-course users are already working or in school, aiming to enhance their skills for efficiency. They don’t need another degree.
Maybe some users of free or cheap courses want a degree, but finding them is like looking for potential degree students in a random supermarket crowd—it’s no targeted pool. If someone really wants a great job, they’re more likely to go for university internships or recruitment agencies, not free online courses.
This upselling marketing strategy was a big failure because 2U assumed that people who look similar on the surface (taking online lessons) are the same group. But what people are thinking and what they want can be very different, even if their actions look the same from the outside.
In Conclusion: Know Your Business Structure
To sum up, 2U had no real chance of becoming profitable while aiming for degree student revenue. The business was structurally flawed from the beginning.
The key lesson here is: Before you start or invest in a business, take a good, hard look at its cost structure. Are the main costs variable or fixed? Can you acquire repeat customers, or is it always a one-time deal? Is there room to increase prices or decrease costs?
If they had had a little bit of accounting simulation, it could save you from a lot of heartache – and money – down the road. Sometimes, it’s best to have the courage to cut your losses early.