This piece is an attempt to collect my thoughts on a type of business I’ve found particularly hard to analyze over time as an investor. I call them “Banana Stand Businesses,” a phrase taught to me early in my career by Antonio Rodriguez, a mentor, GP at Matrix and Arrested-Development fan, though I expect my definition has drifted a bit from those days.
Businesses like this have incinerated billions of dollars of capital and humbled many brilliant, hardworking investors and management teams. In this piece, I’ll do my best to explain what I mean with the phrase, why they’re so addictive to investors/management teams, why they’re so difficult to spot in the loss-making state, and (in an effort to help myself avoid them) brainstorm some best practices for picking up on them during diligence.
What Makes a Business a "Banana Stand:"
I've identified four key traits.
1. Customers love the product
2. The company is growing quickly (often in hypergrowth)
3. It is losing money (which, nowadays, is virtually all startups)
I call these businesses banana stands because they are functionally equivalent to a banana stand that sells bananas at a discount- or sells banana smoothies for the same price as the underlying bananas. Customers will love it, it will grow, it will burn money- and as soon as it tries to make money, it will find that the reasons for its adoration and growth no longer apply. This phenomenon is hardly limited to beach-side businesses- or even to consumer product companies, for that matter- there are practically infinite ways to be a banana stand.
Here are a few examples:
1. A company leases commercial real estate, substantially improves it through expensive renovations, and then subleases it via a slick tech platform with great marketing. Customers are overjoyed that they can get short-term leases in high-quality buildings with beautiful fit/finish/furnishings for about the same per sq ft as a long-term lease would have been.
2. A company buys and sells online ad impressions but is comfortable accepting very low margins on them while paying top dollar for technology/sales talent to enable their sale. Customers rapidly scale their spending through this exciting new channel, which provides a superior ROI compared to all other solutions on the market.
3. A software company offers software at the same price as competitors but is willing to do significantly more customer development work- to the point where a company with a $100k contract gets $50k+ of engineering time per year. That engineering time is considered R&D, but little of it can be used for other customers. Customers are delighted to finally find a software company that doesn’t say “no” to feature requests.
All are real-world examples that will likely be familiar to many readers- and anyone who has a history in venture or growth investing probably has other examples springing to mind. Many have sad, ignominious endings- at some point, investors and management teams alike learn the hard way that what they thought was a stellar, customer-adored product was actually some implicit form of customer subsidy. In most cases, an attempt to run such a business profitably leads to a collapse of growth, customer dissatisfaction, and a sharp valuation decline.
Why Silicon Valley is Addicted to Bananas:
1. Many investors have been trained that rapid growth, happy customers and a big market are the holy trinity of venture/growth investing. Banana stand businesses don’t just seem to have these traits- they actually do have these traits. In fact, it is dramatically easier to build a company going “$4m to $15m of ARR with an NPS of 80” if a customer subsidy is core to the value prop. Building net-new, efficient frontier-expanding products is hard- giving money away is much less hard.
2. Though I strongly suspect most cases are innocent, it’s hard to ignore the moral hazard created for both investors and founders in these situations. One trait of banana stand businesses is that as long as investors are okay with the company running at progressively higher losses, growth can keep going- often long enough for a management team to become prominent or an investor to make partner at their firm.
3. Unfortunately, there are many business models (marketplaces, SaaS, hyperscale e-commerce) where losing money actually does make sense for well understood, unit-economic reasons- and VCs look at so many of them that a company running at a -20% EBITDA margin doesn’t raise eyebrows the way it otherwise would.
4. Finally, there is always a counter-narrative- i.e., the company will always have an explanation (which it usually believes) as to why it will be highly profitable in the long run, at scale. If an investor wants to believe in it for some reason, they will have a robust argument to make that is hard to defeat without rigorous, first principles research and thinking.
In short, banana stands are attractive because they have the look and feel of successful, hypergrowth success stories, without any obvious drawbacks.
Why They’re So Hard to Spot:
1. First, it is rarely as simple as “This company is underpricing its competitors.” Watch out for ways of “underpricing” that aren’t underpricing at all. A company can effectively compete on price simply by providing a much higher level of service at the same price- US-based customer support, white-glove service, a higher quality consumer product sold at below-industry standard gross margins, etc.
2. Second, the particular ways a company adds value to customers are often opaque- even to the customers! Especially in complex/emerging business models, it can be devilishly tricky to figure out what customers really care about/value relative to the competition.
3. Beyond all, the real challenge is that no one dislikes banana stand businesses. Employees, customers, management- everyone is often effusive. It can be very hard for an investor to come away from a glowing customer call with a negative take on a company. It requires mental gymnastics.
In short, banana stands are hard to spot because they thrive in complex value chains, and few involved have motives to question the long-run narrative- they thrive on a mix of complexity and moral hazard.
How to Avoid Them:
1. Look for a clear “why now” for a new business model to exist relating to the underlying advancement of technology, market forces, etc. If there is one, the odds that a business is a banana stand are much reduced. Without a clear why now, you are implicitly supposing that a valuable opportunity had been ignored for a long time- an atypical state for capitalism.
2. Really understand how a product adds value and how that would look at scale- listen to the customers, but do your best to read between the lines. Watch out for telltale signs of variable-cost subsidies: “It’s like X, but with much better customer support,” “It’s the same price as Y, but much higher quality,” etc.
3. Realize that, paradoxically, it is much easier to go from -40% EBITDA margins to 40% steady-state EBITDA margins than it is to go from -40% EBITDA margins to 5% steady-state EBITDA margins. In the latter case, the business could be giving away 8x its future profit pool to customers!
4. Talk to a competitor or investor who is smart, profitable and losing share to the upstart. Though biased, they will often have the most cogent argument for the unsustainability of the other model- take what they say seriously and vet it out, even if you suspect a genuine “innovator’s dilemma” situation exists.
In short, much of the traditional diligence one would do on high-growth companies (evaluating pipeline metrics, growth rates, interviewing customers and employees) is useless for businesses of this type- only by approaching them with healthy skepticism, an appreciation for the efficiency of the business world and first principles thinking can the truth be ferreted out.
Though this is written from an investor perspective (my perspective), these frameworks are just as useful for CEOs/management teams. While it can make for a fun ride, in the end, no one wants to be running a banana stand, especially when times get hard. Thinking critically about how the business you are running/evaluating adds value to the world and being wary of the above dynamics leads to better outcomes for everyone- at the end of the day, as delicious as they are, the world doesn’t need any more bananas.