Applying Leverage to Arbitrage

Leverage is the accelerant that helps startups acquire customers quickly and convincingly.

In the last two articles, here and here, I laid out the Three T's of Startups. That is…

✅ A small team… (constrained inputs)

in a limited time frame… (constrained time frame)

…to maximize as much traction as possible... (maximized outcome)

in order to raise the next round of capital from investors. ✅

With that,

The surface area of success, what I wrote about in the previous article, focuses on the constrained part of the expression (the small team and the limited time frame). 

Leverage focuses on the maximization part of the equation (maximizing as much traction as possible). It is the accelerant that helps you dominate that small surface area of success very convincingly.

In this article, we’ll focus on leverage - what it is, where does it start, what it looks like in practice, and where to look for it.

Leverage Defined

Leverage exists in many places in business - ways to save time, ways to become more internally efficient. However, the leverage that I am referring to here is customer-acquisition oriented. It is an asymmetric way of acquiring customers and earning revenue.

Startups that use leverage have a seemingly unfair way of acquiring customers that distances the company from competition in a very convincing way.

In his book Zero to One, Peter Thiel says, "Superior sales and distribution by itself can create a monopoly, even with no product differentiation."

It's not that the startup is slightly ahead in the market. It's that they are WAY ahead.

Where Leverage Starts - Example from the Golden State Warriors

Leverage starts with seeing. It starts with seeing a market inefficiency. It starts with seeing an arbitrage opportunity in the market.

The term "market inefficiency" is often is too technical to be helpful. So, I will break it down through a story.

In 2016, I read a Wall Street Journal article about the NBA team, the Golden State Warriors. The article puts perfectly how seeing and acting on a market inefficiency and applying leverage, can result in winning in a very convincing way.

In 2010, Joe Lacob, a venture capitalist from Silicon Valley at Kleiner Perkins, along with Peter Guber, bought the Golden State Warriors for a record $450 million.

In the game of basketball, there’s a thin arc painted 24 feet from the hoop - the three-point line. A shot inside of that arc is worth 2 points, a shot outside of the three point line is worth 3 points.

Since the three-point line was introduced to the game of basketball in 1979, the 3-pointer was viewed as a novelty, a risky maneuver reserved for end-of-game situations. In fact, the year when the three-point line was introduced, only 3% of the shots put up were three-pointers. Over the next three decades, that number crept higher. When it reached 22%, the growth curve flattened. It seemed that basketball had found its optimal ratio of three-point shooting.

Even though the "market" had settled on its optimal ratio, Lacob and Guber saw something different. They dug into the data and found that the rate of return of a three pointer, a 24-foot shot, was worth dramatically more than a 23-foot shot. 43% to be exact—even though the shot difficulty was nearly identical.

Nearly same shot difficulty, yet a tremendously different scoring outcome. And yet, only 22% of shots taken in a season were three pointers! Why wasn’t it much higher?

That was the arbitrage opportunity. The three-point line was a market inefficiency in plain sight.

While the rest of the league treated the 3-pointer like a edge opportunity, Lacob, Guber, and his team asked: What if you built your entire offense around it? What if the 3-point line wasn’t just a feature of the game, but the game itself?

Seeing this arbitrage opportunity led them to make Stephen Curry their centerpiece player - he was not as tall as most NBA players but he could shoot from anywhere. So, the Warriors started building a team around Stephen Curry that would allow him to take more 3-pointers. They added 6 foot 7 inch sharpshooter guard Klay Thompson. Most 3-point-shooting teams had one superb shooter surrounded by a collection of supporting players. Now, the Warriors had two. They also hired Steve Kerr, who was completely new to coaching but who himself savored the importance of the three-pointer from his time as a three-point sharpshooter with the Chicago Bulls championship dynasty of the 1990s.

They unleashed Curry to not only shoot more three-pointers, but to shoot from virtually anywhere. Off one foot. From 30 feet. From 35 feet. At the time that the Wall Street Journal article was written in 2016, Curry had taken 253 such deep shots and made 47% of them. 

The result is that from 2016 and in the subsequent years, the Golden State Warriors were virtually unstoppable, winning the NBA Championships in 2015, 2017, 2018, and 2022.

The author quotes Joe Lacob as saying, "What’s really interesting is sometimes in venture capital and doing startups the whole world can be wrong. No one really executed a game plan—a team-building architecture—around the 3-pointer.”

Parlayed to business, this is equivalent to a seemingly unfair way of acquiring customers and revenue to win in a convincing way.

Except it wasn't unfair. The Golden State Warriors just saw something that others did not.

Most Founders Don’t Employ Leverage

I'm going to say something bold but true.

Shrinking the surface area of success, that I wrote about in the previous article, is achievable. In my mind, it is necessary, but it’s not overly difficult to do if you set your mind to it.

Yet, leverage involves something way more subtle. It involves seeing something that others do not that can lead to drastically different cadence of acquiring customers. Because it is sublte, very, very few startups ever employ leverage.

I find that many startup founders are innovative with their products, but when it comes to anything beyond their product, such as customer acquisition and GTM strategy, where this leverage lives, the outside of the box thinking falls off a cliff. So, they play in the same go-to-market channels as everyone else does in the market.

To borrow from the NBA example, most startups try to recruit slightly better players than the other teams, come up with unique playbooks, but are fundamentally playing the same game.

As Peter Thiel writes in Zero to One, "If you’ve invented something new but you haven’t invented an effective way to sell it, you have a bad business - no matter how good the product."

To win in startups, and win convincingly, founders cannot play the same game that the market is playing. They have to apply leverage to arbitrage.

How to Find Arbitrage

Truthfully, finding arbitrage is undoubtedly an art. Because this is such an art, following a process perhaps is too overly formulaic. As an investor, I know it when I see it but I struggle with writing a playbook on how to find it. Maybe some day... But, I find it more helpful to rather tell you two stories that give examples about some places to look for arbitrage.

RobinHood

With some arbitrage opportunities, it requires the leverage of new business model.

When RobinHood launched, one of the things that initially surprised the entire market was that consumers could place trades for free. At that point, all of the other brokerage platforms charged consumers a percentage fee to place a trade.

RobinHood identified a market inefficiency within the way that brokerages generate revenue.

Every time you placed a trade on RobinHood, they didn’t just send it off to the stock market to execute the trade. Instead, it sent it to big firms like Citadel, who actually paid RobinHood for the chance to fill a consumer order. Why is that? Because those firms made tiny profits on each trade and RobinHood would capture a portion of the spread.

So RobinHood’s real business wasn’t trading - it was selling consumer's order flow behind the scenes. That’s how it made hundreds of millions in revenue without charging users a cent.

It was an arbitrage opportunity that led RobinHood to employ a different business model than the rest of the market. In so doing, it changed the whole retail stock trading industry.

Zappos

Zappos is another arbitrage opportunity that fascinates me. When Zappos started, they were trying to solve the inventory fragmentation problem. In the late 1990s, shoe stores had limited selection and shopping online for shoes was uncommon. Instead of buying shoes and holding inventory upfront, Zappos went to local shoe stores, took pictures of the shoes without buying them, and uploaded them to their website. When a customer bought a shoe online. The Zappos team would go back to the store, buy the shoe at retail price, and ship it to the customer.

The arbitrage opportunity here was one of inventory arbitrage. Zappos wanted to offer a large shoe selection, but didn't want to carry inventory.

Leverage Often Has an Expiration Date

Now, it is important to note that leverage has an expiration date.

It's not a singular, foul swoop move that founders will employ and ride off into the sunset into success without changing strategy. No, winning quickly and convincingly leads others to try to reverse engineer and copy the success of that company.

Look at the example of the Golden State Warriors. Since they identified the three-point line arbitrage, other NBA teams have moved into using the three-point line a lot more.

Look at RobinHood - when they started, RobinHood was offering consumers free trades and all competitive brokerages were fee-based. Now, RobinHood's arbitrage opportunity of free trading is just a staple of the market because the consumer expectation has changed.

So a type of leverage has an expiration date. Basketball teams or companies like RobinHood or otherwise eventually time out from applying leverage to a particular arbitrage opportunity.

So, startups will need to move into another arbitrage opportunity, and then another, and then another over time.

But that's OK. You don't need to determine the next five arbitrage opportunities because by the time that the startup has fully realized one, the market landscape may have changed, which could illuminate another one.

You just need to find the first three-point line.

Closing Thoughts

With the last two articles, we discussed shrinking the surface area of success and applying leverage.

Both of them serve different purposes.

Shrinking the surface area of success is intended to move a startup from a low likelihood of winning to a high likelihood of winning.

Leverage then is the accelerant that helps startups dominate that small surface area of success very convincingly.

Leverage starts with seeing. It starts with seeing a market inefficiency, an arbitrage opportunity in the market. Yet, very, very few startups ever employ leverage to acquire customers quickly and convincingly.

But it shouldn’t be that way.

Where is a three-point line in your market?

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