Startup Economics 101: Your Best Bet is to Make Money

When I’m meeting with an entrepreneur for the first time, I always like to ask what is their plan for profitability (or to break even). Before I jump in with my 2 cents, I just want to say there is no right or wrong answer to this question. Each company is different and competitive dynamics may dictate the answer depending on the product. Balancing growth vs. profitability isn’t just a startup issue. Companies will have to routinely make decisions on which path to pursue throughout their life cycle.

The VC community is all over the map on this issue. Some investors prefer startups grow at all costs while others want a clear path to revenue and profitability.

I believe in traditional business principles (probably the result of my education). Give me some Adam Smith or John Maynard Keynes and I’m a happy camper.

“In the long run we are all dead” — John Maynard Keynes

I believe all companies must go through periods of growth when profitability must be sacrificed (in the short-term) in order to facilitate innovation and maintain (or grow) market share. Unfortunately in the startup community, many believe these cycles should last years (or maybe even a decade).

I admit my bias for companies that have a fundamentally sound, sustainable business model. I prefer startups that have a road map to achieve break even cash flows within 12–18 months. When I talk to entrepreneurs and their plan is to raise 3–4 rounds of capital before generating a profit, my eyes glaze over. All I hear are the words “dilution”, “serial fundraising” and “be prepared to fund us with a bridge down the line”. I don’t know if my mindset is the result of being located on the East Coast where investors tend to focus on risk protection (as opposed to the Westside which has more of a “dollar and a dream” mentality) or my decade as an investment banker working with buyout firms where cash is king.

I’ve seen many VCs tell companies not to worry about revenue, just grow their users (or whatever metric is relevant). I’ve heard entrepreneurs worry that once they get revenue or become cash flow positive, their valuation might be effected in a negative way. One bright-eyed soul told me if he achieved positive EBITDA then VCs could use fundamental methods to value his company. He believed using a discounted cash flow analysis would significantly undervalue his startup.

I’m glad Damodaran is alive and kicking or he would turn over in his grave.

I understand there are examples of companies reaching unicorn status without revenue or cash flow, but these companies are the exception not the rule. I guess a deeper question is should venture investors focus on finding unicorns or building sustainable companies. If unicorns are the goal then the “spray and pray” and “swing for the fences” model is the only way to go. It becomes a numbers game for VCs and the more investments you make, the better chance you have of finding the next big thing. However, if our goal as investors is to establish a viable company then unicorn hunting isn’t required to achieve strong returns (i.e., less failures mean you don’t need home runs to carry the portfolio).

It’s great when a company has an established timeline to achieve profitability. They are de-risking my investment and who doesn’t love that. Don’t get me wrong. I’m not suggesting sacrificing growth or market share in the name of the almighty dollar. What I am saying is my role as an investor is to provide capital (and hopefully experience) to help expand operations and get the company to the point where it can stand on its own two feet. This period of support may be longer or shorter depending on the startup, but it shouldn’t be indefinite.

Trust me entrepreneurs. The more VC money you take, the less control you have. If you are a serial fundraiser, you will struggle with getting the best terms and when the influx of money starts to slow you will end up taking whatever you can get. You don’t need a crystal ball to tell you how that story is going to end.

Now imagine another world where a company is making a little cash and only needs outside capital for growth initiatives. Now the company has expanded its ability to access the capital markets (it doesn’t just need to take VC money) which results in more negotiating leverage and better terms.

As an investor, I don’t believe I’m sacrificing returns by investing in company #2. I believe I’m teaching a man to fish vs. giving him a fish every 9–12 months at an increasing valuation.

Bottom line: making money gives startups more options, not less.