Stop Reading Tech Crunch And Play Your Own Game
Burning cash is a bad strategy for most entrepreneurs.
Many of the most popular new companies in the world are losing truckloads of money every single month. SnapChat for example generates negligible amounts of revenue, burns a reported $30 million a year, and is estimated to be worth as much as $20 billion.
How is this financially possible and why is SnapChat so valuable?
Fast growing tech startups with little to no revenue are financially supported by cash investments from highly speculative investors, like venture capitalists and angel investors. These investors search for companies that they believe have the future potential to generate massive revenue and large net income regardless of their current financials. In fact, many of these investors will view revenue and profit as a negative. The logic is that you’re wasting time and money on something other than growth and grabbing market share. Counter-intuitive, yes, but this does make sense in some instances.
Back in 2009 it was estimated that Facebook was losing $200 million per year. As of Q3 2014 Facebook posted gross revenue of $3.2 billion with 82.4% gross margins and 25.2% net margins. In other words, Facebook brought in $3.2 billion and made $806 million after all expenses. Facebook is now profitable and their early investors earned massive returns on their original investments.
The people and firms pumping cash into SnapChat are hoping for a similar fate for the ephemeral photo chat app that is estimated to have nearly 200 million active users. Companies like SnapChat are valued based on user growth and engagement metrics combined with the size of the future business opportunity. Anytime you are betting solely on the future it’s extremely risky, but the size of the potential reward has spawned a massive subset of the financial industry that is purely focused on high-growth startup investing.
A high cash burn financial strategy presents a problem for entrepreneurs. Venture Capital firms design their investment strategy around the assumption that most of their portfolio companies will fail or produce dismal results. When a typical VC-backed company grossly under performs, the firm looks to it’s other portfolio companies to make up for the losses. They only need one Facebook for the fund to be considered a massive success. If you are the entrepreneur of a grossly under performing company you do not have this luxury of diversification. If the ship goes down, you go down with it. A company with little to no revenue that is fueled by investor cash lives and dies based on its ability to raise its next round of funding. If user growth or engagement slows down for a significant period of time, it’ll be very difficult to raise your next round. If you’re burning cash and can’t raise the money you need, your company is dead.
However, a company that focuses on profitability and cash flow in addition to overall growth has many more options. A company that generates cash is in control of its own fate. Venture capitalists will tell you that you have two options 1) take their money (along with their onerous terms and dilution) to “blow it up” or 2) build a humble “lifestyle business” that you can hang your hat on. This is nonsense. While there are certainly some business ideas that require massive upfront investment and a winner-takes-all mentality, most businesses operate in spaces where competition is relatively mild. Unless you’re building ground-breaking technology, you’re competition is likely less fierce than you think.
Ignore startup blog headlines and the glorification of fundraising. Raising money isn't cool, it’s just super expensive financing. Stop reading Tech Crunch and play your own game.