Why Bootstrap? Part 3. Simple Business Fundamentals

I’ve always been a big fan of simplicity even before it became trendy, so I’ve had the pleasure of seeing it catch on in society. From web design…to electronics design…to software design…I’ve been observing how people have been captivated by the beauty of simplicity over the years, especially in the recent years. For example, think about cell phone design before the iPhone came out. They were clunky, button laden devices that we can’t even imagine using today. That was only 9 years ago. In the world of consumer electronics, the iPhone showed people that simplicity was the ultimate sophistication…and people started developing an appetite for it. These days, people crave the simple and appreciate that simple things are intuitive, pure, and embodies clarity. There’s something about simplicity that’s just “right”.

This article was originally posted on bootstrapology.com

I think there’s also beauty in the simplicity of bootstrapped startups. When you look at how these startups operate…it can be summed up in the most simplest of terms that even a child can understand. For example, a core goal of bootstrapped startups is to earn more than you spend (aka net profit). Wow…mind blowing wisdom right? I think even a child can understand that in the context of a lemonade stand, if it cost you 5 cents to make and sell a glass of lemonade…you’ll probably want to sell it for above 5 cents. Selling for 15 cents is good…selling for 4 cents is bad. This core tenet is engrained in most bootstrapped startup’s DNA, simply because if they don’t have positive net profit…they will keep losing money and will need to close up shop fast…unless they have a magical money tree to draw funds from. Focusing on this singular goal of net profit is what keeps most bootstrapped companies alive to pursue higher goals.

Many bootstrapped startups take this one step further by adding a second simple goal…total profitability (basically to have all debts paid off and monthly net profits). Yet another mind melting concept right? Since bootstrapped startups are typically funded by the entrepreneur’s own pockets…it naturally becomes a pretty high priority to have your net profits start paying off your initial investment expenses…hence achieving the zen state of “profitability”. So let’s say it costs you $100 dollars of initial investment to build your lemonade stand and to buy the lemonade making equipment. You’ll definitely want to understand your net profits to know how long it might take to recoup that initial $100 investment. If in your math you see that it’d take 2 years and countless glasses of lemonade to make it all back…even a child might have the wherewithal to reconsider the feasibility of a lemonade business.

You may have heard of the phrase “first money in…first money out”. It’s a simple mechanism for bootstrapped businesses to implement to make sure their initial cash investment is accounted for in their business finances. When your own money is invested into a company…you’re usually highly incentivized to work towards recouping it back, and that’s where profitability comes in. As simple as these two concepts sound, I contend that they are usually completely ignored by VC startups.

When you take a deep look at the financials around VC backed startups…they are anything but simple. Maybe it’s just my feeble mind fails to comprehend it all, but the math around how VC startups operate financially is pretty fuzzy, and it takes a lot of mental gymnastics to make all the numbers make sense. For the purposes of this post, I’ll be referring to this phenomenon as “VC math” for short.

Take for example, how the VC industry currently values SaaS startups. Current wisdom says a SaaS startup is valued at around 5 times its ARR (annual recurring revenue)…and there is MUCH emphasis on this as the primary indicator for a SaaS business. Ok, that metric sounds simple enough. But when you drill down to understand how that ARR is tied into profits…the answer is it’s not. VC math is really mainly interested in revenue…not net or gross profit.

So what happens when you primarily focus on revenue? Well, that theoretically means you can pretty much spend any amount of money you want on business expenses (office space, furniture, etc), development of the product (engineers, designers, product managers, etc), selling the product (sales, marketing), and direct product expenses (hosting, bandwidth, customer service, etc).

So, let’s take a VC startup that’s been around for a year, experiencing an exponential 20% month-over-month growth rate, with an ARR of $2M…that would be seen as a great value at a $10M valuation right? Well, what if that startup was also burning through $4M a year in net losses…where would it stand now? It may sound ridiculous as you’re reading this, but this pattern should look fairly familiar…early stage startups hiring 10 engineers, a big sales team, with a fancy office…all right out of the gates in the name of growing revenue. Does that really make sense?

In our little lemonade stand analogy, this would be equivalent to selling $1000 of lemonade a month…but neglecting the fact that you’ve hired a renowned chef to create the recipe, purchased state of the art lemonade making equipment, bought ads on radio and TV to market your lemonade, and hired a full-time sales person to sell the lemonade. It would be foolish to just focus on the $1000 per month revenue without factoring the overhead costs of running the business right?

Ok, so let’s say VC math argues they’re smarter than that. Of course they look at things like CAC (customer acquisition cost), COGS (cost of goods sold), LTV (lifetime value), churn, etc…they have a full picture of the financial health of the startup, they’d claim. The VC theory is that SaaS startups typically sell a high margin product, around 80% gross margin. It’s almost a given fact that if you’re a SaaS product, your gross margins typically won’t dip much below 80%…which is why it’s not a primary focus and why they just track gross margins separately and secondarily from top level revenues.

Ok then, so let’s assume they’ve got gross profit accounted for, which accounts for cost of goods sold. And it sounds like they might even understand their CAC versus their LTV minus churn, which probably accounts for their sales and marketing expenses. Well, what about the other huge business expense of product development, namely engineering team payroll? Well, they’d explain, since the gross margins are so high, they view product development as a sunk cost that they really don’t need to be concerned about at the moment, and the high margins will undoubtedly cover all those costs sometime into the future. Grow as fast as possible and profits will magically follow.

I don’t know about you, but if you’re still keeping score, this is where VC math really starts to break down. In short, how do they get away with focusing purely on revenue, maybe knowing the gross profits to some extent, and pretty much completely ignoring the net profits? If you are not diligently looking at net profit (which is what accounts for ALL expenses including product development salaries…which, btw, is typically the largest cost for tech startups)…you’d basically have no idea what to budget for developer hiring! It’s no wonder it’s such a hot market to be an engineer right now! Due to VC math affecting an entire industry, countless companies are spending indiscriminately to hire developers.

So really, why isn’t net profits and salary expenditures highly scrutinized in VC math? Well here’s my theory. VC’s actually want startups to run out of money and never reach profitability. You see, when you have negative net profit…they know it’s only a matter of time you run out of money, and have to come back to the table asking for more. This is the VC addiction, and yes, the first one is free.

At that time when you come back, hat in hand, they can quickly determine if you have that exponential growth pattern exhibited by their much coveted unicorns, in which case they’ll give you more funds/time to prove it out…or they can decide to end your journey and not waste their time anymore by a “slightly” profitable startup. That’s why most startups are perpetually in a state of fundraising, because they are being churned through this machine that wants to quickly know whether to spit them out…or nurture them into being a unicorn.

Don’t believe me?…just look at the performance of some of the current unicorns. Uber in 2015 was reported to have a net loss of nearly $1 billion in just the first 2 quarters! But they are still valued at over $60 billion dollars, just due to the strength of their growth rate. Airbnb likewise is valued at over $25 billion…while posting net losses last year at around $150 million. Both companies have high valuations based on the assumption of eventual profitability. These companies have been around 7 years and 8 years respectively. This is the VC math game. I think when young startups practice ignoring profitability from the beginning, that value becomes deeply engrained into your company’s DNA…and it becomes a hard thing to reverse.

Call me naive, but I enjoy simple math. VC math feels flipped to me. I’d much rather start by simply focusing on profitability…which is inclusive of accounting for gross profits, revenue, and all expenses. Once again, the goal of profit focus is rather simple: earn more than you spend. Just like revenue, you can grow profitability to your heart’s content…while making sure that bottom line needs and expenses are met. When you achieve profitability earlier, you help ensure that your business is self sustainable.

Bootstrap startups, by nature, focus on profitability right out of the gates. They really have no choice but to be profitable, due to their financial constraints. In my simple opinion, it’s how businesses should fundamentally work.

I hope this societal trend of appreciating simplicity will eventually influence the startup world to pursue simplicity in business design.

This article was originally posted on bootstrapology.com