The Jedi Trick: You Have to Choose Between Growth And Profits
Schematically, a business has two objectives:
- maximizing the value creation, let’s call it “gross value”
- maximizing the difference between revenue and total costs, ie: profits
Traditional companies aims at maximizing profits as soon as possible.
Tech startups aims at maximizing gross value.
You know the story:
A: “How do you make money?”
B: “We don’t and we don’t care (yet).”
A: “Oh. Yeah. I see….”
No you don’t.
Don’t lie, you find it childish, if not infuriating.
But what they do is totally rational, even in a business/financial perspective.
Why startups don’t care about profits for quite a long time?
Tech startups are operating in large market with very specific cost structure: (a) their marginal cost are very low and (b) their returns to scale are very high.
If you build a marketplace or a SaaS product, having 40 clients or 39 clients is almost the same: a new user brings no additional cost or very few (the costs of storage and bandwidth are getting incredibly low).
Startups benefit from traditional economies of scale (especially those dealing with physical products, like e-commerce) but they also benefit from network effects, participation by the crowd and intelligence from machine learning using their data set. So their returns to scale are especially important and might be even everlasting when the their business models are well engineered (cf Nicolas Colin’s Notes on Amazon)
Growth OR Profits
Having that in mind, why do startups turn a blind eye to profits? Because otherwise it would slow growth and as we’ve seen growth is the only way. And eventually if you slow growth you end up with a little cake (and most probably no cake at all, since winners take most).
To put growth on steroid there is not many ways: you need to raise funds to recruit great talents and acquire users. That implies loss for several years but eventually, once you monetize you will earn a lot, quickly.
And if your activity makes some earnings, you reinvest everything into growth. No dividend tolerated in a race to size. Look at Amazon’s financial data:
Bottom line: if you want to grow as fast as possible, you minimize friction (eg: your product is free) as long as possible and raise funds so you can be the biggest kid in town (and eventually monetize with your huge user base). This is why startups have often negative results and focus at maximizing gross value before they start to maximize profits.
Gross profits scale well once startups found their product/market fit, profits come later:
But even if you focus on growth, that’s not done. Growth is hard to build and forecast.
In part 3 we will see some practical mistakes we make when we try to forecast growth.
Want to know more about startup funding? Read our articles:
Part 1 — Startup Funding: Growth Is The Only Way
Part 2 — The Jedi Trick: You Have to Choose Between Growth And Profits
Part 3 — If Growth Was Easy To Forecast, There Would Be Only One VC fund: Nostradamus Partners
Part 4 — You Need to Lose Money, But Some Loss Are A Really Bad Idea
Part 5 — How To Have Growth AND Profits? (Part1: Transactional models)
Part 6 — How To Have Growth AND Profits? (Part2: Non-Transactional Models)
Part 7 — What About Valuation For Late Stage Startups?
Part 8 — Fail Often, Fail Fast. Investors Do Half of That
Part 9 — What daphni will not invest in
Reminder: daphni investment thesis