Why Entrepreneurs Should Stop Worrying About Breaking Even
“When are you going to breakeven?”
For an entrepreneur, that is the single most common question heard from investors. From my experience, the question they are really trying to answer is “Are you increasing shareholder value?”
In the public markets, profitability drives shareholder value. If a mature company like Coca-Cola misses quarterly earnings by even a penny, its stock price could tank. But for an early, fast-growing start-up, there is no correlation between profitability and shareholder value. In fact, fixating on profits too early can actually do more harm than good.
Entrepreneurs and investors that want to build big companies should stay focused on maximizing shareholder returns. Turning $5 million of invested capital into a business valued at $100 million is a great return. This can happen regardless of whether a company breaks even early on.
So how do you determine if a company is losing money wisely? It starts by closely evaluating the unit economics of the business. The difference between the lifetime value of a customer and the cost to acquire that customer must not only be positive, but it should also be high enough to warrant the risk of investment. If this holds true, then the company’s main focus should be on driving growth, rather than reducing spend to increase profitability.
If every customer is profitable, then why doesn’t a growing company make money immediately? Because, to acquire a new customer you may have to lose money upfront and lifetime profit is earned over a longer period of time. In the long run, however, the investment pays out. Indeed, the larger a company can scale in this way, the more valuable a business they create and the more leverage they are able to drive off of their initial fixed costs.
As long as a company with healthy unit economics has access to capital, they should continue to invest. If a company has already overcome their fixed cost investment, the moment the company stops investing in growth, they would be profitable immediately because every customer is lucrative.
Eventually the cost to acquire a new customer becomes too expensive in the face of increasing competition and deeper market penetration. At that point, the company should flatten out their investment and start making a profit.
Not all startups are created equal. If a company with a flawed business model invests in growth, it will inevitably run out of money. Some startups invest $10 to acquire a customer that is only worth $5. There is a graveyard of companies to prove that these numbers will never work. If the unit economics don’t pencil out it is time to pivot.
In the long run, the financial returns from scaling a company with a good business model far surpass those from turning a profit too soon. When an entrepreneur or investor comes across a business model that works, they should hope they are not profitable anytime soon.
Originally published at www.linkedin.com on March 13, 2015.
