“Square” and What Makes a Startup Investible

3.5 minute read

If you are unfamiliar with the world of Venture Capital and startup financing, the tech news headlines you read a couple of weeks ago (on October 5 specifically) would have left you scratching your head in puzzlement. The headlines read something like: “Square Raises $150m at a $6b Valuation (Despite Recording a Loss of $100m)”. It’s the part in parentheses that causes the confusion.

The actual amount raised is reported to be somewhere in the range of $100m to $150m, but that’s irrelevant. What’s relevant here is how Square, the mobile payment processor, was able to convince investors to put that much money at such a high valuation despite losing $100m in 2013. This becomes even more puzzling when one takes into consideration that Square’s valuation was set at $5b in late 2013, before the losses were reported. Subsequently, the payment giant was able to increase its valuation for this round (1 year after the $5b round) despite leaking all that cash.

In fact, most startups get financed despite reporting losses.

So, back to Square and all the confusion behind their latest round of funding. The short explanation is that VC’s tend to look at two main criteria when deciding if a startup is worth the high risk of an early investment:

1. Growth. If “Location, location, location” is the cardinal rule of retail, “Growth, growth, growth” is its startup counterpart. Take a look at Square’s hyper-growth up until March, ’13.*

[caption id=”attachment_2447" align=”aligncenter” width=”300" class=” “]

Square payment processing growth until March 13[/caption]

Today, Square’s growth has “slowed” down in relative terms. However, in the last year, Square’s processing rate has multiplied 6–7 times. The company expects to process $30b in payments in the next 12 months.

Most startups, like Square, lose money because they are financing growth. That could mean hiring, acquisitions, product development, or/ and research. Square has been doing pretty much all of the above. Investors will be happy to keep pouring money in as long as growth persists because they understand that at one point the company can capitalize on its investment in growth (in other words, start reaping the rewords). A highly “uninvestable” startup would be one that burns through cash without recording any real growth, probably because of a lack of product-market fit (it’s that reason 95% of the time, despite what some founders might argue).

1. Operational profitability. Growth is pointless if the company can’t ultimately turn a profit. Thus, a startup has to prove that its current (or proposed) core revenue model can be profitable. In Square’s case, the subject has been debated since day one. However, recently Square has made it clear that it makes money on every transaction- around a very healthy 33% gross profit. How much remains from the 33% once other costs are subtracted is an issue of operational efficiency, not profitability. As such, if the company chooses, it can wipe away that 33% margin with heavy investments in growth, and drive net profit towards the negative.

An understanding of these two factors provides a more accurate interpretation of Square’s financial health; namely, that the $100m net loss is a reflection of continued investment in growth, not lack of profitability. Some would argue that the valuation and burn rate of Square have exceeded required growth rate, and as such have turned the company into a black hole for cash. That argument is plausible, but does not contradict the growth investment analysis proposed in this post.

When weighing up an investment, a VC will also take into consideration the possibility of monopoly , product range, market size, and competition. In addition, a certain class of VC’s look at different criteria from what was aforementioned because their strategy revolves around “flipping” a startup and exiting before any profits are made. These topics will be covered in later posts.

Slice of Advice

Focus on creating a product that has market fit in order to drive growth and profitability; only then will your startup be investible.

* http://wallstreetflaneur.com/the-mobile-payment-threat-whos-to-fear/#axzz3GhEJUZ4S