I recently received a question from a friend in academia, here we go:
Anecdotally, it seems that a lot of startups don’t make profits. I’ve even heard that if the company is looking for funding, it might be desirable to have negative profits, as it shows the company isn’t done growing yet. Does this hold true from your point of view? Do the companies Ventech funds tend to be (or become) profitable, or do they tend to have 0 or negative profits for several years? Thanks in advance for any insights.
Profits are proof of a viable business model
Venture Capital exists ideally to fuel growth of sustainable business models. Profits are also your (the founders) source of independence from additional investors. They are a great way to increase of bargaining power when negotiating a future financing. Being profitable means you have (some more) time on your hand to make strategic decisions on your future. Despite that, the venture funded market expectation is always: high growth.
However, profitability is arguably resulting in less growth (as you could have spend any excess cash into more growth — kudos to Amazon!) and high growth companies create the outliers in a VC portfolio that many of us strive for. Speed is of the essence when growing venture backed firms as most closed end funds run for 10 years, consequently the patience of a VC is regrettably limited. Profits seem to be in stark contrast to the VC mindset. What is the common ground between growth & profitability?
Of course there are many other VCs who have shared their 2cents on the matter: Notably Mark Suster and Fred Wilson. And while I believe my view might take up some of Mark Susters points, a comment by William Mougayar under Fred Wilsons article caught my eye (see Screenshot). This article hopefully reflects some of the following in its essence: “flirting with profits” can help you to know if you are on the right path.
Is it a time bomb or cash machine? 💣 vs 💰
To a venture capital investor, profits are primarily proof of the viability of the business model and its potential value at scale. Apart from that, we do not really want profits, as they are subtracting from a firms ability to invest in growth. We are not living on dividends. Bottom line profits are often opaque when growing a business, hence how do we know a startup makes money some day?
How do you identify a viable business models
In my humble opinion, the best practice is to identify & calculate “proxies of profitability”. Assuming you have relatively stable fixed cost at a higher revenue altitude, your contribution margins in the Profit & Loss statement or unit economics are a relevant indicator for the potential future earnings of your startup. It ensures the operational (or variable cost) part of the business is net-positive.
Starting with contribution margins, you can get pretty good estimates of the firm’s potential overall profitability level. To estimate, you can assume fewer investments in future growth or marketing (probably not zero, as you would still want to replace churning clients and also show moderate amount of growth) and a limited growth on fixed costs. This profitability potential can be used as a starting point for a (EBITDA multiple based) company valuation. Is your estimated EBITDA margin similar or better than peers or incumbents? If this spikes your interest, have a look at the food tech sector: the differences between TakeAway, DeliveryHero, BlueApron and HelloFresh are astonishing (three of them recently IPO’d hence you can find many numbers, also check out this Macquarie report p8–12).
As a potential investor in a company, estimating profitability is a plausibility exercise in due diligence and usually results in a healthy discussion with the entrepreneur as it builds common understanding for the value of the company today and future.
Flirting with profits. The “science” of burning vs earning money. 🔥
Besides utilising the P&L statement or unit economics, you can also focus on subsets of the business according to its products/services, customer cohorts or geographies. For instance, a company like Uber might claim it’s profitable in certain cities/regions, but is still investing in newer markets. TakeAway is for example very profitable in its home market — The Netherlands, due to presumably a very high market share and therefore higher pricing capabilities. UberX as a service might be profitable while UberEat could be still in ramp up phase in certain cities (speaking hypothetical here). Your product in generation 1.0 might have completely amortised its R&D and marketing cost, yet R&D investments in the next generation might result in a overall negative P&L.
Splitting customers into cohorts and showing their purchase activity (accumulated and potentially expected customer lifetime value) vs customer acquisition cost is also a great way to show how variable profitability levels can improve over time.
The potential is in the cohorts: Time is risk 🕐
Calculating expected customer lifetime value vs customer acquisition is one of the key risk assessments an entrepreneur and her investors make, when putting metal to the pedal (growing) and proving a business. It is so relevant, as especially venture-backed high-growth scenario companies run the risk of outspending their potential customer lifetime value.
When you test small customer segments with low customer acquisition cost it may lead you to the believe that the economics at the business model may be sufficiently strong, but it poses the downside that customer acquisition cost for other customer segments might be higher. Consequently, your overall market potential or addressable market might turn out to be smaller than thought. I admit growing slower in such a case only defers the inevitable stale of growth and the rate of learning, but maybe you would have been able to make profit in the meantime.
Making customers buy a service for 12 months upfront, as often done in SaaS, is a great way to improve short term cash flow and show potentially a great step towards a positive CLV/CAC ratio, but what if you customers do not renew their contracts after 12 months? In early stages it might make sense to look closely at those clients who have shorter contracts to learn faster and make customer success & product market fit a priority (as capital efficient as possible!). Of course, this can increase the risk of over-investing in customer acquisition. Igor, COO of Pixonic best known for their Game: War Robots, just wrote a nice piece on the cohorts & marketing spending here).
Strong customer & sector knowledge (and speed of learning) defines great entrepreneurs and their ability to make good choices in terms of experimenting initial sizing & focus of cohorts, pricing model and marketing channels.
Definition of profitability
You might have noticed, the word profitability is used in a variety of different contexts. And traditionally, the very widely used meaning is probably unfortunate and not an unintentional transparency issue in the financial industry, ergo, here are my different definitions and “levels of profitability”, rated from highest to lowest quality:
- Earnings, “full bottom line profitability” — you deduct all cost, also financial interests and depreciation from recognised revenues, ideally over a sustained amount of time (a financial year)
- EBITDA — gives you usually a good idea about an operational profit. EBITDA is often defined specifically designed by companies in accordance to their business, hence it can be deceiving (look closely in the definition, and if you set your “own” EBITDA — make sure it is transparent and shows a good operational insight into your company performance)
- Contribution Margin or CM (in various degrees or levels): Calculate revenues minus variable cost (COGS, but also Marketing, Payment, Logistics…). The depending on how extensive you can be, for example attributing sales team cost could make a lot of sense, but is technically a fixed cost — you define different levels of CM. In case your business model has delay over a month from marketing spending to realizing revenue, it makes sense to add a cohort (time series) perspective or at least look at longer periods of time for comparison.
- Unit Economics (I’d put this on the same quality as contribution margin, if done well) — are the result of calculating the margin of all directly attributable cost and revenue per unit (e.g. per client or user). Defining monthly or weekly cohorts and following their performance over time (in form of cohorts and for more than financial KPIs), gives tremendous insight into how your product, marketing, sales & customer success performs.
- Gross-Profit (or Gross-Margin) — is usually defined as revenues minus the cost of making that product (COGS or Costs of Goods Sold). There are only few examples where it makes sense to accept negative gross-profits, as with every sale you will lose money. Historically it has however been used to strategically drive competition out of a market and create a monopolistic positioning (to increase and gross-profit later on this or other products & services).
- Net-Revenue — as compared to Revenue or sometimes Volume, Bookings, or GMV (Gross Merchant Volume), is the actual revenue your company is receiving and keeping. This is especially relevant for transactional marketplaces that sell third-party items (think any type of eBay, Booking.com, Airbnb…). In e-commerce net-revenue usually is revenue deducted returns.
Investors usually appreciate displaying milestones in the context of these definitions. It can provide additional confidence in the overall progress of your business and it’s potentially increasing enterprise value.
Fixed cost are usually quite variable….😲
When calculating potential break-even points or profitability levels, being critical in the context of fixed costs (esp. HR in a best effort to attribute them to revenue) and how the cost basis increases when revenue grows, is essential. This holds true for the sales team as much dev-ops when scaling your technical infrastructure, while growing. How many clients can your account manager really handle?
Sales teams (as part of personnel cost) are generally accounted as fixed costs. Yet, in a best effort to understand your break-even scenario, these cost of sales may be better understood as variable costs. They variably rise with a firm’s growth in revenue. Hence taking a detailed look at cost of sales, and accounting for potential attributable fixed cost (as variable cost), is often insightful.
Cash is king 👑 but it is not profit
To make things a little more complex: Unfortunately, profits do not always equal a great cash situation (and vice versa). In the case of a SaaS business, clients might pay you 3 years upfront but will also receive services from you also over all those years = you receive a lot of cash on day 1 but revenue and cost recognition over the years will decide if that transaction was net-positive for you business. Hence, if that client requires more manual servicing than anticipated, your profitability margins as well as your cash situation may be stressed.
Equally frustrating, signing contracts or rendering services also sometimes means that cash is only paid at a later stage, e.g. in installments, or worst case turns into “bad debt” when customers go bankrupt and cannot pay for rendered services. While the P&L looks great on first view, cash might sometimes look grim.
Profits are cool when you think about the possibilities! 😎
When you are in the later stages of your business development, say anytime after your Series A or B — being profitable while growing ensures freedom from additional dilution and might also enable you to “buy and build” yourself into the market by buying & merging competitors. It shields you from potential vulnerability to any “Series B Crunch” or possible change in financing market conditions (Are we all living in a bubble?).
What about the Ventech Portfolio?
We do have a variety of profitability scenarios in our portfolio. Beside the high growth cases that still spend significant amounts of cash on customer acquisition, we also enjoy the later stage EBITDA profitable but growing businesses (not when we invested, though!). The latter are typically using the gained capital for strategically moving to new markets / countries, products and acquisitions.
We invest in the early stages when a company is still in “spending mode” (Series A). When talking to founders I love understanding the entry barriers their companies develop through their personal sector knowledge, IP, potential network effects, existing & exclusive partnerships or otherwise. These things can sometimes be worth “more than money” by strategically securing potential profitability through decreasing the chance of new market entrances due to the cost to enter their market.
I care deeply about the potential profitability of our investments; despite it may be not always visible in their immediate P&L statements. Of course companies also get acquired for many other good reasons, yet it gives me good feeling to know there is economic sustainability built into the start-up.
If you are running a SaaS company with recurring revenues, you might feel the described notion of profitability does not apply to your sector. Some say as it is all about CLTV (or CLV), CAC and its ratio being equal or greater than 3. While I agree to some degree, I have a hard time with the obnoxious notion of taking revenues per user and neglecting gross-margin (you may be above or below 80%, but it makes a difference), while possibly also only consideriable variable cost in CAC (neglecting attributable personell cost to CAC from the sales team). The following article is suggesting to calculate LTV based on gross-margin. I believe this is a good practice for transparency to yourself but also shareholder community: http://www.forbes.com/sites/forbesexecutivefinancecouncil/2016/12/29/how-ltv-metrics-lie-and-what-to-look-out-for/#5b79924c2655