Profits vs Growth
One of the things I’ve always struggled with as an investor in high growth tech companies is the tension between getting profitable vs growing more quickly. It has become a central tenet of tech growth investing (in both the public and private markets) that growth is more valuable than profitability and you can always focus on profits once you have “captured the market.” This leads to behaviors like investing heavily in sales and marketing to increase the growth rates of a business beyond what it can grow at “organically.”
A few months ago, I blogged about a formula I came across at a board meeting a while back that says your year over year growth rate plus your pre-tax operating margins need to be at least forty percent. Meaning you can grow at 100% per year and have operating margins of -60%. Or you can have flat growth and have 40% operating margins. Or you can grow at 20% per year and have 20% operating margins. There is no magic to the forty percent target, but I do like establishing some relationship between acceptable levels of profitability (or losses) and growth. Too many times I have seen companies invest in growth for growth sake without having any constraints or sanity checks on that investment and the losses that result from that investment.
We have worked with/invested in a few super high quality companies over the past decade that did not make this tradeoff. They got profitable early on in the life of their company and then were able to use their profits to reinvest in the business and continue to grow at very high year over year growth rates without having to burn money and raise capital. Indeed.com is probably the best example of this group but we have had a number of them and they are all special companies that I have enormous respect for.
These experiences lead me to question the orthodoxy in the world of technology that says if you are not investing heavily in growth (and losing money), then you are not maximizing the potential value of your business over the long haul. It doesn’t have to be that way. Now maybe you need to have a very special company that has real structural competitive advantages in the marketplace to avoid this tradeoff. Or maybe you just need to be a really sharp and experienced business person to be able to do this (that’s how I would describe Paul and Rony, the founders of Indeed.com, for example).
I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make. It roots out bad investments in people, product, sales, marketing, and elsewhere in the business and helps to maintain a lean and mean highly functioning organization. If you don’t need to make money because there is plenty of capital available to fund your losses and you are “investing in growth”, then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.
I don’t want to come off as a positive cash flow freak. It is our business to invest in companies to allow them to run operating losses in order to get a product in market, grow the business and team, and create value for the founders, management, and shareholders. Most of our portfolio companies lose money and we are used to reading income statements with lots of red on them and staring at runway calculations showing when the money runs out.
But I’m a bit sick and tired of the objective of every operating plan I see is to get the business to a point where it can raise money at a much higher price. That’s nice and it’s how the VC/startup game is played. But at some point I’d prefer to see an operating plan that has the objective of getting to sustainable profitability. And I do mean sustainable.
Because, as I said earlier, some of the very best companies we have worked with at USV got profitable early on in their life and maintained profitability while revenues grew100% year over year for a number of years. It can be done. Maybe the reason that many entrepreneurs don’t think it can be done is nobody is telling them it can. So I’m doing that.
Thanks for this. I’ve always loved the phrase “the best type of funding is revenue” – it doesn’t mean you shouldn’t try to raise venture money, but I agree there is way too much focus on valuation and not enough on sustainable revenue and traction. It also means you likely need to move slower than you may like, which takes significant discipline.
.One size does NOT fit all.But one set of rules does apply to business.The decision is whether to follow them or to knowingly violate them. Unknowingly violating them is a possibility but not a viable option.In the life of companies, the big issue is the market. What is the market telling you is possible. That is a trick statement because the “market” may mean either the real market of customers giving you money for your product or the market for raising money.The most important thought is what Fred indicated — have a rational reason for whatever you decide to do. (May not have said it that explicitly but that is what I heard.) Know why you are doing what you are doing.Two other practical observations from a guy who was a CEO for 33 years — don’t be afraid to conduct an experiment. Conducting an experiment is an attempt to find out what you know you don’t know.The other observation is that life is not lived at the extremes — you don’t have to go all in on either of the polar opposites. There is a vast middle that you can explore with a hand on the tiller and navigating first one way and then the other.Last point, whatever you decide to do make damn sure your top people know it and why and make sure everybody else knows it.Don’t let a strategic decision ruin the power of alignment because you fail to tell everybody. Tell them way more than 3 times.JLMwww.themusingsofthebigredca…
There is a vast middle that you can explore with a hand on the tiller and navigating first one way and then the other100%. However in the world of “online learning” (and AVC.com is part of online learning) people are not likely to buy into that. Because they feel that there are simple rules for business that they can follow that will lead to success. As if it’s math or a programming language or engineering. Or that decisions are as easy as simply complying so that you “pass inspection”. Doesn’t work like that as anyone who has been in business and operated one finds out.Keep in mind that when an investor follows rules or orthodoxy they are spreading bets over many investments. So they can be wrong. When you are running your own ship no such latitude exists. That is a difference that is larger than panamax.  https://en.wikipedia.org/wi…
Fabulous comment. The margin of safety and the necessity to be right is different for a VC v a real business.The Panama Canal — and now featuring Panamax — is a wonder of the world. The biggest foe to the original building was the mosquito.Between the two attempts — maybe three — more than 25K died — DIED — building it. Can you imagine something like that today?The Chinese will own it within the next 20 years. Only fair since their countrymen built it, no?JLMwww.themusingsofthebigredca…
The documentary that I watched on building of the Panama Canal was fascinating. I think it was on PBS.  Definitely remember the role of the mosquito.I don’t think any of those big constructions projects could be pulled off today. For one thing labor isn’t what it used to be. Back then human life and so on was not considered valuable and people were not protected like they are today. Think of all of the immigrants (on the canal or building the hoover dam) that were exploited doing construction. Today we live in a world of people wanting everything to be 100% safe and perfect when that is simply not possible.Look at all the manpower, money and effort and money that is going into catching two escaped convicts from that prison in upstate NY! It’s a ridiculous and overblown political circus. Yes it was and it doesn’t get better than this. Clips are on youtube as well. http://www.pbs.org/wgbh/ame…
Do you think we could solve the problem of over crowded prisons and expensive manual labor by having convicts build stuff for us? Worked for Rome. I’d give them $0.20/hour, build a bigger faster canal, and just call it The Anal (“c is silent”). Boom. TeddyBeingTeddy for POTUS in 202O.
I’m always a bit squeamish on prison labor http://www.laborrights.org/…
You know why Cape of Good Hope is so named ?Once the “Cape of Storms” it was a reliable source of water, Vitamin C (scurvy- limeys) and Quinine (Tonic water – malaria cure) – together they make a gin and tonic and upped survival rates by over 80% for the UK – India sea crossing.Entrepreneurs wanted to move stuff by sea (not the Silk Road – echoes of bitcoin ) and the mosquito (malaria) and slice of lime were two sides of that coin. Throwing more funding at the plan without the insight would have been stupid (enter the Dutch who pivoted once they figured that South Africa was an interesting trading proposition) and that was how Britannia came to rule the waves…(temporarily)
.That thing in Suez fucked them, eh?Still love a good G & T — can’t be too careful even today about scurvy, no?JLMwww.themusingsofthebigredca…
It was that that made the connection for me – your mention of Panama – It was to be a hat or a long trench and I went for the trenchStill we’re doing some work with the company that dug the thing – so all the more reason to enjoy a large one !
Not sure about the scurvy connection to the naming of the Cape of Good Hope. Widely accepted that Barthlomew Dias discovered the Cape of Storms in 1488 but upon the return to Portugal re-named it as Cape of Good Hope upon the suggestion of King John II of Portugal. The “Good Hope” signified the optimism that a sea route to India might now be possible by going around the Cape (the land route was disrupted after the capture of Constantinople (Istanbul) by the Ottoman Empire in 1453).Why the Scurvy argument doesn’t seem right is that Vasco Da Gama who was the first person to actually go around the Cape of Good Hope and reach India in 1498 lost between half to 2/3 of his crew to scurvy during the trip around the Cape of Good Hope. That was a good 10 years after the Cape of Good Hope was named.Now, subsequently it is said that the Dutch toward the end of the 16th century landed at Madagascar and consumed a lot of limes/citrus fruits…but that was ~100 years later…Vasco Da Gama in fact lost a sizeable portion of his crew to scurvy.The generally accepted reason for renaming “Storms” to “Good Hope” in 1488 was that it created optimism that a sea route to India would finally be discovered…which happened 10 years later. Thanks.
Girish – I like your argument, – I concede – I was only repeating received wisdom.I must however object to the truth getting in the way of an otherwise completely good story ! 🙂
Agreed James – Never let the facts get in the way of a good story !
Da Gama got citrus fruit (mainly oranges) on a stop further up the coast in East Africa, but by then, most of the scurvy damage was done, and it’s not clear he understood the connection either. He probably avoided scurvy personally due to the consumption of dried fruit on the voyage, something not everyone had.Really extraordinary what he accomplished, finding a sea route to India from Portugal – it was the longest journey of any type ever undertaken by that point – the 15th century equivalent of a moon landing. Good book on it:
Heck yes: With open ocean sailingfor moving goods, no toll roads, toll bridges, castles along the wayto be paid off, etc.
An enjoyable book on this subject, you might have read it…http://www.amazon.com/The-P…Thanks.
.I have devoured everything that McCullough has ever written.Every subject he touches, his is “the” definitive work. His work on Roosevelt’s youth is a keen insight into who Roosevelt was before he became Teddy.Thanks.This raises my opinion of you immensely — already held in high esteem — and validates mine of myself.Well played.JLMwww.themusingsofthebigredca…
Thanks :-).McCullough’s latest book came out last month. Haven’t got to it.The late 19th century- early 20th century saw some emphatic physical statements of American achievement – the Brooklyn Bridge, Kitty Hawk, the Panama Canal (all subjects he has written about)You have to wonder what effect this was having on that newly created empire which was established in 1871, and quickly became in some areas the 2nd biggest industrial power in the world. The period of 1871-1914 is a fascinating one. Thanks.
.Great observation.I heard a talk focused on the creation of America from the Civil War to the Second World War that was fascinating standing for the proposition that we struggled internally and then struggled externally and then rewarded ourselves while continuing to perpetuate and struggle with the same shortcomings as a people.Woven through was the role of transportation, tech and money.JLMwww.themusingsofthebigredca…
Iron, coal, coke, steel, steam,rails, petroleum, cars, airplanes,radio, Maxwell’s equations, special relativity, general relativity,start of quantum mechanics, chemistry and chemical engineering,mechanical engineering, passengersteam ships, electric power, lotsof cheap lumber, Victorian houses,mass production of textiles, microbetheory, start on the mechanization ofagriculture and associated astoundingincreases in productivity — exciting, fast moving times.
I get the feeling the US was an interesting place to be in during that time, especially towards the end
Strategy is choice. Choice is hard. And organizational alignment is the key to making those hard choices stick.I like to joke about executive communications that you should use the advertising framework of reach times frequency. A frequency of nine isn’t a bad rule of thumb for an ad to stick in the consumer’s mind. Five or six might not do it.
no doubt. forgoing profits in the name of growth, especially when growth translates to scaling losses (i.e. lose more money the more you “grow”), is an insanely risky strategy. no doubt its preponderance is born of dysfunctional, perpetually bubblicious financial markets and the warped incentives they create.but, while such strategies will end in doom for all, the companies developing a competence in scaling losses will also be able to price many revenue-funded competitors out of the market who are dependent upon cash flow (and thus are vulnerable in price wars).
Are you talking about the Federal Reserve 🙂
A lot depends on the vertical. If it’s winner-takes-all then it’s better to focus on growth otherwise your competitors will take your market share, even if you’re profitable.If it’s not a case of kill or be killed then I agree 100% on focusing on profitability.
What’s interesting about starting a tech company in Minnesota is that VC’s are on the opposite side of the pendulum of the coasts – if you don’t have a clear business plan and a handful of paying customers, it is next to impossible to raise cash.In some cases, this (stereotypical) Midwest conservatism forces us to be creative, bootstrap longer, and discover value, but at the same time it can greatly hinder exploration in social or undefined markets. You won’t Snapchat or Instagram coming out of MN any time soon, but we’re growing in healthcare and enterprise tech.All in all, I’m with you Fred – it needs to be a balance.
Conorop. That’s exactly where we are in Atlanta as well. Because of the dearth of VC money here, all of our tech companies are usually remarkably lean (too lean). And when you look at the $B exits that we’ve had, almost all of them have been self-funded.Fred – the concept of an operating plan to get to another raise at a higher valuation is complete foreign to all of us not in SF, NY, and Boston. It just isn’t an option.
Exactly the same in Philadelphia as well. Outside of SF, NY, and Boston, cash flow reigns b/c there is hardly any 1st round capital available. Plenty of seed money though. Oddly, our most famous fund in Philly, Josh Kopelman’s first round really doesn’t do much business in Philly.
That sounds like later stage VC investing. Seed/angel is different.
I agree! I can count on one hand the firms/individuals that would be considered a true seed/angel.
Conorop – let’s figure out a time/place to meetup – not many of us Minnesota folks prowling AVC!
.Plus everybody in Minnesota is so damn nice.JLMwww.themusingsofthebigredca…
Especially the girls, lots of blonds!Now if I were X years younger, with my startup working,…! By the way, it is possible tohave 90% of the students aboveaverage!
And people wonder why women in tech don’t get taken seriously. Sigmaalgebra, I suggest you check your comments and think about your audience before posting.
Ah, there’s nothing wrong withblonds or “Gentlemen PreferBlonds” or girls being pretty.If they can also do technology, so much the better.For women in technology or to be taken seriously in general,there are issues: One of themstarts right in the crib where thegirls are interested in people andthe boys, things. Without a lotof effort to change things, thatdifference continues so that thegirls/women tend to be much lessinterested in technology.In a narrow sense, just the techitself, the girls can be fine. Butthe situation gets more complicatedwhen consider ‘social context’,girls wanting to ‘fit in’, and otherinterests of girls, joining groupsof girls for, say, gossip, or findinga husband and being a mommy.My wife was an example — terrificat essentially everything includingtechnology. Valedictorian, SummaCum Laude, PBK, Woodrow Wilson,Ph.D. in essentially mathematicalsociology. In writing artificial intelligence (AI) software, she made the fastest progress our AI groupever saw.But there were also other issuesclosely related to being female.Basically Mother Nature was therelong before feminism and has someconstraints that are not easy tosee but are surprisingly effective.There are at least two ways to address these constraints: (1) Believe that they don’t exist,invest years, lose your investment,slowly figure out more about theconstraints, and be sadder butwiser and have lost some years,and maybe more. (2) Take myword for it that there are strongconstraints and that, first-cut, simple approach, just follow tradition, even if don’t understandjust why. Mostly you won’t beable to beat Mother Nature, andfrom women Mother Nature wantsmotherhood, not software engineering.By far, by a very wide margin, therisky approach is to take thefeminists seriously.
This doesn’t even merit a response. However, I do plan to share this on social media as yet another example that some people in tech just haven’t gotten the memo yet.
By now you have responded twiceto my posthttp://avc.com/2015/06/prof…In your responses, you have saidnothing at all direct orrational to anything I wrote; Ihave written nothing about youpersonally; but, twice, you haveaimed remarks at me personally.Not good: What you are doing isarguing a very weak position –no rational content, justpersonal slights.So, apparently you have norational content to contribute.But, maybe you do: If so, benot shy and, instead, cough upwhat you have. Write it down,and send it. That’s what yourkeyboard and this blog are for.The odds of your being, orknowing anyone, better than mywife at technology are epsilonabove zip, zilch, and zero. Hertalent between her ears was offthe tops of the charts amongvery bright, accomplishedpeople. E.g., two of her profswere President, AmericanSociological Association. So, Iknow first hand that women cando technology.But, also as I learned from mywife, I also know some thingsabout women, also from someexcellent sources. E.g., thereis in E. Fromm, ‘The Art ofLoving’, the remark “Men andwomen deserve equal respect aspersons but are not the same.”Darned right they are not thesame.Why do women gossip? Gossip forhuman females is not a smallthing — it’s one of the biggestthings.Why? One answer is also in E.Fromm as a special case of hiscentral point about people. Formore, read Deborah Tannen,You Just Don’t Understand:Women and Men inConversation. Of course, if you actually arewell informed on this subject,then you know Tannen’sbackground, a professor atGeorgetown. She’s darnedserious, in particular aboutwomen and how they differ frommen.Yes, there’s a lot of text inthe public media about womenbeing equal, just thesame, not just in respectbut in essentially every wayother than some obvious anatomy,and Fromm addressed the originof this thinking: He wrote thatWestern Civilization got thatattitude from the FrenchRevolution where any differencewas seen as a threat ofinjustice. The attitude ismisinformed and harmful to manywomen and families.Well, we’re not talkinginjustice; instead we’re talkingwhat’s real and actual: Net,human males and females just arenot the same, and if you insistthat they are then you will haveone heck of a rock to push up avery long, tall hill. You willnot be successful because MotherNature was there long before youwere, along with her buddyDarwin.Technology? I know what theheck I’m talking about: I holda Ph.D. in Engineering, fromsome work in applied math, fromJohns Hopkins. Not easy to get.I’ve published peer-reviewedoriginal research in appliedmath, mathematical statistics,computer science, and artificialintelligence. My currentproject just had me get somesoftware running, software with18,515 programming languagestatements.About one women who was justterrific in technology, again,from my wife, I know what theheck I’m talking about.About some of Mother Nature’sconstraints on humanfemales, again, from my wife,her sisters, her mother, andmore, I have some rock solid,very telling examples. Netthose females all hadintellectual talent beyondbelief but most definitely werenot males — not even close –but were different. I didn’tsay better or worse but onlydifferent.Heck, one of my nieces from mywife’s family, without herparents even knowing what shewas doing, graduated from a verylarge, very competitive highschool first in her class. Incollege, right PBK. Okay, shewent to Harvard Law and thenstarted at Cravath Swain. Shedidn’t much like that so got anMD and now is a practicingphysician. So, we’re talkingValedictorian, PBK, Harvard Law,Cravath Swain, and MD –brilliant. She’s also drop deadgorgeous. But she’s still verymuch a female, not a male.Heck, I’ll make it a littleeasier for you to understand intwo points:(1) That niece in high school,as Valedictorian, totally blewaway, knocked into the nickelseats, all, 100%, of the harddriving, aggressive, knock’mdead boys around. With PBK incollege, essentially the same.In Harvard Law, to get toCravath Swain, third suchperformance in a row.(2) My wife, while in college,wanted to learn some Europeanhistory but didn’t need thecredits for her Bachelor’sdegree and didn’t want to haveto work hard to protect herrecord. So she audited a coursein European history. The profwanted audits also to take thetests, so my wife did that.But, since she was justauditing, she didn’t try.Well, it was a lecture hallcourse with 300 students.Presto. Bingo. Guess who, noteven trying, led the class?Right: At the end the profcontacted her and explained thatshe had made the highest scorein the class and would havegotten an A. Not even trying.Blew away everyone else in theclass.You are lucky you were not in aclass with her — history,trigonometry, statistics,organic chemistry, developmentalanatomy, etc. — because strongevidence is that the best youcould have done was to come in adistant second.Distant? She was so far aheadin the trig class I taught thatshe could have taken a 0 oneverything after the midterm,including the final exam, stillcome in second in the class, andstill made an A. Of course, asit was, she totally blew awayeveryone else in the class.Fire away. Load up your BettyFriedan, or whatever, mortarshells and take your best shots.By the way, there’s someevidence that really BettyFriedan was a Communist saboteurout to weaken the US by makingUS women unhappy being a wifeand mother with the high USstandard of living. She wasastoundingly successful and,net, one of the most destructivepersons in history.Summary: Can some women bebright, brilliant, accomplished,totally knock the boys into thenickel seats, including in theSTEM fields and business? Yes.Are those women really just likemen? Essentially never. Forwork in the STEM fields andbusiness, do those women havesome constraints, vianature and/or nurture, that, onaverage and in nearly all cases,strongly affect what they do?Yes.Are men and women just the sameexcept for the simplestanatomical differences? Nope,on average and in nearly allcases, not a chance, not evenclose.Why are women different? Goodguess: That’s what MotherNature and Darwin want forreproductive advantage.Am I arguing that the feministsare mostly seriously misinformedand destructive? Yes.Where did the destructive ideascome from? Likely heavily fromthe media that always wants astory, e.g., surroundingfeminism and women’sequality. Why does themedia do this? Because theywant controversy, attention,eyeballs, and ad revenue.Doesn’t this hurt thecredibility of the media? No,the media has no significantcredibility.Apparently you are upset by whatI wrote; in that case, likelythe media has gotten you up onyour hind legs all excited justthe way the media wants in orderto get your eyeballs and theirad revenue.A danger is, if you have sisters ordaughters, you can ruin, yes, definitelyruin, their lives encouraging themto chase that feminist stuff.E.g., the feminist stuff was one of themain things that killed my wife. I jokenot. This is serious stuff. Thisfeminist stuff can ruin lives and familiesand kill people — as in dead.Long term, there’s no problem here:Darwin will handle it. Then all womenvulnerable to the feminist nonsense willbe weak, sick, or dead limbs on the treeand, then, gone, out of the gene pool.But in the meanwhile, feminism will kill alot of girls and women who otherwise couldhave had some really good lives. Feminismis a gigantic trail of tears leading tothe final resolution of the grave.I’m outraged: I don’t like to seekittens, puppies, girls, or women hurt,and the feminists are hurting girls andwomen by the tens of millions.And there are a lot of blonds inMinnesota. No joke.
Your comments state that women in tech should not be taken seriously and are simply “less interested” in technology. Can’t wait to show this to Marissa Mayer and Sheryl Sandberg.”For women in technology or to be taken seriously in general,there are issues: One of themstarts right in the crib where thegirls are interested in people andthe boys, things. Without a lotof effort to change things, thatdifference continues so that thegirls/women tend to be much lessinterested in technology.”
I wonder if Fred and Joanne Wilson are reading this. They have backed many successful women entrepreneurs, women who are, in fact, very interested in technology, in building product and creating businesses.
You found no contradiction orinconsistency in what I wrote.E.g., you just need to payattention to my qualification Without a lot ofeffort to change things,For Marissa Mayer and SherylSandberg, (1) now they are bothin general management, and (2)there is little evidence thatthey have much in technicalqualifications.And for changing things, both inthe past were under a lot ofpressure to do so, Mayer atGoogle early on and working withPage, Brin, and Schmidt andSandberg working for Summers.More generally, women who try todo such things will likely beweak, sick, or dead limbs on thetree in which case Darwin willhave something severe to sayabout their contributions to thegene pool.Understanding men, women, andhow they differ, especially fortechnology and business, is abig subject. Net, on averageand in nearly all cases, the menand women are very different.
Hey, check it out internet people! This guy has a wife, clearly he knows what he’s talking about! We should all respect his hard work on this discussion board- not for the sake of progress or the merit of his values, but simply because he put in so much time and effort to publicly display his ignorance in this way online. Hats off to you sir, for finding a place to vent and inappropriately redirect your feelings of inadequacy at members of a minority. May I suggest you get bent, and/or seek some sort of counseling services?
You attacked me personally andotherwise said nothing clear, definite, or of substance andcertainly nothing at all supported.
The science of gender bias is actually more complex than popular culture generally appreciates.We can all be better informed about the facts. Interesting reading in the scientific literature: Rudman and Goodwin, “Gender Differences in Automatic In-Group Bias” and Eagly and Mladinic, “Are women evaluated more favorably than men?”. Always more to learn!
You know the phrase “MN nice”. It means to be nice to someone’s face while turning around and stabbing them in the back
I get there so often I feel like a resident
Check out Minnesota based Vugo/Viewswagen
Try Switzerland for financial conservatism – but when proven they are strong (not talking the banking industry 🙂
Growing up in small town MN and now living on the upper east side after having gone through my previous startups acquisition, I will tell you there is a radical difference between MN and NYC lol.That being said, the costs for starting in MN are WAY lower than anything in NYC. Get a product built, get some early traction and then look to raise money (*if necessary*) in NYC/Boston/Cali. Unless you are looking for under $20,000 funding wise, a company should already have a clear business plan and paying customers. MN doesn’t suffer from the startup hype we have in NYC/Cali, which is actually refreshing…Additionally, there are some pretty good investment firms in the cities – I know a couple of them personally and they are always look for solid young companies to fund.
You make sense, conorop.
I conceptually like the 40% framework, a lot but… Of course not all businesses have the same long term margin potential so there must be a variation that takes this into account. Adding to my todo list
Damodaran has an interesting post around the value of growth.”it is not growth that you should be paying a premium for but “quality growth”, with quality defined as the excess return you generate over and above the cost of capital…If you accept the proposition that growth creates a trade off of lower cash flows today for higher ones in the future, you have the three ingredients that determine the value of growth. The first is the level of growth, with higher growth rates in the future generating higher earnings over time. The second is how long these high growth rates can be sustained before the company becomes too big to keep growing (at least at rates higher than that of the economy). The third and most critical is the return on capital you generate on new investments”.Source: http://aswathdamodaran.blog…
Nice post. I’ll choose to read this as a positive sign coming out of a recent board meeting you had. 😉
A key point can sharpen focus: ‘maybe you need to have a very special company that has real structural competitive advantages in the marketplace to avoid this tradeoff. ‘ Not every company can achieve this, but the degree to which it can is a major driver of sustainable exponential growth.
Well, every deal, every company, every situation is different.It’s good to be able to “flirt” with profitability sometimes to prove that the model “can” be profitable. But sometimes, the flip side can also occur- i.e. the company has revenues and profits and they think that’s it, and they forget to re-fund their growth.Even the best public/large companies that are profitable re-invest part of their gross profits in growth. Between them and startup growth the difference is just a relative one.
Well, every deal, every company, every situation is different.Exactly. I simply don’t see how it’s possible to come up with a few simple rules or guidelines. As if you are planning for a vacation and say “I only want to go to a place that is warm”. Business is nuance and each and every situation and company and complexity will matter.Business is about decision making. It is not medicine and it’s not about following rules that may apply in different situations.
then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.Agree. Otoh having to watch every penny is an unnecessary constraint and overhead that drains people and quite frankly will usually result in making poor choices. “penny wise, pound foolish”. Because it’s to easy to get positive reinforcement from not spending money.  I am sure that you know many people (in business or otherwise) who continue to be cheap way past the point which they need to be. Thinking frugality is some great virtue that will get them to heaven or makes them a better person.
Fred, isn’t that in conflict with the way VC funds operate? Most VCs require the 20X returns to justify the risk they take… or don’t take. If you want companies to be profitable at every stage of growth how can you get that 20X return without owning 99.9% of the company? Are you saying that VC should become a lower market growth equity PE and be transparent about it?
Really? Never forget the value of “G” in the DCF.
we made about a 100x return on the single round of primary capital that Indeed raised. and we owned less than 20% of the business. something like 15% i believe.
A few thoughts and some simple (probably wrong) math:1) Indeed.com estimated at ~$1b exit (http://www.businessinsider….2) 15% stake worth ~$150m implies $1.5m initial investment3) 2004 USV fund was $125m of commitments, so Indeed.com returned whole fund and then some4) Exit in 2012 with investment in 2005 implies ~93% IRR5) Interesting to go back and read original announcement post: https://www.usv.com/blog/in…All in all – WHOA. Not a bad deal!!
smart guys you invested in
Fred never implied that the companies need to be profitable, only that they should optimize for profitability as opposed to future funding.
Really surprising how many startups operate at a loss without any idea of where the break even landing is. I get it for conpanies like Twitter but conpanies in the sharing economy don’t exactly operate in unchartered waters.
Tying it in with yesterday’s post on ‘Does it tell a story?’, startup teams could do this to examine where the growth vs profit trade-offs and inflection points are.This is an example (not my model).
This reminds me of an interview with Joi Ito that was posted on this blog (http://avc.com/2014/06/vide…. Joi Ito takes the approach that revenue will figure itself out when you grow and says “The traditional obsession with the so called business model […] is a short sighted focus”.In stark contrast to David Heinemeier Hansson who is very critical of growth without profitability (I wrote a post about it a while back http://blog.robertsj.com/tw….I guess it depends on the business you are trying to build, also if you are still figuring out profit-market fit or just copying a business model that already found this.
Yup. In the Midwest, there have been tremendous constraints on capital raising. It’s not like the Valley, or even NYC where there is more money available. (Just because it’s available doesn’t mean you can raise it. But, it’s easier to set up a meeting in a coffee shop than get on a plane and fly to a meeting in a coffee shop) That has forced companies in the Midwest to think about revenue early, very early. People won’t invest without a path to revenue.
The thing that stand out – didn’t those very best companies make a mistake in taking on VC investment (assuming that working with USV is an obvious answer, so we will have to talk theoretically here).
maybe. a few of them didn’t need it
Yes, yes, yes. I love this post.There is a thought, that double sales people, double sales!!! Heck why double lets quadruple. But that is not always the case.It can be true but many times not.South Park did the best spoof on it with the Underpants Gnomes.
When ever I meet a startup, I want to know the sales strategy. I want to know who the target market is, and how long the sales cycle is. My experience is that sales cycles are typically a LOT longer than startups estimate, and that screws with the math around lifetime value of customers and customer acquisition costs.
The time that someone says it takes to sell their product or service really is meaningless unless they have actual data to back up what has happened in the past. Without that any estimate is going to be way off. It only differs in how off the estimate is.Even if someone happened to say “takes 3 weeks typically” that couldn’t possibly be valid. Why? If you know anything about selling you know that there are times of the year that people simply don’t make decisions. Holiday times for example. Or seasonality as another. Or various levels of decision makers that can nix a project and/or delay it because of their schedule and whether meetings and agreement are needed.There is also a great difference between selling to a qualified lead that contacted you vs. selling to someone who hadn’t yet thought about your product at all and might not even want to be bothered with even taking a sales appointment. And a million other little details. Even what appears to be a qualified lead might just be kicking tires (as the saying goes). Look at your own behavior how many inquiries do you make vs. how many times do you actually purchase what you have “requested literature about” (as used to happen in the past).
“I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make. It roots out bad investments in people, product, sales, marketing, and elsewhere in the business and helps to maintain a lean and mean highly functioning organization. If you don’t need to make money because there is plenty of capital available to fund your losses and you are “investing in growth”, then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.”So very true.
Clayton Christenson talks about this problem being prevelant in big corporations seeking to launch startups internally. They throw a lot of money at these incubator business units, removing any urgency to achieve profitability. When the incubator business does poorly, the parent company keeps investing in “growth”, effectively creating a bigger problem.
Heh, totally watching this unfold in the company I work for at the moment. So weird, it’s as if no one there has ever read The Lean Startup before. Instead they’ve thrown a ton of cash down a hole with no chance to recover any of it.
I like the way Amazon operates – They could be profitable every year, but they choose to re-invest every cent they have into infrastructure, operating costs, team, and new developments. This keeps them agile, ahead of the market and prepares the ground for future growth.More than sales and marketing, I think infrastructure esp in physical world businesses will be the key differentiating factor aside from the network effects a distributed and globally powerful network bring with them.VC Investment that goes into preparing markets, and scaling across physical barriers like distance and space would possibly justify investments before reaping their rewards.Because the only reason I took VC was because I had to invest in infra that didnt justify current cash flows but was a bet on the future (with visibility of course).Thanks,Pranay
Down here in Dallas the money folks are very conservative coming our of real estate, oil and gas. They like B2B plays (Tech Wildcatters )preferably with (lots) of revenue and customers
Translation: Raising money at a higher price isn’t as likely as it used to be..
You know, from many years of conversations, that I agree with this. But – right or wrong, appropriate or bubblicious – haven’t most (maybe close to all) the returns in VC over the last, say, decade, come from exits of companies that never achieved real positive cash flows?
yeah. but i am celebrating that ones that did today
amen brotherstill. it took me many years to grok that the role of VC is *not* to create successful companies (though that certainly happens.) rather, the role of VC is to fund the industry’s/nation’s/world’s R&D. which may or may not result in conventional P&L results, but which, over the longer term, result in more/better/more readily available creature comforts, and increases in productivity and efficacy… and, ultimately, profitsof course, that lofty rhetoric still is not justification for the obscene fees! 😉
Totally agree that most of VC is an outsourced R&D function. Back in the 50’s and 60’s, big corporations all did their own R&D. The rise of the venture industry in the 70’s and 80’s was really just another piece of the great outsourcing migration, similar to executive recruiting, IT, etc. Occasionally, VC is about business building, but it’s definitely the exception not the norm. And a lot of people (investors and operators) get mixed up when they’re not fully cognizant of which game they’re really playing.
Top 5 AVC post ever. I’m wallowing up with tears of joy. Profit does matter afterall? So many people look to you and learn from your blog. For young bucks to hear about a word called “profit” and for someone like you to tell them it matters… game changer. Thank you.
Early positive margin shows many risk factors are manageable – Organic positive margin growth (especially on top of a bootstrap) indicates:1) MVP (Viable !!!)2) Some understanding of a commercial market (Not-Negligible)3) Some team competence (useful)4) Controlled technical risk (doable)5) Almost certainly market insight and vision (because such spaces are uncommon)A) If a margin = 40% is proven, growth DOES makes sense (organic or funded).B) If growth = 40% is proven (organic or funded) IT SAYS NOTHING for eventual margin.All else being equal A beats BA) plus funded growth = happinessB) plus more funding = more B)Happiness in a big market <—- Pig in cloverThat’s an objective worth pursuing
Would a re-think of growth vs. profit by VC’s lead to a higher % of exits? Obviously, the current orthodoxy and investment strat is working for many a VC but could even a marginal re-balance lead to more success stories (and frankly more reasonable investments and valuations)?
Another trade off is the “pull the plug” outcome.Given a profitable core – funding is not part of the survival plan – and that makes sense especially in frothy markets.
What are some examples of a profitable startup that didn’t spend enough and got outfoxed by some growth-at-all-costs venture funded firm? Just looking for the real world examples of the cautionary hypothetical that justifies this Get Big Fast 2.0 mentality. Even industries that have big network effects?The video game industry is replete with self-funded successes though most are quiet about their numbers. (Storm8’s CEO did write about this yesterday: http://techcrunch.com/2015/… and the now publicly traded King.com took minimal capital to get to their scale.) Should Zynga have aimed for profitability instead of scale?Amazon is of course the re-investor par excellence. But the account of how close they were to running out of funding (in Brad Stone’s “The Everything Store” among other places) is harrowing. Obviously they created a ton of value but competitively, they’ve only pushed out only other non-profitable retailers with less access to capital. Walmart did $2.3b in net income in first full year of Amazon’s operations (1995)…and $16b last year – one might ask just how impacted have they really been by Amazon?Even when there is a clear invest-now mandate it seems very hard for companies to culturally switch gears to profitability. Instead the capital allocation habits continue and they overshoot with increasingly indiscriminate, costly growth initiatives.
Reminds me of the Silicon Valley HBO episode (Sand Hill Shuffle), where the ex-CEO Goolybib was surprised to hear that he could have taken less money because nobody told him he can.So I am glad you posted this.
Thank you! I was beginning to think there was something wrong with making a profit! Your formulas are much appreciated.
Self-funded companies don’t have the option 🙂 40% metric is a helpful one, thanks!
There is a corollary here with corporate ventures. Many of the most ambitious startups within a corporate environment are not allowed to have the initial negative profit / low profit runway required to scale up, and they are killed prematurely. But the ones that survive and achieve escape velocity are virtually guaranteed to deliver returns accretive to the corporate parent’s profitability. That level of profitability is in their DNA from the start.
“I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make. It roots out bad investments in people, product, sales, marketing, and elsewhere in the business and helps to maintain a lean and mean highly functioning organization. If you don’t need to make money because there is plenty of capital available to fund your losses and you are “investing in growth”, then you can also avoid making the hard decisions that focus an organization and insure a high quality team where everyone is pulling their weight.”This paragraph should be emailed to every stakeholder in the startup community including founders, VCs, angel investors etc., then maybe the “irrational exuberance” ,the phrase Alan Greenspan coined, will end.
@FredThe irony to this post is that all of USV major exits have been to companies running at a loss.Geocities, Tumblr, Twitter, Zynga, etc.
The reason “many entrepreneurs” do this is many dealers give away the first dose for free.
This is the part we all tend to forget when discussing this pretty hot topic: “I also think the profit motive, generating more revenues each year than the expenses you are spending to do that, is a really valuable constraint on a management team. It forces them to think creatively and logically about the investments they want to make.”It’s a red flag that (usually) only those with some experience can see before it’s too late, especially when you’re dealing with young entrepreneurs who haven’t had to balance budgets and forecast and manage P/L, and build cultures.
exceedingly well said Mr. Wilson.
Good article. The Silicon Valley mentality of huge, profitless companies being worth so much always left me puzzled. Most of my encounters in business world have the people with money saying “Show us value,” while preferring the investment keep providing it. I think the incentives of the VC’s and market reinforce the trend.I’d like to see some tech VC’s focused on funding companies aiming to provide good products and services over the long-term that actually make a profit. Especially those displacing the big IT companies’ various solutions.
Late to the party here, but thanks for writing about this Fred.We’ve grown CB Insights through revenue and despite that have managed to maintain a serious clip of growth. It just means we’ve been judicious in how we spend the money to ensure that growth.My co-founder, Anand, talks about this quite a bit in his Mixergy interview with Andrew Warner. If you have some time on your evening commute, highly recommend tuning in: http://mixergy.com/intervie…
Investing in the wrong kind of growth is an artificial crutch.
Maybe I’m just channeling @kidmercury here, but does anyone else see a parallel with government(s)?Separately, though, this tradeoff between the short-term (profit) and the long-term (growth) shows up everywhere – and you have to survive the short term to get to the long term (see gaming term: ‘zerg rush’). Arguably this is one of the reasons behind income gaps that widen over generations – those with less have to devote more, percentagewise, to survival, and thus have less to devote to (financial) growth.
Broadly, there’s a big flaw in theanalysis:CEO: Our potential market is huge, nohumongous, no, astronomically jumbo — wecan own the universe and everything in it.We just need funds to expand to meet thisfantastic opportunity.Skeptic: You have fantastic demand, youmean now?CEO: The desperate customers are nearlybeating the doors down, rushing to stufftheir money into our hands.Skeptic: Desperate you say?CEO: Beyond desperate. The stories Icould tell you ….Skeptic: Well, if for a while you raiseyour prices then you will get more revenueat your current level of delivering yourproduct/service but still have plenty ofcustomers ready to pay your higher prices.E.g., if at your current prices you have300 eager customers for each 100 units youcan provide, then raise your prices untilyou are selling only to the 100 carriagetrade, Chablis-Brie, high roller, cost noobject, Beamer 7 Series, yacht club set(get a brand name with high prestige) andthe other 200 save their money.There’s even a chance that, for each 100units you can provide, your higher priceswill increase the number of customerseager to by from 300 to 600. Call that anice problem to have.The extra revenue you get will be justwhat you need to increase capacity toserve more customers. Then you can loweryour prices to get those extra customers.So, there is a demand curve, andwhat you should do is to increase yourprices to a market clearing level,that is, so that amount the customers wantto buy is just the maximum amount you canprovide now. Then the extra earnings willgive you the cash you need to growcapacity, lower prices, serve morecustomers, grab the market, establish yourbrand name, have economies of scale for abarrier to entry, etc. and be on your way,as you said, to owning the universe andeverything in it.Or, in short, if the business is reallythat non-stop, never-quit, all-go, toinfinity and beyond, with currentcustomers thrilled, with donut scalpersselling your donuts in front of your storefor three times what you have beencharging, then you should be able to raiseyour prices — as is standard with ashortage such as you have — andwith the higher prices and resultinghigher earnings letting you increasecapacity.E.g., if your business is a Web site, thensay that users need to register, and onlyregistered users are allowed in. Have awaiting list, first come, first served,for more registered users, and e-mail themwhen you have more capacity and accepttheir registration application.Tell your advertisers that you have themembers of the Long Island Ferrari OwnersClub, the NY Yacht Club, the BoD of MoMA,the BoD of Lincoln Center, the AllianceCôte-d’Or, the HBS Alumni Association,and the New England Beamer Owners Club allsigned up (the members, along witheveryone with season tickets to LincolnCenter, get priority registrations!) andare raising your ad rates.This is complicated?
Will the fed rate change all of this?
Actually, if have much data to talkabout an answer at all, then the issueis each, say, month decide how muchto spend on growth.Then with solid data, have a deterministicdynamic programming problem. AnExcel spreadsheet is a good way toformulate the problem, say, one columnfor each month and one row for eachvariable and some unknown decisioncells for the decisions to be made.If don’t want to trust in a deterministicproblem but accept that will have someexogenous random variables andhave even a first cut on the distributions,then have a stochastic dynamic programmingproblem.Really, again, if have enough data totalk very seriously at all about whatto do, then very much should attackthe problem with either deterministicor stochastic dynamic programming.These two are the discrete time, usually non-linear versions of optimalcontrol.It should be done. I’ve done suchthings before — they don’t have tobe too difficult.
It can be done. We’ve done it. But at the expense of growth. We’ve sort of been the beneficiaries of having received a lot of “we love you but you’re too early” from VCs. As a result we built out a viable business and got revenues, and can now focus on viral growth.Having said that, my advice to entrepreneurs would be to give up more of your company early on, and accomplish more things at once. The only reason we didn’t do that with Qbix is because we’re really passionate about our long-term vision and plan to be doing this 5-10 years from now. We want to be for people’s social lives what Google is for their information.
Great article as always Fred! You are the most balanced writer on the tech scene around AND you are a VC. Wow!The one thing I think is missing for your piece is the economic cycle. I think you have to tilt / adjust your analysis and ratios depending on where we are in the economic cycle. It was fine two or three years ago to be going gang-busters for growth with interest rates as zero and money freely available. We are now at a stage where interest rates are just about to start going up and money supply will be restricted. They will affect private funding dramatically in the next year or so.The focus at this stage in the cycle now has to become a profit. If it does not and companies keep chasing growth then they will burn cash and be in a difficult funding position when they realize that money is not longer freely available. Some companies (and plenty of unicorns) are going to find this out the hard way unfortunately but sounds like you will have your portfolio companies well warned…………
Profits verses People.
I suspect this is largely a function of the market environment. When capital is available cheap (as is the case today), focus is more on growth vs profitability; whereas during the times of scarcity of capital everyone is laser focused on becoming cash flow positive…
It is next to impossible to raise money for tech startups here in Myanmar. I am currently thinking about opening a life style business (like a taxi company or a fancy restaurant) and use that revenue to support my tech startup which is not going to make any money soon. Bootstrapping seems to be the only option for now.
Great post Fred…too few entrepreneurs focus on profitability
As someone starting a company in Dallas, I can’t afford to play the leaky bucket growth game. Investors here are not as willing to take a chance on a company with no revenue (or plan for revenue. You are 100% correct that it forces a team to be much more scrappy and analyze every penny being spent on growth.
Wilson is being polite here in the way he is framing the issue. There is an even bigger problem than ‘Profits vs Growth’.There is a strong attempt within the larger VC community to actually redefine the meaning of the word ‘profit’ based on ‘subscription economy’ exceptionalism–i.e. that SaaS or ‘as a service’ businesses should NOT be measured on GAAP accounting principles.FYI, my piece from a year ago titled “Software is Eating the Income Statement” which pushes back on Andreessen Horowitz attempt to do just that. Since then other VCs have also taken up this banner of SaaS or subscription economy exceptionalism. Link below.https://medium.com/@Platfor…
I love this blog post!!!!!!!!!!I hope my use of many exclamation points properly communicates my enthusiasm :)I run a company that is growing more than 200% year over year with millions of dollars in revenue and is profitable with nearly 70% gross margins. For more than 18 months in a row now, we have operated cash flow positive every single month.What I appreciate about this post is that I feel like the tech community acts as if there are two options:(1) raise tons of money and burn through it on your way to your IPO (which happens before profitability, mind you) or (2) have a middling lifestyle business.I understand that not all profitable businesses are VC fundable, or will grow into the next big thing, but I think the continuum of companies is much more diverse than most startup entrepreneurs are wiling to acknowledge and enormous value can be created all along that continuum.Or put another way, amazing, HUGE companies are built in a myriad of ways and at the end of the day, fundamentally sound economics are…fundamentally sound.
Here is some sober thinking from Mike Tuchen of Talend along the same lines. Tuchen says companies that raise a bunch of money often become extremely sloppy in execution. http://www.forbes.com/sites…
growth=bribing people with free stuff to help keep the story going
If one does have the backup by investorsand can focus on growth for a longer period it sees a good idea, especially inB2C. Our SaaS company is purely in the B2B market where sales cycles are long.In addition, my experience is that being in the market for a certain period (afew years) and truly claiming to be profitable was a key asset when talking tonew customers and an important stimulator for growth (we now work on, afterbeing in business for several year). This might be a specific experience of astart up originating from Germany.
The growth chasing tendency of entrepreneurs that you complain about has majorly been created and fueled by the valuation strategies of venture capital industry.I do not see any bootstrapped businesses fueled by revenue and not venture capital adopt a reckless growth mindset. This is IMHO probably the biggest reason some entrepreneurs avoid venture capital.
I think it makes sense to earmark money to burn when you’re running experiments to look for a product market fit – plus, who the hell knows what profitability will look like? But when it comes to pouring fuel in to a business for growth, if the goal is to build a sustainable b2b business, I would think you’d really want to be at least be chasing profitability. And I think Fred is talking about growth rounds: B/C, etc..You know, I’ve now worked in both extremes, and I’ve seen how the financial discipline from building organically grown businesses can provide for very helpful, refreshing business instincts that startup teams out here in SF highly value: When you’re working to build a profitable business, you think about how to be better at sales, a lot. Sales also happens to be a critical tool for finding product/market fit.After the crash of 2008 I was in NY focusing on maintaining profitable, organic growth working for a privately owned energy services company. The owner, a former wall-street guy, has built to the company from around ~30 when I joined in 2010 to around ~350 employees today – growing in a highly financially disciplined manner with each leader held accountable for their own regional or functional profit centers. For example, when I opened the NYC office, I wasn’t able to hire another sales person until I could sell enough to support both of our salaries – and the same went for the operations team. This model when done well, can foster healthy competition, financial stewardship, great salesmanship + creativity! While anyone can blow money, this kind of discipline provides an awesome training ground for business leaders that I think Silicon Valley would benefit tremendously from seeing more of.
Maybe your should look at what RawVoice is doing. VC’s did not even give us a chance and all the companies that they invested in our space in are gone.. Millions burned.. But we are still here. We had to be smart, we had to watch expenses and we are still growing rapidly.Would I take VC money now.. No.I also know that we would be in the graveyard had we had the chance to take money in the beginning. Our goal continues to be to not have a lifestyle company but being profitable for 10 years is still quite satisfying.
@fredwilson:disqus I’m curious why more VCs don’t take more of a portfolio approach here, focusing some of their investments in a given fund on startups that have achieved breakeven (and therefore are presumably less risky) and the rest on the negative-cash-flow moonshots (which naturally must be more risky). Private equity firms do the equivalent (i.e. consider allocating some capital to presumably lower risk companies that should generate a baseline return for the fund and the rest to riskier plays). Is this ever part of your equation? If it is for many VCs, it certainly doesn’t get much airtime.
Agree with that last sentence — entrepreneurs look to those who came before them for guidance. And if those who came before them didn’t focus on profit, they assume they don’t have to either.When we hit a down cycle and the funding runs low, which I believe is coming in the next 18 months, those who focused on profitability will be better positioned to attract new capital (if needed).
good to read … many thanks
Angels, incubators and VCs should force their portfolio’s founders to study balance sheets. I’ve spoken with quite a few founders wanting to be profitable, but not doing the right math. Scary.
I was wondering how you can apply this rule to a company that has no revenue at all yet, e.g. a company that is offering an app with a future subscription model (that’s not been activated yet) to focus on user growth for now?
I would focus on user growth and benchmark it against similar companies.
Different markets have different appetites.I have no experience, but I really can’t see VCs in London chasing Unicorns the way people in the Valley are.
Couldn’t agree more, a few days back I read this article (http://blog.hubstaff.com/sa… which touches same point (profitability) but from a really different side..what do you think? – Natwar
Most of the startup in Asia put profit above all. Of course market share is equally important
Of course every business/vertical is different, but there is still a clear take-away here. I like ALWAYS talking about growth and profitability in terms of each other. They are two levers that operate in tandem, and it makes no sense to discuss one without the other.When VC or aquirers ask about revenue, the answer should always be: “Revenue is X because Profitability is Y.”
It was an image, which Disqus doesn’t let us edit after posting, but I’ll try attaching it to this comment too. In case it doesn’t work, here’s a link to the author’s page on the book: http://www.nigelcliff.com/?…