Whether profitability in a start-up matters or not is one of the topics that even the smartest business persons, especially those who are not start-up oriented, do not fully understand.
It is common to hear people talk about a re-known startup as they confidently pronounce that it is on its deathbed for it cannot succeed if it is not profitable. They will also mention about Snapchat that seemingly lost $2 billion in just one-quarter and they will ask, “How does a company lose two billion?” “What a disaster!”
What they fail to understand is that, in actual sense, Snapchat did not lose $2 billion in cash. Rather, it was an “expense” related to a share based option scheme. They only lost about $175 million in cash, but because we are in an era where we only read the headlines, we cannot help but believe that they lost billions.
A healthy tension between growth and profit is a common for any tech start-up. At first, as a tech start-up, you fund invisible growth for the first 6 – 12 months. Sales people provide a perfect analogy to explain this.
Take a scenario where as a start-up you hire six sales representatives in January. Assuming that you give them a monthly stipend of $60,000, you will have taken on an extra cost on your start-up of the same value per month, yet the sales reps may not close any new business in the first half.
This translates into a decline in your profitability in the first two-quarters but from the third to say the twelve-quarter, growth will increase dramatically.
While this logic seems obvious, we can promise you that even the most intelligent business persons overlook this when conversing about profitability. The fact that 70-80% of your cost is on your employees explains why un-profitability to you should mean that you are growing your staff ahead of your revenue.
The trade-off between growth and profit explains why your growth will be slow if you do not invest in hiring more people.
Nevertheless, your objective as the founder of that start-up is what will determine if you will consider growth first or maintaining profitability. For instance, if you imagine that at some point you will eventually raise venture capital money, you should focus on growth. Investors care more about the growth of the company they are investing in than its current profits. In as much as they do not want high burn rates, they never fund slow growth.
When an investor looks at the financial statements of a start-up, they want to understand the growth drivers of that start-up. That is why they will focus on the revenue line to determine whether the number of units the company is selling is increasing over time and how they are performing in terms of customers retention.
When people hear or read about companies, they do not take the time to consider the details. For instance, you may hear of two companies with current revenue of $15 million. If one company is growing its revenue at 50% per annum and the other at 5% per annum, these two businesses will be very different in the future. Since people do not take the time to look at these details, they will not know this with a snap judgment.
The Nature of Revenue Matters
Further, it is prudent to under the “quality” of the income since revenue alone won’t tell you enough. You need to determine
- The product lines involved
- What percentage of the customers makes up the revenue. Does 10% of the customers make 78% of the revenue? This is known as “income concentration.” There is a risk of revenue dwindling in the future if the larger percentage of the revenue comes from a small proportion of the customers.
- Is the revenue determined by a concentrated set of distribution partners?
Revenue is Not Revenue
The revenue in figures may at times be deceiving. You need to take a deeper look at the gross margins. If your company has a higher cost of sale, its gross margin will be small. Normally, companies that sell their products directly to the consumers have a lower cost of sales than those that sell through third-party re-sellers who charge a certain percentage on any sale.
If you feel that this is not convincing enough, please contact us. We experts that will help you understand the trade-off between tech start-up profitability and growth.