Consider two software companies competing in the same market. Assuming that they both have a 60% gross margin and they agree to run their businesses in the same way for a year. They both raise £3 million as seed capital to fund their first year’s operations.
In their first year, the two companies lose £2 million each. In the second year, Company X loses £4 million while Company Y breaks even.
The question is, which company would you prefer to run?
Though at a glance one may label Company X as ‘not profitable,’ there is no way of knowing which of the two companies is healthier to run.
Let us consider what the two companies did.
Company X raised £10 million through venture capital to fund growth. They used the money to do the following.
- Hire a bigger tech team in a bid to roll out an additional product line
- Hire a marketing team to promote their brand and advertise their product.
- Hire a business development team to work on agreements to have their products entrenched in other company's products in a bid to increase customer demand.
- Relocate to a bigger office to offer employees comfort and improve their retention.
If the market had a high demand for their product, the investment could pay off handsomely.
On the other hand, Company Y was more into maintaining the control of their business. They did not want to take dilutions or new board members.
Looking at the two companies, unless you understand the target market, you may not know which company is better to run. If the target market is a vast and fast growing one, Company X will make it harder for Company Y to compete in the long-term. However, if the markets are not large, then Company Y may get a nice exit package at a relatively good price hence make the founding team wealthy since they did not take on venture capital.
Therefore, there is no obvious or correct answer.
Looking into the third to fifth years of the two companies.
The investment made by Company X will pay off, and their annual growth rate will go higher. By the end of year 5, Company A will have earned a cumulative profit of £19 million while that of Company Y will be just £6 million.
While we can argue that the two companies may have a bright future, Company X may use its growth rate to lure more customers, market more, innovate its products more and attract more capital. Due to Company X's growth, Company Y's profits will decline over time.
This explains why large tech start-ups often yield “winner takes most” outcomes.
Super high growth rate start-ups
Consider super high growth tech start-ups, which are the type that uninformed commentators will be quick to tag as being uneconomical for they are not profitable. They are the kind that will have to raise between £60 - £100 million to fund their super high growth operations.
This sounds crazy, and you could think that they should have slowed down operations to “make a profit.” It is not as obvious. If they have a spectacular growth and cheap capital is within their reach, they could be crazy not to raise VC money. It is even likely that after around four years, they could begin filing to have their IPO public.
If a company's growth rate is low, it may need find an alternative use for its profits like returning it to shareholders
If you feel that this is not convincing enough, please contact us. We have specialists in accounting that will help you understand fully the trade off between tech start-up profitability and growth. Talk to us anytime.