But there are yet other dilemmas that surface as the company actually makes progress and gets through the initial phase of starting up and generating revenue. One such dilemma that is sure to face most, if not all companies, is striking a balance between growth and profitability of the business. I
None said that the startup business is easy. Being an entrepreneur is anything but a cushy, risk-free undertaking. The front-end challenges that entrepreneurs face are endless—the Catch-22 of needing capital for traction and traction for capital; getting early employees to buy the vision and give up their comfortable salaried positions for risk and uncertainty; constant worry about running out of cash; living on nothing, often sacrificing all and dealing with angry spouses or others from time to time—the list goes on. But there are yet other dilemmas that surface as the company actually makes progress and gets through the initial phase of starting up and generating revenue. One such dilemma that is sure to face most, if not all companies, is striking the balance between growth and profitability of the business. I have been in the middle of multiple such conversations, of late. It is a non-trivial topic and one that often can and does create tension and friction among board members and between the board and the management.
Let us take a hypothetical example. Let’s say company Jolly Foodies Inc (I actually started a ‘cuisine of the week’ club a couple of decades ago in college) is doing $2 million in annualised revenue but burning $100K a month. There is $600K in the bank (roughly cash for six months). Revenue has grown, albeit organically. The pipeline is strong and management is confident of an uptick in the business. Competition is intensifying. The question in front of the board and the management is whether to cut the burn at the expense of growth and get to profitability, or continue spending (or perhaps even invest further and burn more given the prospects of downstream), so that revenue takes an uptick over the coming months which will potentially excite another venture firm to invest at a higher valuation. The ideal scenario is one where the existing investors are bullish on the business and have deep pockets so that they can bridge the company through the growth phase until the company is able to get another investor on board (at a significantly higher valuation than where the existing investors invested). But often, existing investors are either unsure or simply don’t have the capital available to make that sort of commitment. Often a bridge has to be to something tangible—either investment by a new investor or an exit. In the former, the expectation is that a term sheet is already on the table and it is just a matter of time/paperwork till the cash comes in. So it is a true ‘bridge’ rather than a pier (that is, a bridge to nothing). I have had the privilege of being in both circumstances (choosing between growth and profitability) leading to both positive and negative outcomes in different cases.
In one case, the company had raised significant capital but decided to burn it on TV spend with the hopes of revenue impact through brand enhancement/recall and therefore transactions. With cash running out and burn out of control, I essentially forced the management to cut burn, lay off a chunk of the company and get to profitability, which they did. But at the same time, the key competitor decided to take a chance on continuing to burn and spend on brand building and revenue uptick even though they were also at risk of running out of cash. Their gamble paid off with a sizable infusion from a new investor and continued growth, while my investment, while profitable, had much more organic growth and had to cede market leadership to the competitor and play catch up. In another situation, the board decided to go for growth since investors were paying interesting ‘revenue’ multiples (overlooking EBITDA or profitability), and create a market leadership position. The company did just that, but in the process became addicted to a certain extent to the growth drug and lost site of fiscal responsibility. New investors didn’t quite buy the growth-only story and are focused on net margins and the overall health of the business. The company and existing investors found themselves in a real dilemma, and had to dig deep to essentially bail the company out.
The examples above clearly show that there is no cookie-cutter answer to the question, but here is my fundamental take on creating lasting companies. If the company happens to be in a ‘winner takes all’ or even a ‘winner takes most’ category (think Twitter, Facebook, etc.), then investors need deep pockets to stick with it and simply go for it, with a high likelihood of a binary outcome. In other categories, the fundamental business and business model should be proven before firing on all thrusters. Indian ecommerce players like Flipkart and Snapdeal are in that camp. Investors had to rely on much larger global players coming in, and the only way they would is if the companies were considered leaders in their respective large categories. Time will tell whether these companies eventually succeed and investors make money (especially those who were early and have significant preferences stacked before they see their returns), but I would argue that they had no choice, given the category. And that’s why many other players will either not make it or simply become lifestyle businesses (since they will not have grown and therefore attracted capital and are forced to become profitable at the expense of growth). There are again exceptions in highly profitable software businesses where cash from the business itself can be invested in growth, albeit more organic than a more than 100 per cent year/year growth number that many startups experience with capital infusion.
There are obviously other categories like pharma and semiconductors where the product development cycle itself is long and therefore capital-intensive, and the question of growth versus profitability is deferred.
The life cycle of a typical startup goes something like this (admittedly a gross generalisation, but more as a framework for discussion). Raise seed and/or Series A capital depending on the business to get to products and perhaps to some initial revenue. Raise a Series B typically to prove that ‘the dogs will eat the dog food’ (healthy pipeline of customers, or adoption, if a consumer play) with the unit economics being proven out (and a line of sight towards profitability) and then Series C and beyond to simply ‘pour it on’ once the business model is proven (what I have just described is utopia). A negative gross margin or a razor-thin gross margin business cannot be made up in volume. There are clearly exceptions, and given that the pace of innovation itself is accelerating, there is very often a ‘window of opportunity’ argument that entrepreneurs make with investors when raising capital. Basically saying that unless we invest in the business (and grow) in the near term, we will be obsolesced or leapfrogged by the next new thing and couple of teenage founders who can live on cold pizza, warm beer for weeks and can stay up for four days straight without sleep. By the way, I am convinced that in this decade we will see more teenage entrepreneurs turn billionaires than ever before (please ping me in 2021 for the 2020 Forbes billionaire list).
There are no easy answers here but some rules that I encourage entrepreneurs to follow.
1. Cash is king, and a survival is a pre-requisite to thriving. Keep an eye on that like it is your own money (and you are not wealthy).
2. You should always have (or try to have) at least six months of cash on hand. Investors can smell desperation in case you are about to run out of cash, and then all negotiation leverage goes away.
3. Always have a plan B. Hope for the best, but plan for the worst. Assuming the company make a ‘go for growth’ and ‘f@#$ profitability’ decision, then there ought be complete agreement on consequences and plan of action in case the fundraising exercise does not come to fruition. Plan B most likely will involve cutting burn through layoffs. If necessary, cut deep rather than take the incremental reduction approach. As difficult as it may seem, if the CEO/management is transparent with the employees and are able to create a culture of vision and conviction around their long-term plans, employees will stay and the company will make it through the downturn. I have been through this several times. Often going through a rough patch will make the team and the company stronger, socially and fiscally (in terms of having discipline around spend, for example). As a result, as and when the tide turns positive, the company will actually enjoy higher margins because expenses will have been optimised and operations will be more efficient.
4. Open dialog between investors and management, including plan A, of course, as well as plan B. Having a way to control one’s own destiny is much better than being on the mercy of a potential investor(s).
Much of what I have said may seem obvious, but when one is in the trenches, either as investor or management, the discussions are often not rational, but very emotional, and tempers can run high. In mature markets, growth slows and companies often grow internally through acquisitions. In emerging or nascent markets, companies try to create a leadership position by spending, in what they think is a winner-take-all market. If the market develops more slowly and turns out not to be a winner-take-all or winner-take-most, then companies soon find themselves in the valley of death, out of cash, without any meaningful revenue uptick and a lot of fingers pointing and the ‘should have, could have, would have’ conversations.
(Mohanjit Jolly is the managing director, Draper Fisher Jurvetson India. The views expressed are strictly personal. They do not represent the views of the organization he represents.)
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