aIn the past decade or so, a story has taken hold that successful startups, particularly in the consumer space, must prioritize growth over everything else. After all, investors only support founders who are after great market opportunities, rather than profitable niche businesses.
Didn’t all the big companies like Google, Microsoft, and Amazon implement the same rules of the game – big idea, raise a lot of capital, innovate quickly, hire the best talent, invest aggressively to acquire customers, and ultimately eliminate the competition? Haven’t we all heard of the winner-takes-all model, where the flywheel begins to turn profits as the sector transitions to a monopoly (or monopoly)?
Nothing could be further from the truth. Microsoft has made profits in its first year, PayPal in two years, Google in its third year, Facebook in its fifth, Netflix in six years, Airbnb/Amazon in less than nine years. Even Tesla, which had to invest heavily as a class builder, also made its first profit in ten years.
So, what has changed?
Until a decade ago, startups raised a few rounds of private capital and then had to either hit public markets or enjoy buyout offers from a bigger player. Since the availability of private capital was limited, companies could not maintain a “growth at any cost” guide for long and had to take a more disciplined approach to balancing growth and profitability. The availability of private capital (and plenty of it) gave founders the option of continually raising capital and staying private for longer. Venture capital investments in the United States increased tenfold, to more than $300 billion in 2021. Huge funds like promising companies can now focus on growth and not worry about earnings or quarterly analyst calls.
The vanity metrics that were rewarded were GMV, market share, user growth, and DAU/MAU, and many founders and investors reasoned that profits would eventually follow. Some didn’t even care about earnings as many high-profile and loser companies continued to raise money through ever-increasing valuations, while a few also gained access to the public markets, giving investors big exits.
Hewlett Packard (HP) co-founder Bill Hewlett once warned his team that “more companies are dying of indigestion than starvation” at a time when HP was growing rapidly with a lot of capital. Significantly raising capital, even at significantly higher valuations, comes with the expectation that the company will continue to grow rapidly to justify returns to late-stage investors. History shows that only a few companies can achieve growth against profitability equilibrium, while most companies struggle.
With so much cash at their disposal, many companies resort to investing heavily in brand building, performance marketing, over-staffing, customer discounts and attractive marketing campaigns, without thinking about the returns.
Anecdotes about companies like Amazon are often cited to say that once the company becomes the dominant player, profits will follow. This is often difficult, and one can look at the global taxi industry, where all the players have struggled to make a profit, despite amassing tens of billions of dollars over a decade in the structure of a monopoly or monopoly industry.
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Don’t all big companies need to invest before they can turn a profit?
Yes, it is true that chasing large, addressable markets requires upfront investment, but it is also true that world-class companies can achieve profitability in a reasonable time. While “one size fits all” cannot be applied to all sectors, founders and investors must take a careful approach considering the size of the award (market), monetization ability of the business, lifetime value to customers, cross-selling ability, customer ability to pay, dynamics competitiveness, etc.
Jack Welch, the legendary CEO of GE, once reminded his managers to “control your destiny or someone else’s,” and the same lesson applies to founders.
Most founders start with a frugal mindset, but some change along the way, often due to unrealistic investor expectations or peer pressure. There is nothing wrong with raising a lot of capital with high valuations. It is also acceptable that some early stage investors, founders, and employees receive good returns before the company becomes profitable. However, just optimizing for the next capital appreciation and raising, with no reliable path to profitability, will lead to a situation where all it takes is one failed fundraising and you are not in control of your destiny.
“With great power comes great responsibility”
The Indian enterprise ecosystem has grown impressively and there are a lot of things to rejoice in – innovation, entrepreneurship and big ideas. With more than 100 unicorns and a handful of public companies, as millions of retail investors have given up their faith, it is important to see the emergence of more durable and sustainable business models from India. This will then ensure that entrepreneurs receive support from private capital, and that all stakeholders (founders, employees and investors) generate healthy long-term returns, thus keeping the flywheel in motion. I am optimistic that we will see some great entrepreneurs build world class businesses outside of India.
The author is a Managing Partner of InnoVen Capital, India’s largest debt-risk fund
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(This story appears in the September 23, 2022, issue of Forbes India. To visit our archive, click here.)
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