Should startups focus on profits?
A very useful article for investors who evaluate young companies for financing, and for entrepreneurs who want to attract venture capital and turn their company into a large corporation. Mark Saster, partner of Upfront Ventures, lists the economy of a startup and explains how to evaluate the profitability of the project.
Mark Saster:
')
It amazes me when a journalist writes an article about a promising startup (for example, preparing for a public offering of shares), and contemptuously gives out: “They don’t even make a profit!”.
I cite journalists as an example, because it is they who support the myth that profitability is ALWAYS a priority, and I hear many businessmen, even the most adequate, repeat the same mantra.
There is a normal relationship between profit and company growth. In order to ensure faster growth, it is now necessary to find resources for investment, which will begin to bring results only after six months or a year. This is most easily explained by the example of sales managers.
If you hire 6 sales managers with a salary of $ 120,000 a year, your monthly expenses will increase by $ 60,000, although these sales managers may not bring any income for another 4-6 months. And in the first quarter you will have $ 180,000 less profit than you would if you didn’t hire them. I understand that this is all sort of clear, but even very clever people forget this simple arithmetic when calculating profitability.
It’s not always right to hire more employees. You need to understand whether they will bring profit in the coming year, or whether you have access to relatively cheap capital (what is this concept?) To cover losses until your investments start to pay off.
Most companies (more than 98%) in the world (even technology start-ups) should concentrate on profits. Profitability gives the level of freedom that is unattainable when using other people's money.
• You will have an advantage when attracting investments (many investors are not looking for opportunities to build a huge corporation and appreciate your ability to run a profitable business)
• Profitability gives more options for investors to return investments. While Google and Facebook can afford to buy a company for its employees (at least according to December 2011), many organizations don’t even think about buying a non-profitable company. When they evaluate your company, their thoughts are approximately as follows: “How much time will pass before I get back the money I spent on acquiring the company?” If a company does not make a profit, then you are just a cost item for them.
• Profitability undoubtedly makes the company more stable in difficult times.
Traits of an entrepreneur who should not concentrate on profits:
- it has, or thinks that it has the ability to build an extremely scalable business via the Internet;
- he has access to investors who are willing to help build an Internet project.
And as I like to repeat:
“If your idea is really brilliant, then it will be noticed on the market, and there will be those who want to compete with you. If you are leading the market, proactive capital and investment will help when competitors emerge. If you don’t, someone else will. ”
More details:
I often discussed this issue with many aspiring entrepreneurs. They have already attracted 2-3 million dollars, have created a product that has any leads in the market, have reached the mark of 1 million dollars. At this point, the founder feels that he is already on the verge of making a profit, and promises himself to reduce costs in the coming year and try to get the first profit. He does not want to depend on investors anymore.
To this I answer the question: “What purpose are you pursuing? Are you looking to sell the company next year or in a year? You are planning to keep a small business, but which brings a stable income? Do you see the possibility of attracting venture capital in the future to accelerate the development of the company? ”
In the circles in which I rotate, there are many people who want to build a large corporation — and at a certain stage you will need to attract venture capital. And for this need borrowed funds. I often point out that at the same time investors are much more concerned with the growth of the company, and not with profit, so you need to be very careful not to accidentally cut down the bitches on which you are sitting. Of course, I understand the desire to control everything, for which, in essence, we need a profit. But do not sacrifice investments in the growth of the company in the pursuit of profitability.
Representatives of the venture fund will only smile when they know that you have achieved a profit of 1.5 million in three years with the help of an investment of $ 3 million. The hard truth of life. Now, if in three years you had significantly increased the number of customers, not greatly focusing on profitability, then it is another matter. If you spent 3 years on improving a super-innovative technology, this would also be more impressive. But if you only reduced the pace of development in order to make a profit, then you will need to look elsewhere for funds for further growth.
When I study a company's income statements (also called a “profit and loss statement”), I first look at the line with income. When evaluating a company, you should pay attention to whether the level of income of the company is growing.
I always talk about this to reporters who ask me about stock exchanges. If you take, for example, two companies, each of which has $ 100 million in profit, they may have completely different prospects for the future. One can increase income by 50% every year, and the other - only by 5%.
Even if both companies have the same profitability ratio (profit / income), the first company will do much better by the end of the year. And while the easiest way to evaluate a company is to evaluate the ratio of share price to profit, you should not forget about such indicators as price / profit / growth. {Of course, there are many complex financial instruments, but with the help of this ratio, many can draw preliminary conclusions.}
Investors value growth
The company's value is the expected profit from future cash flows that will be earned on today's investments (as you know, the dollar will cost less next year than today) and a company that grows faster will earn more in the future.
And for a start, when evaluating a company, estimate its growth rates. Estimating only the profits of companies will not give a clear understanding of which of them has more bright prospects.
And when new companies are evaluated (and venture capital funds are often eyeing newbies), it is necessary to evaluate the growth of clients, and not the growth of profits.
It is important what character is your company's profit.
When I evaluate profitable companies, it is important for me to understand exactly how it receives income. Profit brings a single product or product line? 80% of income provide 20% of clients or 3 of the largest customers bring 80% of income?
This is a “concentration of profits”, and the more profits are concentrated, the higher the risk of decreasing profits in the future.
I am also trying to figure out how the price of a product is formed, how competitors determine the price of their product, what are the prospects for future pricing? The rapid growth in the market is fading away with tighter competition and a corresponding fall in prices.
Income income discord
But not everything is so simple and it is not enough to estimate the number of dollars in the “income” line. For example, look at the chart below. You will notice that although both companies have the same annual income, Company 1 has a much higher profit margin, because the cost of sales (CP) is much lower.
The cost of sales is the cost of each sale transaction for the company. For example, if you sell your product through third parties, who take 30% from each sale, then the CP indicator is 30% of revenue (if there are no other costs associated with sales).
The above chart is no exception to the rule. The first company is an ordinary software company that sells its product directly (through its sales managers or via the Internet). For many software companies, profitability is 85-90%, which is why they are a historically attractive business sector.
Company 2 may represent an intermediary company, which advertising networks pay for placing ads on publishers' websites, and for this the company gives 85% of the profits to the publisher. For an intermediary, it is normal to take from 15% to 30% of the sale price.
This may be a travel site that receives a percentage for the sale of airline tickets. Companies like to look at the big numbers in the “income” column, but this is often misleading. Even if you sold United Airline tickets worth $ 500 million, the amount received does not make up your income. Your income will be $ 75 million, which you received as a percentage of the reservation.
This could be an online commerce site, or flash sales that make money on clothing sales, but must pay a high percentage to clothing manufacturers. Many similar sites are essentially intermediaries. Their profitability varies between 15-40%.
Surely you are now shaking your head and thinking: “Well, yes!”, But honestly, even the most experienced of my friends confuse “gross income” and “net income”. I myself watched as people were amazed at the extraordinary income of flash sales sites:
“Company X is already earning $ 100 million. A striking leap! ”
Mm, no.
The company receives $ 100 million of gross profit, and profitability is 12%, that is, most of the money is in goods. Many companies at first, these products were not even physically in their hands. That is, their profit is 12 million.
This is also a very good achievement. But this is not the same as 100 million in two years.
Shouldn't all companies be profitable?
Not necessary. Let's look at the following software development companies, each of which has a profitability ratio of 66%.
The performance of both companies is the same after one year of existence. Both raised $ 1.5 million (capital of a business angel or a seed fund) for current expenses for the first year. Both companies spent a million dollars in the first year.
66% profitability is quite normal (companies sell their product through an intermediary who takes 33% of the profits), but the sales volume does not cover the costs of the development team, management, marketing, office expenses, etc. In most online projects, 80% of expenses are for staff.
So which company is better?
There is no answer to this question. A naive journalist may lament that Company A is not profitable, or that it is a typical online startup that does not care about expenses. After all, they have increased operating costs by half, despite the fact that they did not bring profit.
What really happened? They raised $ 5 million in venture capital to expand their business. This money went to pay the salaries of new technical specialists so that the company could launch a second line of products. We hired a team of marketing specialists to promote the product everywhere. They invited a team of business development specialists, who are working on concluding transactions for incorporating their product into other products in order to increase demand. They removed a larger office for more convenient placement of employees, to increase the attractiveness of themselves as an employer.
If their product turns out to be in demand on the market, then these investments will pay off a hundredfold.
Look at the following company development years:
Although company B showed more prudence in expenses, it turned out that the investments of company A, invested in personnel, brought them more annual income. At the end of the fifth year, company A earned already 14 million according to the final calculations (profit for the investment period), while company B earned $ 5 million.
At the moment, the income of company A is 47 million dollars a year, and the company B is 12 million dollars, so the next period from the sixth to the tenth years of existence, for company A also proved to be more successful.
I know what company I would invest in. Growth rates are very important.
Let's consider an even more aggressive scenario. For example, take the Internet company with "super fast growth." Of those, who are unknown to experts, they quickly declare useless, because they are not profitable.
Companies would need to raise at least $ 35 million to finance their expenses. And most likely, she attracted 50 million or more. Notice that they are. most likely attracted investment in several rounds, and not at once.
Madness? Stupidity? Was it not worth lowering your running costs to become “profitable”?
I repeat, not so simple. If growth is lightning fast, as shown here, and, IF they have access to cheap capital, then it would be crazy not to attract venture capital investments and remain unprofitable.
The ratio between profit and growth
You can increase profits without investing today's dollars in tomorrow's growth.
When another journalist starts to condemn Amazon for insufficient profitability, I would like him to understand the following. Amazon continues to grow at such a frantic pace that, of course, part of its current profits, it reinvests in its own development.
If a company does not grow fast enough, then they should distribute their profits differently, for example, return money to shareholders.
Last argument on profitability and positive cash flow
Another elementary thing, but, based on my experience, and this may be useful. Many investors are more worried about cash flow, and not about the company's income.
It is worth noting, for those who still do not know what the difference is between income and cash flow, that profitability and positive cash flow are not the same thing.
You can be a profitable company, and lose money.
And how are you? And you thought “profitable” means that you make money?
Revenue reports are compiled in accordance with accounting standards that "compare income and expenses for a given period."
For example:
1. An advertising agency (intermediary) may sell advertising in the amount of $ 500,000. May enter into an agreement with the publisher who makes these ads, according to which he pays for his services after 14 days. The advertiser, who bought the advertisements, will pay for them in 2 months.
Thus, I can show that my company is profitable on the basis of these figures in the income statement, but in fact I spent $ 500,000, which I have not yet received (negative cash flow).
2. I could enter into contracts totaling $ 1.2 million over 2 years. And so, I get 50,000 dollars a month a month per month, according to the income statement. But the customer can pay bills by the end of the quarter. And the first two months of the quarter, I will be in the red.
3. The same thing happens with costs. I can buy equipment for 450 thousand dollars, and will distribute this amount for the next three years, during which, according to my calculations, the equipment will be used. And every year my expenses will be $ 150,000, which I have already spent.
Mark Saster is an Upfront Ventures partner. He joined the company in 2007, after 8 years already collaborated with Upfront Ventures as an entrepreneur “on two fronts”. Prior to joining Upfront, Mark held the position of Vice President of Production Management at Salesforce.com, after the company was bought by Koral, where he in turn was one of the founders and CEO. Prior to Koral, Mark ran his own BuildOnline- European software company (SaaS), which was later bought out by the SWORD group. Mark is always looking for enthusiastic entrepreneurs to invest in projects in the early stages of technology development. His areas of interest include digital content and distribution, AdTech, consumer Internet technologies, and SaaS companies; Mark has impressive experience in this sector, given that he has already founded and sold two companies. Follow the link to read his articles in his blog "Two Sides of the Table " ("On two chairs").
The original article can be read on the link in the blog.
Mark Saster:
')
It amazes me when a journalist writes an article about a promising startup (for example, preparing for a public offering of shares), and contemptuously gives out: “They don’t even make a profit!”.
I cite journalists as an example, because it is they who support the myth that profitability is ALWAYS a priority, and I hear many businessmen, even the most adequate, repeat the same mantra.
There is a normal relationship between profit and company growth. In order to ensure faster growth, it is now necessary to find resources for investment, which will begin to bring results only after six months or a year. This is most easily explained by the example of sales managers.
If you hire 6 sales managers with a salary of $ 120,000 a year, your monthly expenses will increase by $ 60,000, although these sales managers may not bring any income for another 4-6 months. And in the first quarter you will have $ 180,000 less profit than you would if you didn’t hire them. I understand that this is all sort of clear, but even very clever people forget this simple arithmetic when calculating profitability.
It’s not always right to hire more employees. You need to understand whether they will bring profit in the coming year, or whether you have access to relatively cheap capital (what is this concept?) To cover losses until your investments start to pay off.
Most companies (more than 98%) in the world (even technology start-ups) should concentrate on profits. Profitability gives the level of freedom that is unattainable when using other people's money.
• You will have an advantage when attracting investments (many investors are not looking for opportunities to build a huge corporation and appreciate your ability to run a profitable business)
• Profitability gives more options for investors to return investments. While Google and Facebook can afford to buy a company for its employees (at least according to December 2011), many organizations don’t even think about buying a non-profitable company. When they evaluate your company, their thoughts are approximately as follows: “How much time will pass before I get back the money I spent on acquiring the company?” If a company does not make a profit, then you are just a cost item for them.
• Profitability undoubtedly makes the company more stable in difficult times.
Traits of an entrepreneur who should not concentrate on profits:
- it has, or thinks that it has the ability to build an extremely scalable business via the Internet;
- he has access to investors who are willing to help build an Internet project.
And as I like to repeat:
“If your idea is really brilliant, then it will be noticed on the market, and there will be those who want to compete with you. If you are leading the market, proactive capital and investment will help when competitors emerge. If you don’t, someone else will. ”
More details:
I often discussed this issue with many aspiring entrepreneurs. They have already attracted 2-3 million dollars, have created a product that has any leads in the market, have reached the mark of 1 million dollars. At this point, the founder feels that he is already on the verge of making a profit, and promises himself to reduce costs in the coming year and try to get the first profit. He does not want to depend on investors anymore.
To this I answer the question: “What purpose are you pursuing? Are you looking to sell the company next year or in a year? You are planning to keep a small business, but which brings a stable income? Do you see the possibility of attracting venture capital in the future to accelerate the development of the company? ”
In the circles in which I rotate, there are many people who want to build a large corporation — and at a certain stage you will need to attract venture capital. And for this need borrowed funds. I often point out that at the same time investors are much more concerned with the growth of the company, and not with profit, so you need to be very careful not to accidentally cut down the bitches on which you are sitting. Of course, I understand the desire to control everything, for which, in essence, we need a profit. But do not sacrifice investments in the growth of the company in the pursuit of profitability.
Representatives of the venture fund will only smile when they know that you have achieved a profit of 1.5 million in three years with the help of an investment of $ 3 million. The hard truth of life. Now, if in three years you had significantly increased the number of customers, not greatly focusing on profitability, then it is another matter. If you spent 3 years on improving a super-innovative technology, this would also be more impressive. But if you only reduced the pace of development in order to make a profit, then you will need to look elsewhere for funds for further growth.
When I study a company's income statements (also called a “profit and loss statement”), I first look at the line with income. When evaluating a company, you should pay attention to whether the level of income of the company is growing.
I always talk about this to reporters who ask me about stock exchanges. If you take, for example, two companies, each of which has $ 100 million in profit, they may have completely different prospects for the future. One can increase income by 50% every year, and the other - only by 5%.
Even if both companies have the same profitability ratio (profit / income), the first company will do much better by the end of the year. And while the easiest way to evaluate a company is to evaluate the ratio of share price to profit, you should not forget about such indicators as price / profit / growth. {Of course, there are many complex financial instruments, but with the help of this ratio, many can draw preliminary conclusions.}
Investors value growth
The company's value is the expected profit from future cash flows that will be earned on today's investments (as you know, the dollar will cost less next year than today) and a company that grows faster will earn more in the future.
And for a start, when evaluating a company, estimate its growth rates. Estimating only the profits of companies will not give a clear understanding of which of them has more bright prospects.
And when new companies are evaluated (and venture capital funds are often eyeing newbies), it is necessary to evaluate the growth of clients, and not the growth of profits.
It is important what character is your company's profit.
When I evaluate profitable companies, it is important for me to understand exactly how it receives income. Profit brings a single product or product line? 80% of income provide 20% of clients or 3 of the largest customers bring 80% of income?
This is a “concentration of profits”, and the more profits are concentrated, the higher the risk of decreasing profits in the future.
I am also trying to figure out how the price of a product is formed, how competitors determine the price of their product, what are the prospects for future pricing? The rapid growth in the market is fading away with tighter competition and a corresponding fall in prices.
Income income discord
But not everything is so simple and it is not enough to estimate the number of dollars in the “income” line. For example, look at the chart below. You will notice that although both companies have the same annual income, Company 1 has a much higher profit margin, because the cost of sales (CP) is much lower.
The cost of sales is the cost of each sale transaction for the company. For example, if you sell your product through third parties, who take 30% from each sale, then the CP indicator is 30% of revenue (if there are no other costs associated with sales).
The above chart is no exception to the rule. The first company is an ordinary software company that sells its product directly (through its sales managers or via the Internet). For many software companies, profitability is 85-90%, which is why they are a historically attractive business sector.
Company 2 may represent an intermediary company, which advertising networks pay for placing ads on publishers' websites, and for this the company gives 85% of the profits to the publisher. For an intermediary, it is normal to take from 15% to 30% of the sale price.
This may be a travel site that receives a percentage for the sale of airline tickets. Companies like to look at the big numbers in the “income” column, but this is often misleading. Even if you sold United Airline tickets worth $ 500 million, the amount received does not make up your income. Your income will be $ 75 million, which you received as a percentage of the reservation.
This could be an online commerce site, or flash sales that make money on clothing sales, but must pay a high percentage to clothing manufacturers. Many similar sites are essentially intermediaries. Their profitability varies between 15-40%.
Surely you are now shaking your head and thinking: “Well, yes!”, But honestly, even the most experienced of my friends confuse “gross income” and “net income”. I myself watched as people were amazed at the extraordinary income of flash sales sites:
“Company X is already earning $ 100 million. A striking leap! ”
Mm, no.
The company receives $ 100 million of gross profit, and profitability is 12%, that is, most of the money is in goods. Many companies at first, these products were not even physically in their hands. That is, their profit is 12 million.
This is also a very good achievement. But this is not the same as 100 million in two years.
Shouldn't all companies be profitable?
Not necessary. Let's look at the following software development companies, each of which has a profitability ratio of 66%.
The performance of both companies is the same after one year of existence. Both raised $ 1.5 million (capital of a business angel or a seed fund) for current expenses for the first year. Both companies spent a million dollars in the first year.
66% profitability is quite normal (companies sell their product through an intermediary who takes 33% of the profits), but the sales volume does not cover the costs of the development team, management, marketing, office expenses, etc. In most online projects, 80% of expenses are for staff.
So which company is better?
There is no answer to this question. A naive journalist may lament that Company A is not profitable, or that it is a typical online startup that does not care about expenses. After all, they have increased operating costs by half, despite the fact that they did not bring profit.
What really happened? They raised $ 5 million in venture capital to expand their business. This money went to pay the salaries of new technical specialists so that the company could launch a second line of products. We hired a team of marketing specialists to promote the product everywhere. They invited a team of business development specialists, who are working on concluding transactions for incorporating their product into other products in order to increase demand. They removed a larger office for more convenient placement of employees, to increase the attractiveness of themselves as an employer.
If their product turns out to be in demand on the market, then these investments will pay off a hundredfold.
Look at the following company development years:
Although company B showed more prudence in expenses, it turned out that the investments of company A, invested in personnel, brought them more annual income. At the end of the fifth year, company A earned already 14 million according to the final calculations (profit for the investment period), while company B earned $ 5 million.
At the moment, the income of company A is 47 million dollars a year, and the company B is 12 million dollars, so the next period from the sixth to the tenth years of existence, for company A also proved to be more successful.
I know what company I would invest in. Growth rates are very important.
Let's consider an even more aggressive scenario. For example, take the Internet company with "super fast growth." Of those, who are unknown to experts, they quickly declare useless, because they are not profitable.
Companies would need to raise at least $ 35 million to finance their expenses. And most likely, she attracted 50 million or more. Notice that they are. most likely attracted investment in several rounds, and not at once.
Madness? Stupidity? Was it not worth lowering your running costs to become “profitable”?
I repeat, not so simple. If growth is lightning fast, as shown here, and, IF they have access to cheap capital, then it would be crazy not to attract venture capital investments and remain unprofitable.
The ratio between profit and growth
You can increase profits without investing today's dollars in tomorrow's growth.
When another journalist starts to condemn Amazon for insufficient profitability, I would like him to understand the following. Amazon continues to grow at such a frantic pace that, of course, part of its current profits, it reinvests in its own development.
If a company does not grow fast enough, then they should distribute their profits differently, for example, return money to shareholders.
Last argument on profitability and positive cash flow
Another elementary thing, but, based on my experience, and this may be useful. Many investors are more worried about cash flow, and not about the company's income.
It is worth noting, for those who still do not know what the difference is between income and cash flow, that profitability and positive cash flow are not the same thing.
You can be a profitable company, and lose money.
And how are you? And you thought “profitable” means that you make money?
Revenue reports are compiled in accordance with accounting standards that "compare income and expenses for a given period."
For example:
1. An advertising agency (intermediary) may sell advertising in the amount of $ 500,000. May enter into an agreement with the publisher who makes these ads, according to which he pays for his services after 14 days. The advertiser, who bought the advertisements, will pay for them in 2 months.
Thus, I can show that my company is profitable on the basis of these figures in the income statement, but in fact I spent $ 500,000, which I have not yet received (negative cash flow).
2. I could enter into contracts totaling $ 1.2 million over 2 years. And so, I get 50,000 dollars a month a month per month, according to the income statement. But the customer can pay bills by the end of the quarter. And the first two months of the quarter, I will be in the red.
3. The same thing happens with costs. I can buy equipment for 450 thousand dollars, and will distribute this amount for the next three years, during which, according to my calculations, the equipment will be used. And every year my expenses will be $ 150,000, which I have already spent.
Mark Saster is an Upfront Ventures partner. He joined the company in 2007, after 8 years already collaborated with Upfront Ventures as an entrepreneur “on two fronts”. Prior to joining Upfront, Mark held the position of Vice President of Production Management at Salesforce.com, after the company was bought by Koral, where he in turn was one of the founders and CEO. Prior to Koral, Mark ran his own BuildOnline- European software company (SaaS), which was later bought out by the SWORD group. Mark is always looking for enthusiastic entrepreneurs to invest in projects in the early stages of technology development. His areas of interest include digital content and distribution, AdTech, consumer Internet technologies, and SaaS companies; Mark has impressive experience in this sector, given that he has already founded and sold two companies. Follow the link to read his articles in his blog "Two Sides of the Table " ("On two chairs").
The original article can be read on the link in the blog.
Source: https://habr.com/ru/post/302088/
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