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The Goal is Not Profitability

I’ve blogged before about how the economics of the venture industry affect how venture capitalists evaluate potential investments, the main conclusion of which is that VCs are really only interested in companies that could potentially IPO or sell for at least several hundred million dollars.

One variation on that line of logic which I think startups/entrepreneurs oftentimes fail to grasp is that profitability is not the number one goal.

Now, don’t get me wrong. The reason for any business to exist is to ultimately make profit. And, all things being equal, investors certainly prefer more profitable companies to less/unprofitable ones. But, the truth of the matter is that things are rarely all equal and, at the end of the day, your venture capital investors aren’t necessarily looking for profit, they are looking for a large outcome.

Before I get accused of being supportive of bubble companies (I’m not), let me explain what this seemingly crazy concept means in practice. First of all, short-term profitability can conflict with rapid growth. This will sound counter-intuitive, but its the very premise for venture capital investment. Think about it: Facebook could’ve tried much harder to make a profit in its early years by cutting salaries and not investing in R&D, but that would’ve killed Facebook’s ability to grow quickly. Instead, they raised venture capital and ignored short-term profitability to build out the product and aggressively market. This might seem simplistic, but I oftentimes receive pitches/plans from entrepreneurs who boast that they can achieve profitability quickly or that they don’t need to raise another round of investment because they will be making a profit soon, never giving any thought to what might happen with their growth rate if they ignored profitability for another quarter or year.

Secondly, the promise of growth and future profitability can drive large outcomesPandora, Groupon, Enphase, TeslaA123, and Solazyme are among some of the hottest venture-backed IPOs in recent memory and do you know what they all also happen to share? They are very unprofitable and, to the best of my knowledge, have not yet had a single profitable year. However, the investment community has strong faith in the ability of these businesses to continue to grow rapidly and, eventually, deliver profitability. Whether or not that faith is well-placed is another question (and I have my doubts on some of the companies on that list), but as these examples illustrate, you don’t necessarily need to be profitable to be able to get a large venture-sized outcome.

Of course, it’d be a mistake to take this logic and assume that you never need to achieve or think about profitability. After all, a company that is bleeding cash unnecessarily is not a good company by any definition, regardless of whether or not the person evaluating it is in venture capital. Furthermore, while the public market may forgive Pandora and Groupon’s money-losing, there’s also no guarantee that they will be so forgiving of another company’s or even of Pandora/Groupons a few months from now.

But what I am saying is that entrepreneurs need to be more thoughtful when approaching a venture investor with a plan to achieve profitability/stop raising money more quickly, because the goal of that investor is not necessarily short-term profits.

Thought this was interesting? Check out some of my other pieces on how VC works / thinks

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Our Job is Not to Make Money

Let’s say you pitch a VC and you’ve got a coherent business plan and some thoughtful perspectives on how your business scales. Does that mean you get the venture capital investment that you so desire?

Not necessarily. There could be many reasons for a rejection, but one that crops up a great deal is not anything intrinsically wrong with a particular idea or team, but something which is an intrinsic issue with the venture capital model.

One of our partners put it best when he pointed out, “Our job is not to make money, it’s to make a lot of money.”

What that means is that venture capitalists are not just looking for a business that can make money. They are really looking for businesses which have the potential to sell for or go public (sell stock on NYSE/NASDAQ/etc) and yield hundreds of millions, if not billions of dollars.

Why? It has to do with the way that venture capital funds work.

  • Venture capitalists raise large $100M+ funds. This is a lot of money to work with, but its also a burden in that the venture capital firm also has to deliver a large return on that large initial amount. If you start with a $100M fund, its not unheard of for investors in that fund to expect $300-400M back – and you just can’t get to those kinds of returns unless you bet on companies that sell for/list on a public market for a lot of money.
  • Although most investments fail, big outcomes can be *really* big. For every Facebook, there are dozens of wannabe copycats that fall flat – so there is a very high risk that a venture investment will not pan out as one hopes. But, the flip side to this is that Facebook will likely be an outcome dozens upon dozens of times larger than its copycats. The combination of the very high risk but very high reward drive venture capitalists to chase only those which have a shot at becoming a *really* big outcome – doing anything else basically guarantees that the firm will not be able to deliver a large enough return to its investors.
  • Partners are busy people. A typical venture capital fund is a partnership, consisting of a number of general partners who operate the fund. A typical general partner will, in addition to look for new deals, be responsible for/advise several companies at once. This is a fair amount of work for each company as it involves helping companies recruit, develop their strategy, connect with key customers/partners/influencers, deal with operational/legal issues, and raise money. As a result, while the amount of work can vary quite a bit, this basically limits the number of companies that a partner can commit to (and, hence, invest in). This limit encourages partners to favor companies which could end up with a larger outcome than a smaller, because below a certain size, the firm’s return profile and the limits on a partner’s time just don’t justify having a partner get too involved.

The result? Venture capitalists have to turn down many pitches, not because they don’t like the idea or the team and not even necessarily because they don’t think the company will make money in a reasonably short time, but because they didn’t think the idea had a good shot at being something as big and game-changing as Google, Genentech, and VMWare were. And, in fact, the not often heard truth is that a lot of the endings which entrepreneurs think of as great and which are frequently featured on tech blogs like VentureBeat and TechCrunch (i.e. selling your company to Google for $10M) are actually quite small (and possibly even a failure) when it comes to how a large venture capital firm views it.

Thought this was interesting? Check out some of my other pieces on how VC works / thinks