We are experiencing a period of slowdown in the venture capital market due to the stock market decline, inflation, and others. Startup valuations are falling, funding rounds are decreasing and some companies – mainly in the tech industry, are not hiring and are firing employees (the famous layoff) in an attempt to increase their profits.
Less than a year ago, there was not too much talk about profitability and a lot about the important high and rapid growth of startups. However, the current days present a very uncertain economic environment, and venture capital companies today apply more detailed due diligence in startups, focusing more on profitability.
With this less than optimistic scenario, what should be the next step for startups to avoid being left holding the bag? Follow the article!
The “growth versus profit” debate in startups is not new, but most entrepreneurs and venture capitalists followed the words of Paul Graham ("startup = growth") and prioritized growth above profitability. This growth can mean an increase in the number of customers, more sales results or even an increase in the workforce. The important thing was to grow to dominate the intended market as quickly as possible.
This growth has two ways of happening:
Investors generally prefer organic growth to measure a company's performance.
Even without seeing profits for a period, the investments and cash burn were able to sustain the company's operations and expansion for an important amount of time. The justification was the search for meteoric growth rates.
Important companies such as Uber, WeWork, Spotify and Twitter so far had worked with this mentality. Yes, these are billionaire companies with no profit at all. Jeff Bezos, the president and CEO of the giant Amazon, took 9 years to generate the first profit for its investors. But, Amazon is now growing at such a rapid pace that it is justifiable that it uses some of its profits to reinvest in growth. (However, if a company doesn't grow fast enough, it must take other actions with its profits, such as returning them to investors.)
Elon Musk is another example. He has cut several employees at Twitter to help boost company profits.
Focusing on growth was a positive strategy when interest rates were under control and the adoption of new technologies was at scale.
However, the scenario has changed. The cost of capital was readjusted worldwide, the ghost of recession took over the markets and the route of risk was recalculated: the golden years of Venture Capital came to an end.
A startup becomes profitable when it earns more money than necessary for its operating expenses. However, only about 40% of startups reach the desired breakeven point.
It sounds simple: profits are signs of good financial health, and viability of the business. If the company's finances take a downturn due to changes in consumption, increased competition, higher supplier costs or economic instability, a profitable startup would have the financial resources to manage the situation more calmly.
In addition, the biggest advantage would be to spare its founders from the exhaustive search for external investment, thus deprioritizing important actions in the business during this period. This financial stability also guarantees the desired independence in management.
While the startup world has historically prioritized growth as the status quo, the landscape has changed recently. Investors today are more concerned about the financial health of companies that may be compromised not only by this market shift, but also by possible reckless scaling.
Today, many startups work in a more traditional and competitive market (or evolve into this audience to gain more markets). In this case, sacrificing profitability to try to secure rapid growth can be dangerous, as it increases exposure to risk, and in the long run can be outperformed by competitors with a better offering.
The unbridled growth search, based on poor planning, with irresponsible cash burn and operational losses, was the modus operandi for a long time in the startup world. The market has become unsustainable and suspicious.
Profitability then became a priority.
Simplifying the profit math:
Revenue - Cost of Goods Sold (COGS) = Gross Profit (also called Gross Margin) - Operating Costs = Profit
In general, founders have already shifted their focus from high growth to profitability. This is evidenced by the high number of layoffs seen in recent months. The challenge is how long it will take for these startups to prove their progress.
Based on what was discussed in the article, you can take the following steps to balance growth and profitability in a more timely manner:
Just keep in mind that shifting focus to accelerating profit doesn't mean investors want the business to stop growing. Instead, they'll want it to grow more sustainably while making a profit. This change will undoubtedly catch many founders off guard, but it's a pivot that needs to be done as soon as possible.
Managing your startup's growth and profit by focusing on what's important both today and in the long term is a crucial skill. What is even more important is the ability to adjust the strategy as the market changes.
Having the ability to demonstrate the path to profit will put startups in a much more confident position with investors. Having a greater emphasis on sustainable success while remaining conservative in your growth plans will also reassure potential investors.
This approach is not just beneficial to investors. In the long term, this change in mindset will be interesting for founders, making their business journey healthier.
This route recalculation is forcing entrepreneurs to focus on building more sustainable businesses, and those that survive this new reality will certainly stay in business longer.
Startups with more proven businesses will not risk closing their doors in the face of a weakened economy and will still be able to wait to raise money (if necessary) on more favorable terms. Investors will definitely continue to look for investment opportunities in new companies, but plans towards profitability will also need to feature prominently in your presentation. Therefore, stay alert!