When Are You Going to Break Even? And Other Premature Questions for Pre-Seed Startups
The majority of my days is spent on pre-seed companies — vetting them, advising them, presenting them to potential investors, convincing said investors to invest in them, drafting investment terms for them, etc. In these interactions, the question of profitability comes up often more often than not, and I’ve always found myself being uncomfortable when investors put founders on the spot to declare a certain date in which they will be profitable. Why is that?
What Is the Point of Investing in a Startup? To Exit
Steve Blank famously said that a startup is an organization formed to search for a repeatable and scalable business model. This makes it fundamentally different from an established business, which presumably has found that business model (often years and decades before) and are focused on optimizing said business model (and profits) through iterative changes and highly granular business planning. Such iterative and granular planning is useless for a company that still is experimenting. Until you have scalability (run rates in the millions of dollars, 100’s of employees, national and international presence), you’re still searching for that repeatable and scalable business model and your company is an on-going experiment. This is especially true for pre-seed companies. Hence, focusing on profits is an exercise in counting your eggs before they are hatched. What matters more is the topline user and revenue growth.
Another side of the coin is what my friend Rahat Ahmed recently published in a viral post, that startups are about value creation, not breakeven:
“In short, startups need to create value, not necessarily make money [profitably]. By creating value, it’ll attract a successful exit which will then return a financial return to investors. Investors looking for dividends, short-term profitability or guaranteed returns should not be investing in a startup.”
I agree with him. Particularly for pre-seed companies, this obsession with profitability can actually be detrimental to the long term prospects of a business. During the pandemic, a lot of pre-seed companies were under pressure to cut back on overheads and spending but at the same time, their revenue growth stagnated or declined. So while they may be at breakeven, investors in BAN’s pool questioned their long-term potential because that breakeven was not driven by top line growth, but bottom line cuts. But this obsession with profitability and break-even point comes from a misplaced understanding that unless a company is profitable, it will not be able to return money to investors.
But how do exits happen in a startup, so they can return money to investors? Typically in two ways: A public offering, or a buy-out by a larger firm, often a competitor and an established incumbent — those same businesses who have established business models who see the startup as a threat. And a buy-out happens typically for three reasons: 1.) Access to a new, growing and novel user base that the incumbent may have a hard time building on their own, due to issues of culture, brand, product-market fit, etc., 2.) Access to a novel new product that can be monetized through the incumbent’s established distribution channels and/or 3.) Access to a novel technology and/or intellectual property. Rahat describes one such example:
“For successful exits, you generally need acquirers (as IPOs are relatively rare by any measure). Acquirers want startups for various reasons, which will often determine which metric leads to the highest valuation. Their rationale could be anything from gaining market share geographically, industry-wise or a defensive maneuver to block the future growth of a competitor.
In a Bangladeshi context, let’s say an app is generating $5 million in revenue, $500,000 in profit and has 100,000 users. That’s $50 in revenues and $5 profit per user! That sounds really good, right? It may still get a lower valuation than an app that has $100,000 in revenue, no profit and 500,000 users. Because if a multinational consumer goods company wants to get access to the Bangladeshi market at scale, the $5 million in revenue doesn’t mean much. They make tons of money already globally. What means a lot to them is getting access to all those users to whom they could then sell their whole existing portfolio of products. If each of those users have a lifetime value (LTV) of $100, then the former company’s valuation is $10 million but the latter is worth $50 million.”
In Bangladesh we’ve already seen angels and early investors in companies such as Pathao and Sheba sell out to strategic institutional investors such as regional tech players and local conglomerates. Why did these investors buy in at considerable premiums to original investors? To access a particular market and user base, that has synergies with their existing models, before such a startup becomes too large and becomes out of reach or worse, cannibalizing their business. They didn’t buy in because they were profitable. They bought in because they demonstrated the ability to scale.
Even in a public offering, which has yet to happen for a Bangladeshi startup, the general rule around the world is that investors would be willing to cut the new company slack for a few years as it looks to optimize its business and become profitable, as long as it delivers growth. You can see this in the case of Facebook, Uber, Delivery Hero and countless others, over and over again, in the technology world. Why would Bangladesh be different?
What Makes a Pre-Seed Company Investable? The Prospect of Meaningful Growth
But let’s get back to pre-seed stage companies, specifically those in Bangladesh. The vast majority in our pipeline and portfolio are doing revenues in the 1000’s and 10,000’s of dollars per month. I do not think it’s particularly wise to demand profitability and break even, because at those numbers, the companies won’t be able to deliver any meaningful returns. And the whole point of investing in startups is to gain outsized returns compared to any other asset class, to compensate for the high risk of failure.
What is better to look for in a pre-seed, post-revenue company? First and foremost, it’s important to create platforms that are sticky — users keep coming back, over and over again, and keep transacting and spending, whether in the form of money or time or both — and have virality — they refer others, who in turn become recurring users. As part of that, an ever declining customer acquisition cost (because you’re not paying for user acquisition — they’re doing it for you), a higher and higher LTV (because they’re spending more and more on your platform) and high retention rates. In analyzing retention, it is important to us to understand the user behavior of the top 10–20% of users — has the product/service become something indispensable and integral to their lives as consumers, once again, measured through things like average minutes spent, daily active users divided by monthly active users, net dollar revenue retention, etc.
High retention and low churn, combined with user and revenue growth, are greater markers of invest-ability at the pre-seed and seed stages rather than pure profitability on a net or even EBITDA standpoint. And I’m not saying that a startup will have all of these right from the beginning — what matters is improvement over time, and measuring that.
But I don’t see enough founders talking about retention in their decks and pitches. They seem more focused on marketing spend to attract new users, which would be useless if they don’t stick around. There also seems to be confusion on what LTV is — many decks simply multiply potential number of transactions with an average order value for a period of time, which is a wish, rather than actual historical data reflecting churn and other elements. In a future post, I will write more into tactics behind inducing and measuring retention.
When Should the Profit Conversation Come In? Once the Business Model is Established
Don’t get me wrong. A company will not survive without eventual profits. But I think it should be at the later stages of funding (Series C, D plus) when a company should start optimizing their business model and plans for profitability to be achieved over a multi-year period, first at the unit level, then at the gross/contribution margin level, then at the EBITDA level and eventually at the net level. It is important to have this line of sight. In immature ecosystems where later stage funding, as well as meaningful exit opportunities are still few and far in between, those conversations might happen earlier, maybe at the A+ and B. But not at pre-seed.
The second scenario could be that the company prefers to gestate for a while, with a low cash burn strategy, before its growth levers are fully optimized ahead of raising capital and pursuing rapid scale. I think this can actually be sensible, especially for self-funded or limited funded companies that want to or have to run at operating break-even (or close to it) for a while as they look for repeatable and scalable business models. Such a business would be able to circulate more of its capital back into growth once it pursues scale.
The third scenario is when a company and its shareholders do not want to raise further funding. That’s perfectly reasonable, and might actually help them sleep better at night, knowing they are not under pressure to constantly fundraise. But keep in mind, that also limits their potential returns. At that point, it may be more of a lifestyle business than a high growth startup.
Remember, startups = growth.
Many thanks to Rahat for the inspiration and quote.
