Over the weekend, Mark Suster and Fred Wilson each put up awesome posts discussing the idea of profitability in startups. Mark’s is a master class about how to look at the financial characteristics of a startup and Fred’s discusses what he’s been working on with some of his more mature companies.
They are both worth reading right now. I’ll be here when you get back.
Between the spring of 2000 and the end of 2001, I had the worst, most stressful, and most painful business period of my life. While I’m sure the financial crisis of 2008 was worse for many people, for me it paled in comparison to the misery of this 21-month stretch.
A very simple thing happened that year in my world. The market shifted from rewarding (and funding) growth to rewarding (and funding) profitability. It happened over a few quarters, but with the perspective of time and age, it feels like it happened overnight. I remember the trigger point being a 3/20/2000 article in Barron’s titled Burning Up: Warning: Internet companies are running out of cash — fast. I was on the board of several companies on their list of 100 public companies that would be out of money by the end of 2000 and remember that my reaction to the article was anger, frustration with being maligned, and incredulity that Barron’s would write such an irresponsible article.
My reaction was stupid and immature. Instead, I should have paid attention to the message, thought about it, and taken appropriate action. Instead, I, like many of my colleagues (investors, board members, founders, and CEOs), operated in a state of blissful denial until everything blew up.
I learned that the markets reward growth until they don’t. Then they reward profitability. The trick is to be in a position to make the switch when you need to. Lots of CEOs and boards fantasize about this, but don’t actually have a plan in place to do this as they expect the future – where the switch from growth to profitability – will never come. Or, they hope the exit will happen before this moment.
I was too inexperienced in 2000 to understand this. Given the exuberance, many of my mentors, who had been through other financial cycles, chose to ignore this. The phrase “it’s different this time” echoed broadly throughout the land. I succumbed to the siren song of growth at any cost and paid the price – both literally and figuratively.
Now, I have zero prediction for when the markets will shift from rewarding growth to profitability. Instead, I operate under the assumption that this can happen at any time, and the best companies can grow quickly and either be profitable or be able to become profitable by making manageable modifications to the cost structure within whatever cash constraints they currently have.
Some version of this was on my mind when I wrote the post titled The Rule of 40% For a Healthy SaaS Company in 2015 and the post titled Is 2017 The Year Of Flat Headcount? earlier this year. While I think about this regularly, Mark and Fred’s posts prompted me to pile on to their point and write about it.
There’s a special bonus in Mark’s post, which is in the section titled Revenue is Not Revenue is Not Revenue. He does a nice job of discussing the importance of understanding gross margin and has a line that made me smile.
If you’re shaking your head and thinking, “duh” I promise you that even some of the most sophisticated people I know get off track on this issue of “gross revenue” versus “net revenue.”
I’d add that this includes getting confused about GMV and MRR when talking about revenue and amazingly occasionally confusing revenue with income. It keeps going, when one asks the question “does profitability mean being EBITDA positive, cash flow positive, or net income positive? Or something else?”
If you are a CEO of a company and any of this makes you nervous in any way, I encourage you to grab a few of your investors who have been investing in startups for at least 20 years, take them out to lunch, and talk through these issues with them to understand them better and figure out whether or not to care about this in the context of your company.
If you are growing at a rate of less than 50% year over year, you should consider viewing 2017 as the year of flat headcount.
As budgets are settling down and getting approved for many of the companies I’m on the board of, I’m seeing a general trend of much less headcount growth in 2017 than in 2016. In some cases, companies got ahead of themselves. In others, they need to integrate all the people they’ve added. In some, they feel like they have a critical mass of people and want to march to get profitable on current headcount. And still others are profitable and have realized significant operating leverage in the past two quarters that they want to continue.
While there are different reasons, many of these companies are being a lot more targeted and selective with where they are adding people. These are generally the companies between 50 and 200 people who have growth rates that are 50% or less. But I’m also seeing it in companies with larger growth rates (100% year over year – yup – we can to that and only add 10% new people.)
I hadn’t really thought of it as a trend until I reviewed a board deck this morning and it’s called out as a feature. I agree that it’s a feature. A company with $10m+ of revenue that is growing at 50% or more can often get profitable within 12 months if it focuses on its operating costs. Headcount is almost always the largest increasing operating cost.
I see a nice second order effect in all of these companies. Given the focus on getting profitable, they are now clamping down on other discretionary costs around the system. That money you’ve been wasting on a PR agency – delete. That extra space you thought you might need, but don’t – sublet. The outsourced recruiter you’ve been paying a retainer to – gone. There’s a long list of operational efficiencies that go along with the focus on getting net income and ultimately cash flow positive.
While this isn’t a universal truth, nor should it be, it definitely feels like a trend, especially as companies start putting a lot more focus on ICDC as part of their growth strategy.