For companies that do become profitable, there are significant new opportunities, some new challenges and many internal changes to expect.
11 Aug, 2017ENTREPRENEUR.COM
Becoming a profitable company can feel like an elusive goal for many startups, and most aren’t fortunate enough to make it to that level. But, for the companies that do get there, there are significant new opportunities, some new challenges and many internal changes to expect.
Before I dive deeper into the topic, it’s worth noting that there are many different ways of defining profitability: being cashflow positive, having positive EBITDA or having positive contribution margins. For investors and executives, each may be useful in different scenarios, but for the purposes of this piece I’ll use “cashflow positive” as the key metric: The business in total is generating more cash than it spends during a given period, which results in a steadily growing amount of cash in its bank accounts.
The single biggest change post-profitability is a difference in thinking by management. The material need to raise more money shifts to the more methodical (and enjoyable) capital planning discussions on how to increase valuation with things like R&D investments for product innovation or entering new market segments. That doesn’t always mean that the team won’t raise more funding, but if they do, they will do it under the very different conditions of having shown that the business can now sustain itself. Profitable companies seek further funding for many reasons: accelerating product development, entering new markets or pursuing acquisitions of smaller companies that can add capabilities to further grow the company. Often, though, it comes down to simply wanting to have a stronger balance sheet for future flexibility to pursue new growth options as they emerge.
Another reason a profitable company might take in more cash is to bring in the expertise, advice or relationships important for the next phase of the company’s growth. Take AppLovin, for instance, a company that was recently acquired by Chinese private equity firm Orient Hontai Capital for $1.42 billion. After hitting profitability, CEO Adam Foroughi decided that he still wanted to raise another round not because AppLovin needed the cash, but “because I thought these (new investors and their firms) were influential people who could help us grow."
One of Norwest's portolio companies, Sojern, the travel marketing platform, has decided, for now, not to raise further capital since turning profitable in late 2015. CEO Mark Rabe says, “Building our business to support profitability has allowed us not only to accelerate R&D investment and new market development, but also to attract and retain top talent through expanded employee benefits like 401(k) matching.”
Sojern has also seen strategic planning changes after achieving its goal of profitability. Rabe notes a “subtle but powerful shift” in the relationship with its board of directors. “Board meetings transformed from being focused on key performance metrics and cash planning into a forum for exploring long-term strategies and the initiatives by which to realize them.”
As the profitability mindset starts to take hold, companies enter new danger zones. The excitement of generating cash can create a feeling of invincibility or entitlement which, in turn, can lead to risk-prone decision-making. Examples might be ramping up headcount too quickly, spending on brand marketing programs that don’t immediately turn into new customers or signing a new lease on that gleaming showcase office space.
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What Silicon Valley investors have learned, painfully in some cases, is that when a business hits a bump in the road, loses a major customer or has a product misstep, it may have to cut costs dramatically and quickly. Some operating expenses (“OpEx”), like marketing spend, can be cut quickly, with cash freed up right away. Others can be implemented quickly but take some time to show an impact on cash, particularly the difficult decision to go through layoffs. Longer-term capital expenditures (“CapEx”) can take years to correct and realize savings. Dramatically increasing OpEx or CapEx on things like equipment or facilities can not only push a company back into being unprofitable, they also take away the flexibility to quickly fix problems in the business later.
Executive teams and boards should start to think of allocating earnings between offense and defense. Profitable companies may shift offensive priorities quite a bit based on being able to undertake those efforts without debt or dilution if they can be funded purely from earnings. Defensive initiatives, however, are the new factor for profitable companies, and typically means strengthening balance sheet reserves for future needs by saving some portion of earnings. Each company will have a different mix of how it allocates profits between offense and defense, depending on the company’s objectives, strategy, and risk tolerance.
As for offense, investing to further increase the customer base can be wise, but Boston-based CarGurus draws an important distinction between broad-appeal brand marketing and targeted customer acquisition spending. Profitable for eight years, CEO Steve Kaufer recently told Xconomy that he chose to reinvest some of its earnings -- pragmatically -- into performance-based marketing instead of a big branding and PR blitz. “We could’ve invested in the brand earlier,” he said. But, “I sleep better at night knowing we’re profitable.”
Sojern’s CEO Mark Rabe wanted to encourage his employees to think about profitability in the same way he did and, together with the board, decided to shift the company bonus plan from being based on revenue targets to one based on EBITDA. “The goal wasn't to just touch the profitability line, but to stay permanently on the other side of it.”
There’s no doubt about it: Hitting profitability marks a major coming of age moment for startups. Your customers are paying for value that your business is creating for them, and, importantly, that value is now greater than the cost for you to deliver it.
For investors, sustained profitability marks the point at which a company can be viewed as a legitimate business rather than just a concept, and reinforces the notion that betting on it was a smart move. For executives, this is the point when they can leave behind some of the anxiety of raising more money, and begin to get creative with their paths to strategic growth.
But, disciplined spending remains critical to ensuring that the company stays profitable and continues to improve its balance sheet. At the end of the day, the unglamorous balance sheet is the most important resource a company has for sustaining new business headwinds, competitive threats and macroeconomic cycles.