Are gross profits the key to bulletproofing your startup?

6 months ago, I wrote about the real cost of customer acquisition after visiting the offices of a prospective startup that we were evaluating. After writing the blog, I provided the founder with explicit feedback on why I was passing on the investment. I had laid out our rejection feedback mechanism a couple of years ago, and we continue to follow it at Artha even today.

Handling rejection is not easy. I was in sales for many years, and I still consider myself to be in sales as I sell the opportunity of investing in our fund to prospective investors. As a sales manager, I trained, managed, and fired thousands of salespeople for almost a decade. Therefore, I have directly or indirectly dealt with rejection, a lot.

Hence it does not surprise me when I get a range of reactions to our feedback emails from founders. Their responses range from the grateful and gracious to anger fuelled expletive-laden multi-pager emails, giving feedback to our feedback. I do remember that this founder fell into the former group.

I believe that my post is more relevant today than at the time I wrote it. In 2019 (it seems so long ago now), the early-stage investment market roared on the back of a surge in micro-angel investors & a flood of friends & family capital. These uninitiated investors, many of them investing directly into equities outside of mutual funds, for the first time. They were lured in by stories of the 100s of Xs someone they knew had made.

Unfortunately, their ambitions made them blind to runaway gross losses their investee startups were making, i.e., the direct cost of revenue exceeded the actual revenue brought in. In layman terms, it meant that for every ₹1 of income the startup earned, the direct cost of generating that income exceeded ₹1. Not a sound business situation in any market condition!

My team and I met many of these hyper funded startup founders. We tested their penchant for profitability, at least at the unit economic level, but those were different times. The founders commanded and received unbelievable valuations. My team and I sat and gaped on the side-lines as we saw our anti-portfolio list swell faster than the list of startups that were in our portfolio! I wondered if we were facing a new normal, like a valuation black hole where the laws of economics did not function.

Unbeknownst to the world, a novel virus was raising its ugly head some 4348 km away. In the flash of an eye, the funding flow stopped. Many founders were caught unprepared, and unfortunately, their cheap capital fuelled startups died a quick but painful death.

As investors have realized many times in the history of euphoric investing – it is a startup’s dharma to make a profit. One cannot run (or fund) a startup that makes losses, not for too long. A startup can be accused of buying revenues when its direct cost of bringing in the revenue exceeds the revenue brought in. In a cruel twist, a startup making a gross loss assigns a zero or negative value to the operations apparatus that keeps the doors open. It won’t take a valuation expert to tell you that if opening the doors is worth less than zero – it is profitable to shut those doors.

To clarify, I do not endorse a net-profit strategy for startups that want to grow and scale. However, profitability, at the unit economic level, is a must before a founder decides to chase growth. Fast-growing startups must invest in creating long-term assets (tangible or intangible) to manage hypergrowth because minor issues quickly become massive at scale. Therefore, even the best-managed fast-growing startups build capacity before productivity can catch up, leading to net losses.

A part of the cost of growth gets compensated by adding positive unit economics of every transaction, creating gross profits for the startup. The gap (if any) is filled by venture capital or private equity investors that want to capitalize on the startup’s growth potential.

Even in a harsh fundraising environment, a startup with gross profits can survive. The founders can cut non-critical investments & expenses, utilizing the gross profits to grow the business, even if it is slow growth. Only a gross profit-generating founder can choose to sacrifice growth for sustenance.

However, founders that attempt scaling despite unfavorable unit economics do not possess that luxury. They need a perennial source of capital to continue their revenue buying program. If there is any threat to their source of money, their startup will be in trouble, deep, deep trouble. Just how big is their issue, these founders and their investors are beginning to find that out now.

Moral of the story: gross profits are worth their weight in gold. 24-carat gold.