Profitlessness and the new trade-offs

One would think profitability had inched its way to irrelevance in this new age of equity investing—when startup after startup was going to market without ever having made a penny in profits. The list of such companies is long and features many unicorns which have burned—not earned—money to grow.

Generally, a founder’s own money is finite and growth is slow. It might mean a business grows by 10 to 15% a year, and that the company is built over 10-20 years to profitability. Most companies do not have the patience to wait that long.

Enter venture capital (VC) and the game changes. They look at companies differently. They see potential, a big opportunity and a great idea. Most importantly, they see an opportunity to invest and then exit in favour of another investor at a substantially higher valuation. “If you want to grow quickly, you will have to burn a lot of money and as a result raise a lot of money also,” says Ashvin Chadha, co-founder of Anicut Partners.

The investment model VCs use has a lot to do with it. They raise their first fund and invest in, say, 10 companies. Of which maybe two or three will do well. The only way for them to raise further funds is for these portfolio companies to show an uptick very quickly. So, VCs focus on the businesses that are doing well. They raise money every three years or so, and it is within that time frame that their portfolio companies need to show growth at a fast clip, so they can keep pushing company evaluations.

Two to three years may be too little time for a company to show growth organically. But a portfolio company must show an ability to deploy more capital quicker. Though profits have long been the lens through which a company is judged and valued, in this seemingly new age of investing, other criteria and milestones have become important.

“Profit is not the only measure of value. Profits have long been the major criteria for the valuation of a company. They remain as important as ever but new criteria are being used,” says Akshaya Bhargava, founder and executive chairman of Bridgeweave Ltd.

This may also be why VCs love tech businesses.

“Earlier, the only way for a company to grow was to expand its product suite and geographic footprint. These are time-consuming activities. In the last decade, technology has made it possible to achieve huge, multi-country growth within a very short period—without having a physical presence in each country. This means topline growth, that was achieved earlier in 25 years, can now be achieved in just three to four. This makes growth a very strong measure of company success in the early years,” elucidates Bhargava.

Another measure is unit economics, says PWC’s Amit Nawka, partner and leader, deals and start-ups. “In some companies in their growth stages a unit might make a profit but the aggregate will not.”

For instance, a supermarket chain first sets up stores in Bengaluru. It may be profitable in Bengaluru, because it has been there the longest and understands the market. But when they set up stores in Hyderabad, they make losses. These losses will offset all the profit made in Bengaluru, and the company as a whole may then report a loss.

“What investors want to understand is whether they are making profits in a few units. And if they are then it's only a matter of time that the rest of the business will become profitable. They want to know if the unit economics is positive,” says Nawka.

The rule of thumb used to be that unless you were profitable there was no use of going public—a rule backed by SEBI. But the regulator now permits loss-making companies to list in Indian bourses, with the rider that 75% of the stock is held by institutional investors.

“SEBI changed the rule because there were a lot of pushbacks from Indian founders who said they would list overseas where there is no such rule and the government did not want that,” says Chadha. The rationale for SEBI’s earlier conservatism was that many fraudulent companies went public in the past and erased a lot of investors’ money.

“Regulators don't want small retail investors to lose money. But now startups are so well funded they have due diligence, good auditors, etc. They may be overvalued. But they are not mismanaged or scams,” says Chadha.

Profitlessness is heavily criticised by the retail investor, who is ruthless. “They are brutal in their ask and they move month on month and quarter on quarter. That's the nature of retail investment, very few will allow you to go many years before they start asking for returns,” says Sanchit Gogia, founder and CEO of Greyhound Research.

Many of these companies are 'industry firsts', says Gogia and are still defining the market, be it Paytm, OYO or WeWork.

"They need a lot more time from an establishment perspective. If we talk about a traditional business, like chemicals, or FMCG—these are well-defined categories with well-established players and metrics where the industry norms are set. Unfortunately, tech companies and these ‘industry firsts’ don’t have that.”

Expect to see more such trade-offs where companies sacrifice profits for their topline or marketing and customer acquisition. After all—Amazon, one of the most highly valued companies in the world—broke even years after its establishment as an online bookseller in 1994.