Last week, I was fortunate enough to run into a well-known VC in Bangalore. After some idle chit-chat, we got around to discussing one of his portfolio companies, which was in the market to raise a follow-on round. The VC lamented that the company was comfortably profitable and in his opinion, shouldn’t try to raise a new round of funding at all. To say that I was somewhat bemused on hearing this would be a wild understatement.
To understand my consternation, it might be warranted to step back and take a look at the fundamentals of the venture capital hypothesis itself.
At its core, VC investing is about three things. Firstly, it involves an explicit expectation to provide a return to its investors by making “bets” that are riskier and therefore potentially more lucrative than other comparable capital deployment avenues. This risk is almost always on markets and large markets at that—the bet is either on the emergence of new markets that don’t exist today or on entrepreneurs figuring out a way to re-imagine and re-fashion an existing market into a completely new model. Finally, the power law of VC returns mandates that to secure a meaningful valuation and a needle-moving return from startups operating in these new markets, these companies have to be the market winners, or, at worst, meaningful contenders in that category.
If you put all these things together, it is not difficult to see why profitability is almost a pejorative in the world of traditional VC investing.
If a startup reaches profitability, it could mean one of two things, neither of which is desirable for a VC.
Firstly, it could imply that the market is not big enough to provide VC-scale returns. One way of interpreting negative bottomlines for startups whose toplines are growing rapidly, is to view this as the cost of creating the market—the price that the startup is paying for evangelizing its solution and value proposition. If such a startup reaches profitability, it could imply that the top of the market has been reached and therefore not large enough or growing fast enough to provide VC-scale returns. Profitability could be viewed as a sign that the startup has given up on the imperative of revenue growth and exponential growth at that.
Secondly, it could imply that the market is not attractive enough. One reason why startups burn so much cash as they go from inception to IPO-scale, irrespective of the sector that they belong to, is that early success in a nascent market is a signal for new competitors to emerge chasing the same pot of gold at the end of the same rainbow. To stave away such competitors, the original startups inevitably have to spend a lot more on sales and marketing and rationalize the price points of their solutions, both of which impact margins negatively. Against this dynamic, a startup reaching profitability could imply that the market is not attractive enough to lure competitors and such an absence of competitors indicates that the startup is unlikely to yield meaningful returns to a VC.