Here’s what you should know:
- Recently, there’s been a shift in focus back towards profitability within the startup ecosystem. Prioritizing profitability from the start instills a culture of responsible spending, validates business models earlier, and can bolster investor confidence.
- It is crucial for startups to align all expenditures towards the goal of profitability. Temporary negative net income can occur, but overall spending should aim for profit generation.
- Return on Invested Capital (ROIC) is a crucial metric for startups, indicating efficient use of capital for profit generation. Prioritizing ROIC can lead to better strategic decisions and value creation.
- Startups should strive to stay lean in the early stages, often through bootstrapping. Venture studios can provide resources and support, helping startups to avoid high early capital investments.
- The recommended approach for early-stage startups is to raise just the necessary capital to mitigate key business risks. Once Product Market Fit is achieved, startups can then consider increasing investments, guided by key metrics like the Customer Acquisition Cost to Life-Time Value (CAC:LTV) ratio.
Over the past decade or so, the venture capital landscape has undergone a notable transformation. This shift, propelled by the growth of progressively larger venture funds, led many startups to prioritize raising as much money as possible. This explosive growth, though seemingly advantageous, inadvertently distorted many founders’ perception of success.
Over the past several years, a lot of people began equating the quality of a startup with the amount of money it raised. Only a few years ago, profitability was often discussed in VC circles as if it were a pitfall to be avoided—a sign that a startup wasn’t growing quickly enough. This culture of relentless, venture capital-fueled growth cultivated a widespread notion that a “startup” was merely another term for “a business that loses money.”
However, an excess of capital can often result in decreased productivity (as we’ve previously noted), and there are far more sustainable strategies for building startups. In our perspective, it is incumbent upon a savvy and capable founder to resist the temptation of raising large amounts of capital early on and instead concentrate on building profitable, enduring businesses.
Why Focus on Profitability Early
The recent burst of the venture bubble has seen “focusing on profitability” reclaim its rightful place in the limelight of the startup ecosystem. This resurgence underscores the reality that profitability should always have been the primary objective.
An early emphasis on profitability reaps several rewards. It aligns the team’s mindset with responsible spending and instills a culture of value creation from the get-go. This orientation also enables startups to validate their business models sooner, encouraging resilience and flexibility. Additionally, profitable companies can often finance their own expansion, minimizing reliance on external funding, and maintaining a greater degree of strategic control. Lastly, the solid fundamentals derived from an early focus on profitability can bolster investor confidence, making fundraising far more viable (and inexpensive) when it does become necessary.
To be clear, we’re not suggesting that your startup should never experience negative net income. There will undoubtedly be times when it’s judicious and responsible to spend more than you earn within a certain period. When we talk about “building profitably,” we simply mean that startups should scrupulously align every dollar spent with the quest for profitability.
The first step in building profitable startups demands a shift in thinking and a redefining of success. At Mark II, we avoid obsessing over the amount of money our startups can raise. Instead, we concentrate on the metric that truly holds the most weight: Return on Invested Capital (ROIC). Ironically, by focusing on ROIC rather than raising capital, you often have easy access to as much capital as you need.
A focus on driving long-term returns on invested capital can guide founders to make better strategic decisions that create and preserve value for themselves, their customers, and their investors. This pivotal measure illustrates how efficiently a company employs its invested capital to yield profits. ROIC enables investors and management teams to assess a company’s productivity, efficiency, and risk.
In our quest to maximize ROIC, we advocate for our startups to remain as lean as possible in the early stages. This is often achieved by bootstrapping early product development and maintaining this frugal approach until Product Market Fit (PMF) is established. For more on how to know when you’ve achieved PMF, we always recommend this classic post by Marc Andreessen.
Bootstrapping involves financing your startup through personal savings and the revenue generated by the business rather than through external capital. This path to self-sufficiency often demands a substantial initial investment in terms of the founders’ time and effort.
Venture studios like ours can serve as a valuable asset for launching a lean startup. At Mark II, we shoulder the initial costs involved in getting a new startup off the ground (such as legal fees, design support, and so forth) so that founders are not burdened with the need to tap into personal savings. Furthermore, our internal studio team serves as a free executive team and support system to assist our founders as they navigate initial product development and operational needs.
Nonetheless, we still expect our founding teams to kick off their journey by working without pay (often dedicating nights and weekends for several months) to build and launch their initial product. Our approach helps circumvent the need for costly early capital investments and is the essence of “sweat equity”. We prefer to collaborate with founders who demonstrate this level of commitment.
Incrementally Increase Investment
As both investors and founders, our approach to venture capital is anchored in a disciplined and strategic view of initial product development and growth. In the early stages of a startup, it’s optimal to raise just the right amount of capital needed to mitigate key business risks.
This strategy aids founders in sidestepping excessive dilution and ensures they maintain a sharp focus on reaching Product Market Fit. For a more comprehensive understanding of our perspective on early-stage capital usage, we recommend this post.
Once the startup has successfully eliminated the key business risks and attained PMF, it can then consider escalating investments for growth. However, this decision should be based on the company’s capability to accurately evaluate the return on invested capital for customer acquisition. This evaluation is usually achieved through key metrics like the Customer Acquisition Cost to Life-Time Value (CAC:LTV) ratio.
One of my mentors once offered a valuable piece of advice that stuck with me: “Don’t keep too much money in your pocket, or you’re likely to spend it.” This simple yet profound wisdom speaks volumes about the human propensity to become less efficient with resources as their abundance increases.
Consequently, we strongly advise our more mature companies against the temptation to raise large sums of capital (even when its easily available). Instead, we suggest they tightly manage their available capital resources, only considering significant investments in growth channels once they have demonstrated positive ROIC metrics. This helps ensure that they maintain the discipline and profit-centric mindset that made them successful.
The journey of building profitable startups is both challenging and rewarding. It begins with a simple mindset shift – emphasizing building a profitable business right from the inception. This shift is crucial in fostering lasting enterprise value that benefits all stakeholders. Emphasizing profitability not only ensures the company’s sustainability but also cultivates a disciplined approach to growth and resource allocation.
Remember, the ultimate success of a startup is not about the capital it raises but rather about the enduring value it creates and sustains.