‘When are you going to break-even?’ And other premature questions for pre-seed start-ups

The majority of my days is spent on pre-seed companies - vetting, advising and presenting them to potential investors, and convincing investors to invest, drafting investment terms, etc. In these interactions, the question of profitability comes up quite often and I have always found myself in uncomfortable positions when investors put founders on the spot to declare a certain date when they will be profitable. Why is that?

What is the point of investing in a start-up? To exit

Steve Blank famously said, "that a start-up is an organisation formed to search for a repeatable and scalable business model." This makes it fundamentally different from an established business, which presumably has found that business model (often years and decades before) and is focused on optimising the model (and profits) through iterative changes and highly granular business planning.

Such iterative and granular planning is futile for a company that is still in the experimentation phase. Until you have scalability (run rates in the millions of dollars, hundreds of employees, national or international presence), you are still searching for that "repeatable and scalable business model" and your company is an ongoing experiment.

This is especially true for pre-seed companies. Hence, focusing on profits is an exercise similar to counting eggs before they are hatched. What matters most is the topline user and revenue growth.

Another side of the coin is what my friend Rahat Ahmed recently published in a viral post saying that start-ups are about value creation, not break-even: "In short, start-ups need to create value, not necessarily make money (profitably). By creating value, it'll attract a successful exit which will then return a financial return to investors. Investors looking for dividends, short-term profitability or guaranteed returns should not be investing in a start-up."

I agree with him. Particularly for pre-seed companies, this obsession with profitability can be detrimental to the long term prospects of a business. During the pandemic, a lot of pre-seed companies were under pressure to cut back on overheads and spending, and at the same time, their revenue growth stagnated or declined.

So while they may be at break-even, investors in BAN's pool questioned their long-term potential because that break-even was not driven by top-line growth but bottom line cuts. This obsession with profitability and break-even point comes from a misplaced understanding that unless a company is profitable, it is not able to return money to investors.

But how do exits happen in a start-up so that they can return money to investors? Typically in two ways: a public offering or a buy-out by a larger firm, often a competitor and an established incumbent.

And a buy-out happens typically for three reasons: (1) access to a new and growing user-base that the incumbent may have a hard time building on their own, due to issues of culture, brand, product-market fit, etc.; (2) access to a new product that can be monetised through the incumbent's established distribution channels; and (3) access to novel technology and intellectual property.

Rahat describes one such example: "For successful exits, you generally need acquirers (as IPOs are relatively rare by any measure). Acquirers want start-ups for various reasons, which will often determine which metric leads to the highest valuation. Their rationale could be anything from gaining market share geographically, industry-wise or a defensive manoeuvre to block the future growth of a competitor.

In a Bangladeshi context, let's say an app is generating $5 million in revenue, $500,000 in profit and has 100,000 users. That is $50 in revenues and $5 profit per user! That sounds really good, right? It may still get a lower valuation than an app that has $100,000 in revenue, no profit and 500,000 users.

This is because if a multinational consumer goods company wants to get access to the Bangladeshi market, the $5 million revenue does not mean much. They make tons of money already globally. What means to them is getting access to all those users to whom they could then sell their whole existing portfolio of products. If each of those users has a lifetime value (LTV) of $100, then the former company's valuation is $10 million but the latter is worth $50 million.

Illustration/TBS

In Bangladesh, we have already seen angels and early investors in companies such as Pathao and Sheba sell out to strategic institutional investors such as regional tech players and local conglomerates. Why did these investors buy-in at considerable premiums to original investors?

To access a particular market and user base, that has synergies with their existing models, before such a start-up becomes too large and becomes out of reach or worse, cannibalizing their business. They did not buy in because those start-ups were profitable. They bought in because those start-ups demonstrated the ability to scale.

Even in a public offering, which is yet to happen for a Bangladeshi start-up, the general rule around the world is that the investors would be willing to cut the new company slack for a few years. In the meantime, it looks to optimise its business and become profitable, as long as it delivers growth. You can see this in the case of Facebook, Uber, Delivery Hero and countless others. Why would Bangladesh be different? 

What makes a pre-seed company investable? The prospect of meaningful growth

But let's get back to pre-seed stage companies. The majority of them are earning revenues in the 1000's and 10,000's of dollars per month. I do not think it is particularly wise to demand profitability and break-even. Because at those numbers, the companies will not be able to deliver any meaningful returns. And the whole point of investing in start-ups is to gain outsized returns compared to any other asset class, compensating for the high risk of failure.

What is better to look for in a pre-seed, post-revenue company? First and foremost, it is important to create sticky platforms - where users keep coming back and keep transacting, whether in the form of money or time or both.

As part of that, an ever declining customer acquisition cost (because you're not paying for user acquisition — they're doing it for you), a higher and higher LTV (because they're spending more and more on your platform) and high retention rates.

In analysing retention, it is important to understand the behaviour of the top 10-20% of users. Has the product/service become something indispensable and integral to their lives? Consumer behaviour is measured through things like average minutes spent, daily active users divided by monthly active users, net dollar revenue retention, etc.

High retention and low churn, combined with user and revenue growth, are greater marks of investability at the pre-seed and seed stages rather than pure profitability. I am not saying that a start-up will have all of these rights from the beginning but what matters is an improvement over time.

But I do not see enough founders talking about retention in their decks and pitches. They seem more focused on marketing spendings to attract new users, which would be useless if they do not stick around.

There also seems to be confusion on what LTV is - many decks simply multiply the potential number of transactions with an average order value for a period of time. This does not reflect the actual historical data of churn and other elements. In a future post, I will write more into tactics behind inducing and measuring retention.

When should the profit conversation come in? Once the business model is established

Do not get me wrong. A company will not survive without eventual profits. But I think it should be at the later stages of funding when a company should start optimising its business model. In this phase, the company should plan for profitability, first at the unit level, then at the gross margin level and eventually at the net level.

It is important to have this line of sight. In immature ecosystems where later-stage funding and meaningful exit opportunities are few, those conversations might happen earlier.

In the second scenario, the company prefers to gestate for a while - with a low cash burn strategy - before its growth levers are fully optimised ahead of raising capital and pursuing rapid scale.

I think this can actually be sensible, especially for self-funded or limited funded companies. Because they have to run at an operating break-even for a while as they look for repeatable and scalable business models. Such a business would be able to circulate more of its capital back into growth once it pursues scale.

The third scenario is when a company and its shareholders do not want to raise further funding. This is perfectly reasonable and might actually help them sleep better at night, knowing that they are not under pressure to fundraise constantly. But this also limits their potential returns. At that point, it may be more of a lifestyle business than a high growth start-up.

Remember, start-ups = growth.

The author is CEO of Bangladesh Angels

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.