Marc Andreessen recently tweeted a reminder that a company’s stock or valuation is based on future performance—not current performance. He is, of course, correct.
I have been following, with great interest, the ongoing debate about current Venture Capital, Private Equity and Start-up funding activity over the last 5 years and if it has created another bubble. The money guys will tell you it’s very different than in the 90’s where EBITDA, not profitability, was the accepted measure of a tech company’s performance, IPOs were the preferred method of raising significant capital and investment banks didn’t really understand the technology.
I would argue the institutional money guys still don’t really understand the technology. Currently, raising money through private equity is the preferred path for many tech companies where everyone wanted an IPO in the 90’s. I would argue it is the same cow by a different name.
After Uber disclosed an operating loss of $470 million, it received enough participation in its latest bond offering to signal a valuation of over $50 billion. That’s right… $50 billion valuation on a company that lost $470 million last year and doesn’t even explain how or why it lost it before new investment dollars fly in through a bond offering.
At some point, profitability must have a far greater stake in the measurement of a company’s viability. Scaling a company through self-funding is slow and incremental. It can be tedious and frustrating.
This emphasis on profitability isn’t happening because the private equity market is flush with cash—enabling and encouraging start-ups to embrace concepts like “run-rate, IRR and total addressable market” to justify their race to scale at the cost of profitability. This is the rub. Private investment wants to see growth—especially top-line revenue. Profitability is assumed to be coming at some point—even when there are no strong indicators this will actually happen.
Revenues still rule in financing rounds. If you show exponentially increased revenues from the previous round, your valuation usually goes up. What if, instead of top-line revenue, PE shops saw profitability increasing on the same revenue numbers from the previous round?
Unfortunately, it is reasonable to assume the valuation suffers even though the founders were actually running a better company.
So what should a start-up do?
Elliot Bohm, the CEO of Card Cash offers a very reasonable strategy is his Inc Article, “Why you shouldn’t always be looking for Venture Capital.”
He proposes the strategy they executed at Card Cash which was to take an initial round from a VC fund which adds brand credibility and allows you to build your business and then use traditional debt funding to grow.
This, of course, requires startups to get off the milk wagon of private equity and focus on building a business where profitability is part of the strategy. To use traditional debt like short-term loans, you have to prove you can actually service that debt. Banks are a for-profit business so they aren’t likely to loan material amounts of money to a business that can’t create net income.
Private equity models work and they can help a good company and concept become great through financial support. They can also enable less than responsible behavior as startups enjoy playing with other people’s money.
Truly durable companies are profitable companies. The longer start-ups focus on the value of an exit and how many rounds of financing they can execute, the less likely they are to see a profit. It would be almost revolutionary to see the prestige of “exits” be replaced by the elusive, but more impressive measurement—profitability.