Analyst Angle: Why venture backed startups are supposed to lose money

Editor’s Note: Welcome to our weekly feature, Analyst Angle. We’ve collected a group of the industry’s leading analysts to give their outlook on the hot topics in the wireless industry.
I remember the day when an entrepreneur came by the office when I was a part-time Venture Advisor with Diamondhead Ventures. He presented the plans for his new company. The plans demonstrated some exciting new mobile technology. I thought to myself, “Hey, we may have something here. This looks promising.”
When the entrepreneur got to the financial section, he presented (as most do) a detailed spreadsheet showing revenue and expense for the next three years. He then said, “We expect to be cash flow positive within the next few months and stay profitable after we close our round of investment.” I can assure you that the entrepreneur was very serious. He was trying to make a good first impression.
I can remember thinking, “Ah oh, this guy doesn’t have a clue. He doesn’t know that you are supposed to lose money – at least for a while – if you raise venture capital.” I asked him why he thought he’d be able to stay profitable after the funding. He smiled with confidence and said something like, “We have a good product. Once we announce it, everyone will want to buy it. We’ll always be profitable.” It was not going well.
I thanked him for coming in and then discussed the opportunity after he left with others at the firm. While we all liked the new technology, the entrepreneur clearly didn’t have a good handle on how to best run the company after the investment was made. We ended up passing on the investment.
The entrepreneur didn’t have a grasp of how important it is for venture-backed startups to actually lose money – at least for a while – after the investment is made. This would seem opposite from what you’d think. After all, if you’re making an investment in a young company, you want it to grow and become more profitable. You wouldn’t think that you would want your new investment to intentionally lose money. However, most venture-backed startups are designed to lose money in the beginning. Here’s why.
When a startup company builds a product (or creates a service), it will begin to generate some sales via rather small, self-funded promotions. There may even be some small growth. But, the company can’t possible reach out to millions of customers with a small amount of capital from personal wealth, friends and family.
In order to grow the company fast and to realize the potential of the product or service, a significant amount of total capital (over multiple rounds) is required – typically up to $20 million for software and $50 million (or more) for hardware. Some firms grow very quickly and require hundreds of millions of dollars to reach market potential. Facebook is a good example.
When venture investors infuse the first round of capital into a startup, the purpose is to provide the funds to hire qualified people, finish key development efforts and then be able to have the necessary funds to grow the company’s sales.
Thus, it’s important that the startup’s management team and the investors “line up” with the business development strategy. There needs to be a common vision. Then the management team is tasked with the responsibility of achieving the goals and adjusting to market conditions in order to have the company increase its revenue from 10 to 100 times it was before the investment.
Therefore, a venture-backed company’s financial operations dips into significant losses while the people are hired and the plans put in place to significantly grow the company. What the investors want to see is a tremendous growth in revenue and customers such that the company can eventually return to profitability at a much higher level than before.
The value of a private company is typically placed on a small multiple (typically 2x-4x) of revenue and/or a higher multiple of profits (typically 10x-20x earnings before interest, taxes, depreciation and amortization or EBITDA). Thus, in order to create value in a private company where there is no public market for the stock, investors put up capital in order to help the company grow to much higher levels of revenue and profits. And, during that process, the company has to lose money (in the financial statement) in order to realize the higher levels of profits at a future time.
Of course, this whole process can come to a screeching halt if all the people are hired, products are built, and then customers and revenue don’t materialize. Young companies never follow the original plan exactly. And, sometimes in the process of building and selling one product, you find out that the market wants a different product and, therefore, everyone has to agree to change the strategy in order to be successful.
And, while no one likes to shut a company down, it’s a simple fact that 50% or more investments made by institutional investors in private companies don’t work out. Most of the time, the technology can be sold “at cost” to another company who might want to add the capability to their product line. It takes some tough skin to reverse direction and shut a startup down. No one wants this to happen – ever. But, going into the investment, everyone has to understand that if things don’t work out, then the firm may not be able to stay in business.
What all investors like to do is talk about those startups in which the results equal or sometimes exceed the original plans. Everyone is happy when this happens.
So, realize that venture-backed companies are designed to lose money – at least for a while. And, if you are in one, realize that you have to grow revenues and then get the firm profitable at some point. Most investors are tolerant of management making changes to the original plan as long as they are able to realize positive results.
My advice to entrepreneurs: Don’t be afraid to lose money when you take on additional capital. But, likewise, be able to execute on the plan to grow the business. Keep your investors smiling and the world will smile with you.
J. Gerry Purdy, Ph.D. is Principal Analyst, Mobile & Wireless, MobileTrax L.L.C. As a nationally recognized industry authority, he focuses on monitoring and analyzing emerging trends, technologies and market behavior in the mobile computing and wireless data communications industry in North America. Dr. Purdy is an ‘edge of network’ analyst looking at devices, applications and services as well as wireless connectivity to those devices.
Dr. Purdy provides critical insights regarding mobile and wireless devices, wireless data communications and connection to the infrastructure that powers the data in the wireless handheld. He is author of the column Inside Mobile & Wireless that provides industry insights and is read by over 100,000 people a month.
Dr. Purdy continues to be affiliated with the venture capital industry as well. He currently is Managing Director, Yosemite Ventures. And, he spent five years as a Venture Advisor for Diamondhead Ventures in Menlo Park where he identified, attracted and recommended investments in emerging companies in the mobile and wireless. He has had a prior affiliation with East Peak Advisors and, subsequently, following their acquisition, with FBR Capital Markets.
For more than 16 years, Dr. Purdy has been consulting, speaking, researching, networking, writing and developing state-of-the-art concepts that challenge people’s mind-sets and developing new ways of thinking and forecasting in the mobile computing and wireless data arenas. Often quoted, his ideas and opinions are followed closely by thought leaders in the mobile & wireless industry. He is author of three books.
Dr. Purdy currently
is a member of the Program Advisory Board of the Consumer E
lectronics Association (CEA) that produces CES, one of the largest trade shows in the world. He is a frequent moderator at CTIA conferences and GSM Mobile World Congress. He also is a member of the Board of the Atlanta Wireless Technology Forum.