Here’s how startups should be managing their growth and profitability
Premium- Businesses need to work within the limitations of underlying economics of target markets
In times of overly buoyant markets, entrepreneurs have easy access to capital, which allows them to discount their products and services. Such discount-driven subsidized pricing may lead to the entrepreneur believing there is a much larger market (thanks to the price elasticity of demand) than there actually is. This perception of a larger market might generally be shared by optimistic investors as well. As a result, the company ends up raising capital at a valuation that may be much higher than the underlying market potential.
Unless the valuation is corrected in time or new revenue streams are built, it becomes the most critical number for the founder as well as existing investors. Growth needs to justify the valuation.
Hence, a loop is created where previous-round valuations need to be justified, forcing the founder to increase the gross transaction value (GTV) or gross merchandise value (GMV), even if further deep discounting is required, that is, expanding the market (artificially).
This might become a vicious cycle, which we have already seen playing out in certain instances in the Indian market. In such cases, the sustainability of the business completely depends on the availability of capital from the private market. If the market turns cautious and capital dries up, the company may face an existential threat. We have already seen this happening in both Indian and global contexts.
On a related note, if the company is making a healthy gross profit, its ability to organically invest in marketing, promotions, brand building, and customer services consistently increases. It can start to self-fund part of this growth and, beyond a certain point, the dependence on external capital is moderated. It took some of the best startups, which are an aspiration for incoming entrepreneurs, less than five years to turn earnings before interest, taxes, depreciation, and amortization (Ebitda)-positive and start funding their growth.
For India, the time taken might be slightly longer, as the market is still in the early stages of growth, but investments should be streamlined to be in line with market potential over time.
Moreover, a company operating at positive gross margins can control overheads and growth-focused investments to stay alive in times of difficult capital markets. They can start making investments again when capital becomes more readily available.
Another related point is that in markets where the path to profitability was shorter, digital startups solved the discovery and convenience problems, while the market could already spend.
In India, the capability to spend is also a limiting factor; though admittedly, it is improving at an accelerated pace.
As long as the burn is to drive discovery, convenience and superior service, it makes complete sense, but an effort to solve for the spending capability through burn might not be very prudent. Businesses need to work within the limitations of the underlying economics of the target markets so that they cater to the population that can actually afford the products and services (unless the digital move changes the cost dynamics significantly and brings down the price bar).
Sustained gross margin losses can be counter-productive and can build unsustainable artificial markets. We understand and appreciate the startups’ need to stay in the red to make growth-focused investments, such as in marketing and customer service. In our humble view, a critical function of the entrepreneur is to keep an eye on the “investment-profitability trade-off" and to pull the right levers opportunistically.
Finally, most often, the ultimate aspired exit route is an initial public offering (IPO), even after consolidation. Public markets generally value both growth and profitability in addition to market leadership.
A high-growth business might justify a negative net income (it still might not explain negative gross income), but moderate growth with large losses is unlikely to attract significant interest from public investors in a steady-state market.
Even after a high-growth phase, a significant gap in potential public and private market valuation might clearly indicate a perception of an artificially-inflated market. It might be time to reflect and take hard corrective actions.
Anurag Goel is a general partner at Cactus Venture Partners.