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Tech and high growth IPOs: Why profits no longer matter

So far this year, we’ve seen some of the biggest names in tech file to go public. What’s one thing they’ve all got in common? Billions of dollars in losses. Robert Collings explores why profit is not the ultimate aim for high-growth tech firms.

4th Sep 2019
Mobile app Uber on a Apple iPhone
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As has been widely reported, Uber closed 2018 with an operating loss of $3bn, while high-growth WeWork ("The We Company"), generated an operating loss of $1.7bn. Even the cash-rich Slack generated an operating loss of $154m.

They’re all household names and are growing at incredible rates. They’ve raised billions in funding. They’re some of the most valuable companies around. So, with this amount of success, does profit really still matter?

Tech startups are a different breed

If you’re looking at a classic ‘owner-managed’ business then of course, profit matters. Profit indirectly drives an increase in cash, which allows the business to continue operating, paying dividends to shareholders in the process.

However, tech startups aren’t like that. They’re not in business to fund a comfortable lifestyle or enjoy minor growth each year. They’re in business for explosive growth. They’re in business to drive change at a global level. They’re in business to make the world a better place.

Explosive growth is expensive

Generating hockey stick growth is tough and requires a scalable business model. Tech companies need to sign up a lot of paying users to drive revenue growth, and that often comes at the cost of sign-up incentives, referral rewards and other costs.

This is often the reason why so many tech companies are operating in a loss-making position – their sales and marketing costs are incredibly high while they establish themselves as a market leader in the industry. This doesn’t necessarily mean that the business model doesn’t work; it just means they’re paying for rapid growth.

Growth and profit are mutually exclusive

It’s very rare to be able to unlock rapid growth whilst making a profit. Look at WeWork for example. The company is opening thousands of new locations which incur large setup costs, yet each location takes 24 months to mature and bring in a steady flow of revenue. The idea is that, in theory, if WeWork stopped opening locations, they would be profitable once all of the locations mature.

It comes down to unit economics

Unit economics is the term used for the profit or loss made on each unit. A unit depends on what you do. WeWork looks at each location, whereas Uber looks at individual bookings. Loosely speaking, it’s the gross profit per unit.

An overly simplistic way of looking at this is to consider the following three things:

  • Unit economics
  • Administrative costs
  • Growth costs

If you assume that the unit economics are positive (ie you make a profit on each unit you serve, irrespective of how small it is), administrative costs are fixed and growth costs relate only to growing user numbers, then you can start to see how this works.

The growth costs are an investment in driving up the volume of ‘units’, which increases the money coming from these units. There will eventually come a point where gross profit exceeds the admin costs, but the company is still loss-making with the growth costs factored in. Scale back on the growth costs and the gross profit will level out at a point which exceeds the admin costs. Then you have a profitable company.

Think of it as a butterfly

A butterfly begins life as a caterpillar, in a similar way that a tech company begins life as a tech startup. At some point in its life, a tech startup (the caterpillar) will mature into a tech company (the butterfly). Once it’s a fully established tech company (think Google, Apple, Amazon, etc.), then it becomes more like a standard company and can generate enough profit and cash to support itself. It’s at that point when profit becomes important. The reliance on outside investment drops and it becomes a self-sustaining company.

So, profit doesn’t matter, but only up until a point.

In the early days of a tech startup, no one worries about profit. It’s all about growth and users, using investor cash to fund that rapid growth. Unit economics are important, but overall profit isn’t.

Once the company reaches the later stages of its growth (which, I should note, doesn’t necessarily correlate with when it goes public), then profit comes as a result of the slowdown in growth. If profit doesn’t come, then the board will likely look to cut costs through streamlined operations which may eventually drive a profit.

So, profit doesn’t matter but only when the company is a startup focused on explosive growth. It does matter, however, when the company reaches a point when it wants to be self-sustaining or level out on growth. The secret to successfully reaching that point? Unit economics.

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bike
By FirstTab
04th Sep 2019 16:08

Interesting article.

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Jonathan@Aiteo
By [email protected]
05th Sep 2019 09:14

"Robert Collings explores why profit is not the ultimate aim for high-growth tech firms."

Or, alternatively, the headline writer (I won't blame Robert for this one) demonstrates they don't know the meaning of the word 'ultimate'.

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Hallerud at Easter
By DJKL
10th Sep 2019 15:26

My big concern with jam tomorrow is what if there is no tomorrow for that business model- they go years and years without striking a profit then tech advances overtake their offer and they never report a profit.

I was buying and selling shares during an earlier period when profits did not matter and saw how that worked out for some of the players.

Must be an age thing ,as I approach counting dividends as one falls asleep in retirement, but give me a plodding 4% div yield and say 4% reinvested in the company, an intrinsic P/E of 12.5 and I am happy.

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