Investors, especially those betting on young and fast growing companies, continually grapple with the tug of war between quickly growing the top line and getting out of the red. This fault line is markedly evident in venture-backed companies and it always catalyzes lively conversation between a company’s investors and its operating executives. Analogously, growth company stock pickers, increasingly machines but that is another topic, deal with the same dynamic as they settle on forward looking multiples. Sometimes the tug of war triggered fault line grows into a gap and in cases becomes a canyon – but does it have to? Friction and tension is healthy in setting strategy and allocating resources to execute it, but I don’t think the growth vs profit question is purely binary.
The get-big-fast mentality was turned into a mantra by a little-known computer geek toiling away at a macro hedge fund in the mid-nineties. He famously made a cross-country drive from Manhattan to Seattle and wrote the business plan of his company, now worth half a trillion dollars, along the way. Jeff Bezos is the geek, Amazon is the company, and growing sales at all costs was the mantra. He has proven, along with many others, that significant investment in sales and marketing helps bankroll top line growth above and beyond what is achievable organically. You don’t need a degree from Princeton, like Bezos has, to figure that out. What does take some real intellectual horsepower is striking a balance between growing the top and bottom lines.
There are some great heuristics and rules of thumb that help benchmark a company’s growth path. My personal belief is that achieving unit economics, or at least having line of sight into ways to achieve them, is critical. Traditional balance sheet corporate debt helps drive the behavior of large and mature enterprise managers. Why? Because they need to generate steady cash flows to service that debt, and by consequence this serves as risk-taking constraint. You don’t need a “belt and suspenders” strategy in the startup world, but my sense is that achieving balance between growth and profit with equity-backed small companies is valuable and focusing on a path towards unit economics has a grounding effect for management teams as they embark on a path.
I like the path Neeraj Agrawal, a general partner at Battery Ventures who also happens to be one of my grad school classmates paints in the SaaS world. What he lays out is generally applicable in tech-driven companies across verticals. In short he lays out what he terms “T2D3”– triple triple double double double. T2D3 puts some math around a company’s top line trajectory once it achieves product-market fit. That elusive fit is extremely hard to achieve, but the general goal in the first year after fit is achieved (think Series A-ish territory) is to hit a sales number that has two commas. If that number is $1m or $2m, then by year five, the company should be running a top line of $70m-ish or $140m-ish respectively.
I will not get into what the previous paragraph means for a company’s staffing plans and capital spend, but you get the picture in a broadly scale-driven model. The thinking behind this, and it works, is that once a company is operating at scale it can generate defensible and (hopefully) outsized profits (think unlocking shareholder value via the increasingly elusive IPO). Foundry’s Brad Feld relayed some nuggets he learned, termed the “Rule of 40%”. Simply stated: your company’s annual revenue growth rate added to your operating profit margin should equal forty percent. The brutal simplicity and clarity of this heuristic is hard to overstate and below are three scenarios that bring it to life:
- If your company is growing at 40%, you should be breaking even. Another way to put it, if your company is not growing then it should be delivering 40% operating margins.
- If your company is growing at 90% year over year, you can rationalize losing money at a rate of no more than 50% of your sales.
- If your company’s top line is declining 15% year over year, then your margins better be 55%.
Neeraj and Brad lay two good markers, but the fact is that startups are built to grow fast, not necessarily to last. The winners do both, grow fast and last – and the only way to last is to make money.
Grow fast, you ask? Think 1% or more a week. At 1% WoW its ~%67 YoY growth, at 2.7% WoW its 720% YoY pop, you get the picture. This level of growth is possible only during the early years of an enterprise because the law of big numbers eventually catches up – even with superstars like Google, Facebook, Amazon and Apple. A good proxy for revenues in some instances is user base, but you better have several ways to monetize it – back to unit economics. The numbers are not the only thing that matter, the quality of the numbers matters too. Another listed company analogy that illustrates this involves forecasting future earnings. The quality of earnings typically translates to predictability and reliability. Although there is a lot of emotion that goes into valuing the free cash flow and earnings of a high-growth public company, the dynamic of revenue growth and bottom line quality (and growth) is similar to the startup dynamics. The story in both cases is in fact, about growth, actually expectations of growth.
Achieving balance between growing fast and becoming profitable is difficult, no question. What I can tell you is that at Fenway Summer we care about both, but striking the right balance is not for the faint of heart. Thinking and gaming different options with entrepreneurs as they build their businesses is intellectually stimulating and executing the plans is always exhilarating. It is mostly, not completely, about growth. Go get ‘em!