What ever happened to profits?

At last week’s NVCA Annual Meeting, there was a lot of talk about getting the exit market revved up again. The NVCA unveiled their Four Pillar strategy for getting the IPO markets back in action. I agree that regulatory relief would be helpful and it would be really great if we cultivated (once again) relationships with bankers, accountants and advisers whose livelihood is inextricably linked with our business. What was missing at the meeting, however, was a critical discussion of the underlying changes in the industry that are undermining our ability to create a viable crop of IPO candidates.

We actually have had a viable market for IPOs at times over the last decade and there have been numerous (if not plentiful) IPOs. Having spent the better part of two decades taking companies public as an I-banker, I have an informed perspective. There is no question that there has been a significant shift in the underlying financial fundamentals of venture-backed companies. Compared to pre-Bubble Days (tech not credit bubble), the average company requires substantially more capital and more revenues to get to cash flow breakeven and profitability.  Even then, growth is slower and profits per revenue dollar are lower compared to earlier generation companies. What happened?

Well, core cost inflation has not been off-set by an ability to increase prices…this is generally not good and is the result of either the plethora of companies in the same space or poor business fundamentals.  Additionally, the venture industry has grown enormously and has become institutionalized. There is simply more of everything–  VCs, capital, capital per deal, start-ups per industry niche and a cultural shift among companies to have higher relative current income (as well as equity) and many of the trappings of large (yikes!) companies. I can remember the days when companies with $10-20MM in revenues had a VP of Sales and Marketing, the CEO was the President and COO, and survived without VPs of BD, HR and a General Counsel. They also reliably made money.

Then there was the thrilling shift to valuations based on multiples to revenue instead of earnings. This sleight of hand, occurring in the mid-90’s, was the successful outcome of attempts to justify higher valuations that were accorded to public growth companies as we got into the prime of the equities boom. Unfortunately, this shift had a lasting and negative effect on the way young companies are run. Instead of building companies to have good growth profitably, the mantra became great growth regardless of the cost. Plentiful capital and a seeming lack of interest in earnings is a toxic combination. “If you’re missing revenue budgets….you must be underinvested in sales and marketing. It could not possibly be the attractiveness of the product, the pace of market acceptance or the quality of the target market application.” Pouring in more sales and marketing for a product without natural pull is a great way to sweep up all the early adopters but does not provide a basis to cross into the majority. It is easier to spend money finding the last of the early adopters than it is to innovate your way to the market majority. Ever hear of a long-run off a short dock?

Public market investors have once again gotten too smart for that. Revenue growth without profitability (including profits that scale) offers no testimony of a business model with longevity. The best way to create long-term value and great businesses is to focus most on building a company that can be independent with products and services which can deliver real ROI in growing markets. Product market focus, patience with results and prudence on expenses will yield a crop of companies that can provide a range of attractive exit options to investors.