One of the craziest things I’ve ever heard from an investor (and I’ve heard plenty of crazy things) was, “I hate high margin businesses.”
The managing partner of the fund, we’ll call them “Donald Ventures” said this to me at the beginning of our final meeting. I was taken aback.
I thought to myself, “That statement makes absolutely no sense.” So instead of reacting to his crazy comment, I just moved on with the pitch.
After the meeting, I didn’t know what to think. Fortunately the partner who was leading the deal, “Raul”, was probably the most successful investor in our sector ever. Better yet, he had just joined Donald Ventures after running a very well known fund.
Fast forward one year later. I was back in front of the whole Donald Ventures partnership for a review meeting (they had decided to invest), and about five minutes into my presentation Donald said again, “I hate high margin businesses.”
And yet again, I ignored Donald’s crazy comment. The only problem is that Donald’s not crazy. Here’s why:
In the Ponzi Scheme, growth at all costs era we live in, profitability doesn’t matter.
You have to look at things from the perspective of investors like Donald. Donald’s theory of investing goes like this:
- Grow your revenue as quickly as you can regardless of your gross margins or profitability, then…
- You will be able to attract other investors to continue funding the company, and…
- Your valuation will increase each round as you continue growing your top line, so new investors will continue to pay top dollar to continue growing the top line, and…
- We (the investors) will be able to liquidate our holding at a tidy profit in an acquisition or an IPO.
Let’s compare Donald’s theory of investing to Investopedia’s definition of a Ponzi Scheme:
Donald’s scheme works great until the market slows down and investors stop paying up. In other words, it’s just like a Ponzi scheme.
You, the CEO, need to operate with discipline even if your investors don’t.
Do you remember Sequoia Capital’s famous 2008 R.I.P. presentation to their portfolio companies (Sequoia Capital’s 56 Slide Presentation Of Doom)? I sure do.
The presentation was all about the new fiscal discipline you needed to have if you were going to whether the storm. Here’s the key slide from the presentation:
Does this seem familiar? If it doesn’t it will at some point soon because eventually this cycle will end, the Ponzi schemes will crash and burn, and you’ll have to survive.
The way you survive is by becoming cash flow positive.
I was having a conversation a few weeks ago with a CEO of a bootstrapped startup. His company is doing really well, and we were talking about whether he should take on venture funding.
He was getting advice from people he knew to just grow the top line; similar to Donald’s thought process. I gave him an alternative take.
My take was that you want to build a sustainable business that can stand on its own. And the way you stand on your own is to become cash flow positive.
When you’re cash flow positive, you don’t need to worry about raising money any more. You control your own destiny.
The balancing act is when should you try and become cash flow positive?
You can slow your growth if you get to cash flow positive too early. That’s the challenge that bootstrapped founders have because they have to get to cash flow positive on limited funds. So it may take longer for a bootstrapped company to get to scale than its venture backed equivalent.
On the other hand, the venture backed equivalent can get caught in the Ponzi scheme trap I explained earlier. You can staff up, have huge expenses, and not pay attention to the bottom line as you go through multiple rounds of funding.
Then you’re caught.
You’re burning a ton of money and investors will not pay up. This is the worst possible position to be in. You’ll have to make painful cuts to staff if you’re going to survive, and even that may not be enough.
Your valuation will suffer, and you’re looking at a down round. That’s not what you want.
The answer is you need to work backwards.
It’s a puzzle, I know, but start with the thought process (if you are not bootstrapping) that you have an infinite amount of money and can hire as many people as you want. Add in your revenue stream, and determine how much money you will need over the life of the company.
That’s your starting point.
Then you need to determine what your constraint is. Is it:
- Your ability to raise money? Or is it…
- Your ability to hire really good people? Or is it…
- Your revenue ramp?
The answer will tell you how to realistically plan out how long it should take to get to profitability.
For more, read: Why You Should Ignore The Rise Of The Unicorns