Growth or Profits? Yes.

This week I’ve been running the Entrepreneur’s BootCamp here at Babson. I do several of these a year on campus and around the globe. It’s always great to spend time with creative individuals with diverse backgrounds and ideas.

As you can imagine I field a lot of questions about getting a company off the ground and always about raising money. One question that kept coming up this week was whether investors are more interested in a growth story or a path to profitability. Everyone, especially those from outside the U.S. are baffled by unicorns like Lyft and Uber that state in their respective prospectuses that they may never be profitable. As you can imagine the discussions and opinions on this topic are wide ranging. For me it’s beginning to feel like the end of a bullish cycle. More on that later.

So which is it - growth or profits? It would be hard to argue that growth isn’t important, especially when so many startups are valued on a multiple of revenue alone. This is not to say that profit is unimportant, or unachievable. In fact, some early-stage startups will go out of their way to tell you that they can be profitable, but would have to slow down their growth. In industry sectors where rivalry is fierce and companies are fighting for market share slowing down growth might be a strategic mistake. However, grow too fast and burn a lot of cash with no regard for how you will ever be cash flow positive, which is different from being profitable, and you will find yourself in a jam should the market turn sour and capital become scarce.

Perhaps the only benefit that I see to getting old is that you’ve been around long enough to develop pattern recognition skills. Back in the late 90s I can recall being in a board meeting where the CEO stated his desire to control the burn rate. An investor/board member implied that capital was fungible and there was plenty of it around to continue to fund the business. A few months later, after the Internet Bubble had popped, the investor was singing a different song. Not all businesses can gain immediate benefit from reducing operating expenses especially if your fixed costs are high and locked in. Anyone who was in the startup world in the early 2000s remembers the carnage.

Neeraj Argrawal of Battery Ventures recommends what he calls the T2D3 strategy for SaaS companies. Simply put T2D3 recommends getting to $2 million annual recurring revenue, then tripling revenue for two years, then doubling revenue for three years to get to $1 billion in revenue. It is a path that several SaaS high fliers have followed successfully. He doesn’t mention cash flow or profitability, but my guess is that at these run rates most companies are at least cash flow positive.

Brad Feld talks about the Rule of 40% for “Healthy” SaaS businesses. The 40% Rule states that your growth rate plus your profit should at up to 40%. Therefore, if you growth is 25% your profit should be 15% and if you are growing at 40% your profits are 0%.

I like the Rule of 40% because it places some focus on profitability; however, both of these heuristics are SaaS focused and from the investor perspective. Exceptional levels of growth without positive operating cash flow require the company to raise funds externally to support growth. This translates into more dilution for the founders and employees. You also have to realize that you are building a culture that is based on growth (read spending) and ramping your operations (people and capex) to service that growth. If a market hiccup turns into terrible indigestion that requires remediation you may face some difficult realities. First, is that you have to cut costs rapidly and deeply. Second, is that your growth will have to slow. Third, is that investors no longer love you. Fourth, is that your company culture needs to change and some employees may no longer love you. As Eric Clapton sang, “nobody knows you when you’re down and out.”

Now for some clarification with regard to my comment about the bull market cycle. I don’t know when it is going to end, but I do know that trees do not grow to the sky. There will be a reversion to the mean at some point in the not too distant future. When it happens a lot of investors who have never been through a down cycle will panic and begin to bark out orders that are contradictory to what they may have been saying just weeks earlier. The best way to be prepared is to be in a position to get cash flow positive without any unnatural acts. This means having an eye on both growth and profit from the start. One thing I do know is that you can’t cut your way to prosperity.