Profitability or High User Count: Which Leads to Startup Success?
Some analysts argue that revenue drives growth, while others say user growth drives revenue. Both have worked.
Google reached $1 billion in revenue within five years of incorporation, and now has a market capitalization of over $400 billion. Twitter showed no focus on revenue in the first five years, but was able to parlay 500 million users into a $22 billion public company, now growing revenue.
Every startup dreams of achieving that milestone, when they can focus more on scaling the business and enjoying their earnings rather than fighting for another investment infusion. Most are still confused about the right priority. Should they focus on increasing revenues and profitability, or entice more and more users with “free” services to increase their valuation.
Traditionally, it was simple. A business only achieved critical mass by becoming cash-flow positive. Revenue growth (top line) then had to be converted into profit growth (bottom line), before a business was deemed to be self-sustaining and worthy of public investment.
It’s only been in the last 10 years that social-media companies, such as Facebook and Twitter, have achieved market valuations in billions of dollars, while clearly sacrificing revenue to gain users. In my view, the pendulum is swinging back, with investors looking more for the traditional indications of business integrity, stability and growth. Here are factors to consider:
1. Some element of organic growth is a good thing. The purest form of capitalism has always meant charging a fair price and making a fair profit. Re-investing profits to grow the business is organic growth. The concept of free goods and services to get you hooked, financed by deep pockets or advertising, seems marginally ethical to many.
2. Long-term stability requires revenue growth and profit. Most modern investors still look for a business model that embodies a gross margin over 50 percent and a net margin in the 20 percent range. A healthy business, ready to scale, has been doing this for a year or more, with an existing customer set generating a non-trivial and growing revenue stream.
3. High customer loyalty and high team passion. Startup productivity is embodied in key ratios, including low cost of customer acquisition, high retention and high revenue per employee. High customer churn and lackluster team members are still indicators of a high-risk investment opportunity to be avoided by both public and private investors.
4. Growing appreciation for the value of the solution provided. These days, you need customer evangelists who see the value and will pull in their friends through viral actions to keep the business growing. Too many of the high user-growth startups have been fads, and numbers can go down as fast as they go up, as per Friendster and MySpace.
5. Understanding competitive early-mover requirements. First movers in a new space need users more than revenue to maintain market share, so investment pitches need to highlight this priority in requests for funding resources. More complex and defensible businesses should highlight their organic drive to profitability and brand leadership.
Unfortunately, the Internet and heavily-funded startups have nurtured a customer expectation of free web services and smartphone apps. In these domains, it is now difficult to monetize at all until you have a large critical mass of users. Growth scaling is important in these cases, both before and after revenue flow begins. The business plan must reflect both growth phases.
Even after a startup has achieved a critical mass of users, the expectation of long-term revenue growth and profitability does not go away. Twitter is facing this challenge right now, as the large majority of public investors expect a near-term financial return on their investment, every quarter of every year.
A higher focus on user growth may be necessary early, but is never sufficient. If you are in it for the long run, don’t forget the basic business principle that if you lose money on every customer, you can’t make it up in volume.
Martin Zwilling is the founder and CEO of Startup Professionals, a company that provides products and services to startup founders and small business owners. The author of Do You Have What It Takes to Be an Entrepreneur? and Attracting an Angel, he writes a daily blog for entrepreneurs and dispenses advice on the subject of startups.