How Long Should a Startup Remain Unprofitable?

The duration a startup can remain unprofitable varies significantly based on several factors including the industry, business model, funding situation, and growth strategy. This article explores the nuances of these factors and provides insights based on the true unit economics of the business.

Funding and Investor Expectations

Startups that secure significant venture capital (VC) funding may have more leeway to remain unprofitable for several years, as long as they demonstrate strong growth potential and a clear path to profitability. Investors often expect a longer timeline for tech startups, which may prioritize market share over immediate profits. However, the true measure of profitability should focus on the unit economics rather than reported financial statements.

Industry Norms

Different industries have varying expectations for profitability. For example, tech startups often prioritize growth and user acquisition over profit in their early years. In contrast, traditional businesses like retail may be expected to demonstrate profitability sooner. The key is to understand the true unit economics and not rely on commonly employed heuristics.

Business Model

The scalability of the business model plays a crucial role. Subscription-based models, for instance, may allow for longer unprofitability periods as they can generate consistent revenue over time. The focus should be on the unit economics of these recurring revenues rather than GAAP (Generally Accepted Accounting Principles) profitability.

Market Conditions

Economic conditions and market competition can significantly affect the timeline for profitability. In a booming market, startups may attract more investment despite losses. Conversely, in a downturn, the pressure to become profitable may increase. A prudent capital allocator should focus on the true unit economics of the business rather than relying on market conditions.

Path to Profitability

Startups should have a clear plan for achieving profitability. Investors and stakeholders will want to see milestones that indicate the business is moving toward sustainable profitability, even if it takes time. However, the true measure should be the unit economics of the business, not just GAAP profitability.

Principles of Capital Allocation

The relevant first principle is: invest in capital projects above your cost of capital. No matter whether a company is profitable from a GAAP accounting standpoint, it should continue to invest so long as it is reasonably confident that it will generate a return above its cost of capital.

In a growth phase, GAAP earnings are often depressed because a company may have to expense costs that are actually capital investments. This can mask the true unit economics of the business. Similarly, some businesses may appear unprofitable but have a high value due to exceptional economics. It is crucial to focus on true unit economics rather than reported financials.

Examples and Illustrations

Consider a business where selling a widget has a price of $10 and a unit cost of $9. Over a customer's lifetime, they may buy 100 widgets over 10 years. In this case, the business makes $100 for a customer over 10 years but only $10 in a given year, with most of the $100 earned upfront. If the cost to acquire a customer is $110, then the value of a customer is -$10, and the business will never be profitable. Many such businesses exist, and they are worth $0 per share full stop. If faced with these facts, a decision-maker should wait 0 years for the business to be profitable and return capital to investors as soon as possible.

In contrast, consider a situation where it costs near $0 to acquire a customer, and this cost is actually quite small, especially if this marketing expense is the primary capital expense from an economic standpoint. Moreover, assume the market is large and that it is reasonably certain there are many more customers out there. In this case, the business should continue to invest as much as possible, even if accounting earnings appear to be negative. Under GAAP, the business may show zero profit, but from an economic standpoint, it is getting a 10 to 1 return on investment! Depending on the precise timing of how the customer lifetime value is earned, this can be quite good.

The point is that the answer depends on the facts quite a lot, and understanding the true economics is crucial to making sound investment decisions.