It is tough to balance between growth and profits for the founders of start-ups, and the rule of 40 has now become a well-adapted industry standard to measure technology start-ups. It says a tech company can make losses, burn cash to drive growth as long as the company is scaling the business and growth is more than 40 per cent.
The math is easy:
Growth = 100 per cent you can have a burn rate of 60 per cent
Growth = 50 per cent you can have a burn rate of 10 per cent
Growth = 40 per cent you can’t burn cash, you have to break even
Growth = 20 per cent you should have a 20 per cent profit margins
Growth = Flat 0 per cent you should have 40 per cent profit margins
This is the thumb rule to measure and track technology start-ups, which solves the complex question for founders on how to balance growth and profitability. The rule of 40 was first written by Brad Feld.
Yet, there are two problems for every start-up to solve — not enough customers and/or not enough capital. In the start-up world everyone is either growing or dying. Maintenance is a myth. Outsized returns are possible only if there is perpetual velocity and virality in star-tup growth. Every VC fund has a life of 10 years, it has LPs (limited partner), the investor in fund managed by the VC (general partner). Every investment made by a VC is driven by a timeline to return the capital back to the LPs with profits, which creates a situation to drive founders towards growth.
But the difference is that in the old economy “the purpose of business is to create and keep a customer”. In the new economy it is “get more customers, Increase their average purchase value & Increase frequency of purchase”. Growth is prioritised over profitability to demonstrate to investors a viable business model that can scale and generate returns.
In the process, some start-ups lose money for a longer time horizon for multiple reasons. There is no standard template to the process of making money, and I believe there is nothing wrong if the start-up is making losses as long as there is a path to profitability. But we need to track two metrics — the amount of cash available and the monthly start-up burn rate. The current venture capital model focusses on market share, revenue growth or user traction, and does not encourage frugality or fiscal restraint. Choosing not to be profitable over growth is now the strategy in anticipation of future large profits.
But VCs are attracted to growth, not mindless growth. The unit economics must have a path to profitability. If the company burns its cash before it raises venture capital, it’s a failed idea. Start-up founders who once raised venture capital is on a treadmill, seeking new rounds of funding and new growth expectations.
Founders having a false of hope of getting the next round of funding burn cash and drive themselves to point of no return. VCs evaluate companies based on whether the start-up can build profit margins if the costs remain the same. If yes, then these start-up ideas are breathing life and kicking their way to growth.
Start-up valuations are not dependent on profit or loss, but on future growth prospects. Start-ups with accelerated goals build their business using venture capital funding. But in 2023, once the start-up is profitable, they control their destiny — they can raise more capital to grow faster if they choose to.
The writer is the Founder & Partner of 100X.VC