Many venture founders are taking the “growth now and profits later” approach to building their business. I believe many of such ventures will fail as at some point the cash required from investors to fund such growth will not be available.
A business starts making money when its total Contribution is greater than fixed costs. (Revenue less the Variable costs is “Contribution”). The first challenge for any business is to reach break-even point. Once a business reaches break- even, it can grow into a profitable business over time as typically, increase in Revenue (and hence Contribution) is always faster than increase in Fixed Costs – in investment jargon, what analysts call “Operating Leverage”.
“Growth now profits later” is prudent if a business has a predictable variable contribution per unit of sales and needs investment to grow Sales to reach the break-even point quickly before competitors emerge with a copy-cat model.
The challenge is that many ventures are being grown while Operating at negative or very low unit Contribution, primarily because of customer acquisition expenses – discounted cab rides, cash back, free coupons on purchases, or sales below purchase costs. The true unit contribution economics and hence break-even point are unknowns at present. The “belief” is that once a customer has transacted for a while, they will become loyal… and “profits” will result as unit Contribution will exponentially increase when the discounts are turned off.
The implicit assumption in the above argument is that after increasing prices, customer behaviour – in terms of purchase volumes, frequency, and loyalty will remain the same – and that new competitors will not emerge with a similar philosophy to customer acquisition. This is a significant assumption, especially in a value for money market like India.
The risk then of a “Growth now, profits later” approach is that break- even points will continuously get pushed back requiring far higher investment than initially estimated. At some point investors will throw in the towel (as perhaps we are seeing with many ventures at present), or there will be a significant drop in valuations at which subsequent rounds of monies are raised. The public markets in India offer examples of many such companies whose valuations have crashed over 95% from their peak levels. Founders would do well to study economic history – the most successful companies have not been built on the support of investor’s money but on the support of their Cash flow generation. Rather than buying customers, founders may be better served identifying core consumers organically, the time tested way. Progress, the latter way may be slow, but it will be sure; and data on credible unit economics will enhance chances of securing subsequent rounds of funding to reach break-even point