Is Raising Funds More Important than Profitability?

Is Raising Funds More Important than Profitability?
Finance

Raising funds, getting new valuations, and Series B financing are an inescapable fact of life any startup. We celebrate those companies that are able to pull in eye-popping investments, as with digital bank Monzo – which got valued at £1 billion last year and is looking at raising more funds in order to expand their services to the U.S. And yes, despite all this, Monzo still hasn’t reached profitability.

This is far from an isolated case. Uber’s main competition, Lyft, got valued at $15 billion last month, but are still nowhere near profitability. Uber itself hit a valuation of $82.4 billion on the public markets today, but the company still operated at a $3 billion loss last year. The same holds true for Spotify.

What’s going on? Is our vaunted, fundraising-driven startup model even sustainable in the long run? 

The Startup Bubble

The reality is that we are currently in one of the biggest bubbles in business history, and the air is starting to come out. In the past 10 years, getting money from VCs, angel investors or hedge funds has been relatively easy. A few successful start-ups, like Facebook, Tinder, or Deliveroo inspired a whole new generation of entrepreneurs to start their own business and seek funding. Charming entrepreneurs who knew how to talk and sell their idea took advantage of this, sometimes unconsciously, without looking at the bigger picture.

This has led to a number of companies’ unchecked growth via funding, despite dim prospects for profitability. In fact, 81% of U.S companies which filed for an IPO in 2018 were unprofitable. For many, bringing in more funding and higher valuations has been easier than actually making the business profitable; companies are often happy to rely on spending the money they’re raised from investors instead. In some cases, these companies are up to 50% overvalued. Unfortunately, as a direct result of focusing on growth rather than profitability, we now see many Silicon Valley startups like Hustle facing mass layoffs.

Exit Strategy

When talking about profitability versus raising funds, we also need to consider that VC firms are always looking to exit within 5-10 years. The ideal outcome for a VC is for the company to either sell or enter the public market. This helps explain why they would rather have companies focus on growth and attaining higher valuations instead of profitability. A higher valuation means a better exit for investors. VC investors would rather have their companies be worth more, as profitability doesn’t necessarily mean they will bring more returns to investors operating on this type of time horizon.

Is this model sustainable? In short, no. We wouldn’t be calling it the startup bubble if it weren’t going to burst at some point. A great many of these startups which rely solely on VC investment will fail when the VC money dries up, precisely because they are not profitable and cannot compete with the Big Five without external support. We are essentially repeating what happened in the dotcom crash of 2000, where hundreds of companies crashed in part due to overvaluation. If companies don’t start focusing more on profitability once they’ve reached a certain level of growth, they could find themselves facing the same fate sooner rather than later.

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