Assessing businesses’ viability requires careful attention to the fundamentals

Bill Gurley just published a good post about the $100m rounds that are going on. His overarching point is that the rounds are dangerous for investors who don’t understand the companies as well as IPO investors coming in at similar valuations and for companies who lose the discipline of profitability.

This warning that investors should make sure they really understand the viability of a company caught my eye:

In order to overcome such risks, [that the company has not found a profitable business model] the onus is on the investor to dive deep and unpack the actual unit economics in the underlying business. This requires analyzing the “true” contribution margin of the business; not simply looking at gross or net revenue and the proper contra-revenue treatment, and not even looking just at gross margin as defined by the company. Many companies embed costs that are truly variable (for instance customer support, marketing, credit card processing) below the gross margin line. If you want to know if the business model truly works, you must pay careful attention. Otherwise, you may have simply found a company that is simply selling dollars for $0.85.

Amen to that. Margin structure is critical but boring to understand. I think that, combined with the competitive pressures of winning deals explain why late stage investors don’t look at them as thoroughly as they might.

But they are important, and we work closely with our partners companies on the fundamentals of their businesses. Get them right early on and success will come more easily, but ignore them until later and you risk building a house of cards. That can fall apart at a late stage as Fab did, or, much more commonly it will collapse before the business gets through it’s Series A or Series B.

Ultimately this is all about having a viable business, and ideally a business that everyone can see is clearly viable from as early a point as possible. For us the key elements to get right early on are finding a big market, connecting with a deep need, building a product that resonates with customers, getting the team and culture right, and finding a path to scale with a positive contribution margin.

It’s interesting to note that by the time companies get to raising $100m the aspect of their fundamentals that troubles Bill Gurley is the contribution margin. I guess that’s the one that companies which are great at fundraising find easiest to put off getting right.

  • Gavin McNally

    Hi Nic, when is best time to bring an idea to Forward Partners, I mean should the person get the idea down on a business plan or do some basic validation work on Social Media/Survey Monkey?

    Forward Partners i understand will want a well researched idea, can you give me a short list of the type of research you guys would be looking for? Thanks.

  • http://www.theequitykicker.com brisbourne

    Hi Gavin – of you have a good understanding of your customer, however acquired, an idea for a good product and an opportunity that will yield a £100m+ exit that’s sufficient.

  • Gavin McNally

    Thanks Nic i will put my idea through your website.