A growth engine without a profit engine is incomplete thinking

UberGrowthEngine

I just saw this diagram on Growthhackers in an article explaining Uber’s success. And they have had a lot of success. In case you’ve missed it they have recently raised money at a $40bn valuation, they operate in 35 cities and have grown headcount from 75 to 300 over the last year. I haven’t seen any revenue numbers but I’m sure the growth there is strong too, and I hear them talked about all the time in London now, and not just in tech circles.

What follows is not a criticism of Uber. I’d be very surprised if they don’t have a good plan for getting to profitability.

My issue is that entrepreneurs seeing the diagram above and seeking to emulate the success of Uber might latch onto a strategy that delivers growth but not a sustainable business. Last month veteran Valley VC Bill Gurley wrote a warning to investors in $100m late stage growth rounds with the following quote:

Investors must realize that it is materially easier to take a company to substantial revenue if you generously relax the constraint of profitability. Customers will love you for giving away more value than you charge, and therefore, focusing exclusively on revenue success is a sure-fire path to risk exposure.

Looking at the diagram it’s easy to understand why Uber grew so fast and have raised so much money. Steps 1-3 are expensive to deliver, but done well they will result in superfast growth. The hope, of course, is that the quality of the experience will lead to high levels of repeat business and cheap word of mouth driven marketing in the future, which will make the business profitable. That may well transpire, but simply following this diagram you could spend a lot of time and money building a business where customers value your product at less than it costs to provide.

In addition to a growth engine, companies need to understand their profit engine. It’s simple, but critical – the cost to deliver a service must be less than customers are happy to pay for it and the cost of acquiring customers must be less than that delta. Companies using the diagram above to design their strategies should also make sure they are comfortable that customers won with a heavily discounted service will eventually pay a higher price, that the cost of customer service will decline to manageable levels as the business scales, and that they have scalable marketing channels through which they can acquire customers at low enough prices.

 

 

 

 

  • Don Corbett

    Great points Nic. I would like to add the trend towards hiding true customer acquisition costs / marketing in company filings to boost gross margins (ala one massive daily deals site). I do think a lot of VCs are backing these local companies (as described above) because they want to 1. capture the market by eliminating any competition by offering an unsustainable, highly discounted price with the aim of increase pricing / optimise monetisation at a later date. 2. Obviously maximise a return on their investment with many of these companies getting significantly high multiples of their revenue (in some cases revenue run rate) which naturally leads to higher valuations. More cities = more revenue = higher valuation at next round = investor (paper) return.

  • http://www.theequitykicker.com brisbourne

    Funding hyper growth is a great way of making money. One of the big questions in venture at the moment is ‘how fast can that be?’ as the pace of change increases. Companies that grow too fast can teeter into unsustainability but companies that grow slower than they might either miss opportunities altogether or end up being worse less than they might have been. The key is to get the right balance. Easy to say. Hard to do.

  • Rmicals

    I would argue that as far as the UK and Europe are concerned there is still way too much caution.

    We’re far from that scenario here. Too many pieces have to be in place to convince investors. There’s a lot of rationality and not a lot of optimism and hence growth capital. This is a business of uncertainty anyway. You take it for granted that many will fail.

    In fact right here it seems like the opposite is true, a lot of businesses could be bigger successes by many multiples without the hesitation or skittishness E.g why did Hailo follow a safe rational strategy of joining established monopolies rather than focussing on value? Why wasn’t it quicker/able to raise as much money as Uber? Why are great british companies like graze.com not in 30+ countries by now? It’s a great product that seems to gain traction quickly, it has a solid viral marketing scheme and not a whole lot of competition in the ecommerce space. There are loads more examples one can give. The one thing that I have no doubts on
    is the quality of ideas and potential execution that can come out of London. So I guess the question is how many potential twitters, airbnbs etc have been nipped at the bud or been given up due to capital.

    Of course you need to think out your strategy carefully as you say Nic but even your best estimation could throw some unexpectable scenarios. You need to know how to adapt in any market to survive.

  • William Reeve

    There are several reasons to why Graze.com is not yet in 30+ countries, and I think Nic’s post points to at least one of them. It is relatively easy to sell $1 for $0.95; it is also easy to do this in 30 countries; it is harder to win the race to build companies that sell $1 for $1.05+. Selling $1 for $0.95 is a hare strategy; the other approach may look like a tortoise, but remember the fables.

  • Rmicals

    Sure my argument is not that it’s easy. My argument is that it’s possible. No doubt you know the graze accounts better than I do but at £4 for snacks and what seems like a great inventory management system, graze does not strike me as a business selling dollar bills for 95 cents. It strikes me as having premium margins as far as food is concerned and a product people love. Of course there are other logistical and infrastructure costs per country but two countries in 7 years seems conservative. My point is quite simple given the choice between some businesses turning out to be selling 95 cents on the dollar (sometimes on dumb assumptions in hindsight) and some turning out to be selling 1.05 at tremendous scale do you think we should be erring on the side of caution?
    Moreover given how quickly information gets out these days do you think you still have the luxury of being the tortoise? Things are very different from the Industrial revolution.

  • http://www.theequitykicker.com brisbourne

    I don’t think the question should be ‘what’s possible?’ but rather ‘what’s sensible?’ given businesses’ potential and shareholders’ appetite for risk and returns.

    Shooting for the moon all the time makes sense for people and funds with lots of money who need large returns to move the needle but it isn’t right for lots of entrepreneurs with companies that have a strong chance of a very good exit but only a small chance of $1bn+.

    In short the goal of the startup ecosystem should be to create strong sustainable companies of any scale. If we do that well we will get some behemoths, but if we only shoot big we won’t get enough success at the lower levels.

    *Nic Brisbourne *
    Managing Partner

    @brisbourne | forwardpartners.com | theequitykicker

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  • Rmicals

    To quote George Soros -‘ it doesn’t matter how often you win or lose, what matters is how much you make when you win and how much you lose when you lose’
    If you believe you are more likely to create >10 $100mn companies instead of one $bn company sure then what you are saying makes sense. As an entrepreneur I just find that in the UK that space seems to be a super saturated space. It makes me wonder whether I should move to the valley.

  • http://www.theequitykicker.com brisbourne

    It’s a bit more complicated than that, largely because by creating 10 £100m companies you still have a chance of creating £1bn companies (which we very much want to be part of), but if you shoot for £1bn from the outset then you often ruin the chances of a profitable £100m exit (which is a crying shame).

    The other complicating factor is dilution and equity stakes – taking that into account it’s not 10 £100m companies but more like 5.

  • Shodement

    Great article Nic! I believe that the management team behind Uber probably defined a possible worst-case scenario already. What is the worst that can happen if Uber’s decision doesn’t lead to revenue? How long will it take them to recover?