In the most recent tech boom, the conventional Silicon Valley wisdom has been to ignore profits when starting a venture-backed company.
All that matters is growth — if you have product-market fit, you’ll get users. Initially, investors are looking for a usage curve that goes steeply up and to the right. Eventually, you’ll figure out how to earn revenue from those users, either by charging them or through a third-party who wants access to those users (like an advertiser or another company who will pay referral), so the revenue curve will follow the user curve.
And at some point after that, you’ll reach a magic point where your costs are spread across enough users that you’ll start to turn a profit.
This has led to all kinds of weird accounting. Privately held startups almost never talk about real, GAAP profitability. They talk about positive unit economics. (That’s nice — they’re not losing money on each sale!) They talk about being cash-flow positive. (That’s better — they’re taking in more money from operations than they’re spending!) They talk about being profitable if you ignore that pesky stock-based compensation. (Which means they really might be on to something!)
This is how companies like Twitter, Box, and Square are able to go public at valuations worth billions without ever having turned an annual profit in their history. All of those companies are over five years old. Twitter is ten years old.
But one Silicon Valley VC, Chamath Palihapitiya, thinks this conventional wisdom is all wrong.
Palihapitiya was an early Facebook executive, and he saw how that company was able to become profitable in “six years,” and was able to go public a couple years later.
As he told Business Insider’s Biz Carson in an interview:
“I feel like a lot of entrepreneurs hear all this talk about profitability and realise they need to lower their burn. So, they just start chopping off perks and people. If you’re trying to get to profitability by lowering costs as a startup then you are in a very precarious and difficult position.
“You need to grow through profitability. Startups should be, if you graph their financial performance, it should be what’s called a J curve. You start out at zero, you’re not making any money, you’re not losing any money.
“As you start the company, you start spending spending spending ahead of revenue. But then you come out of it and very quickly you should become a company that spends less than it makes. And what I mean by very quickly, is that window of time should be in that 6 to 8 year time frame, 5 to 8 years. And the reason is because if you build your business model correctly it’s almost unavoidable.”
To get there, startups should dispense with the other momentum metrics and report profitability:
“Why should I not report on GAAP? Like the young entrepreneur right now that is starting a company, she should be telling herself “alright you know what f— all the nonsense, I’m reporting GAAP from day one.” Immediately clarifying. You can’t hide the cheese. And then you have to set a goal, I’m going to spend less than I make.
“I swear to God if you say that people will scratch their heads. Now, you don’t have to do that day one, but you have to have a goal of getting there, right?”