This post was in response to a Question on Quora: I always hear that tech investors care about user counts not profits, but I always read that investors care about profitability. Which is it?
Think about it this way…
An investor can invest money in different kinds of assets… stocks, debt, real-estate, commodities, bonds, etc. Each asset class has a different risk-reward profile. Some are low-risk, low-return investments and some, like stocks, are high-risk, high-return assets. Usually investors invest in different asset classes so that they have a diversified risk-return portfolio. And the goal is to have a balance so that their net returns, over a period of time, are meaningful.
Within this, investing in startups (especially concept or just beyond concept stage startups) is most often the highest risk investment. Therefore, investors who invest in startups look not for nominal returns (e.g. like they would get in fixed deposits) but exponential returns – often 10x + return on the capital invested. I.e. if they invest USD 1mn in a startup, their expectation would NOT be to get a dividend of 15-20% per year, but to increase the value of that investment to say USD 10 million in 4-5 years time.
Why is that: Because of the high-risk nature of the startup investing business, if an investor invests in 10 startups, 6-7 of them will shut down in the first 2-3 years… that means that the investor will lose all invested capital in those. Of the remaining e, may be 1 or 2 will barely return capital if they survive. Therefore, if the investor has to be profitable on his/her investments in startups, the one successful company has to make up for the losses on the other startups AND deliver a profit. Hence, while a 10x return on ONE investment will look like a lot, if at all they get it, the overall portfolio will still make only a decent return… if all all.
Overall, mature investors will have a diversified portfolio so that over a different cycles they have a decent return.
Now, coming to your question on whether investors care about profits. The answer is ‘of course yes’. But investors are keen on the path to profitability and the scaling up of the venture, as only when the FUTURE profitability of the venture is high will the valuation of the venture be high. Hence, investor funded companies will often make a trade off between immediate profitability and scaling up.
In this approach too, there are different kinds of ventures. One example are ventures that need to be profitable at a ‘unit or transaction level’ but may not be at a customer level on the initial transactions e.g. an e-commerce venture that could make a 30$ profit on a USD 100 transaction that a customer makes, but it may have cost the company USD 300 to acquire that customer… and hence, the customer will become profitable only after 10 transactions. So, while the initial phase does look loss making, the view that we need to take is about ‘the lifetime value of a customer’. I.e. if the customer were to buy 4 times a year from the company, and if the customer were to be with the company for 10 years, the company will could make make about USD 1200 from the customer over that 10 year period. (in this case, from the investors point of view, building a large base of customers, even if they are not profitable in each transaction, will be more valuable than doing a small base of customer whom you acquire at very low cost).
Similarly there are other types of ventures…e.g. a community where there is no transaction happening, but the monetization of the community will happen only after a period of time and when there are enough numbers for the monetization to happen (e.g. though advertising, etc.). In this case, while immediate profitability is not the objective, long term business case certainly is important.