Revenue vs. Growth

There are two paths that entrepreneurs go down when they are starting a company.  They can try to grow as quickly as possible without regard to revenue so that they can sell out or they can focus on cash flow and revenue, while still trying to grow the business.

I’ll call the first one the Facebook Method.  For companies that subscribe to this thinking, their goal is to add users, traffic, page views or some other metric as quickly as possible.  After reaching a certain critical mass, the goal is to try to be acquired by a larger company that will figure out how to make money from their success.  If no other company will acquire the startup for fair value, the startup will look for a good revenue model.  In order to reach this goal, theses startups usually have to take on large amounts of angel or VC funding.  This method was most popular during the tech bubble years of the 90s, but still is popular with many startup founders, as its the easiest way to start a company.

The second method is to start with a well defined revenue model and try to become “ramen profitable” as quickly as possible.  Companies that start with well defined revenue models expect to become profitable much more quickly than the companies that subscribe to the first model.  Many times, they will be profitable within 6-9 months, rather than a few years.  These types of companies do not necessarily have to bootstrap or eschew VC funding, but they generally have stronger footing when they do go to raise money.  They can get better terms because they do not need the money to stay in business.

Both Paul Graham and Mark Cuban have written about these two competing strategies in the recent months and it seems that both fall into option two rather than option one.  Graham’s recent article titled “Ramen Profitable” is about the necessity to have a revenue model that actually generates revenue from the start, rather than hope to grow big enough and then find a revenue model.  Graham explains Ramen Profitable this way:

Ramen profitable means a startup makes just enough to pay the founders’ living expenses. This is a different form of profitability than startups have traditionally aimed for. Traditional profitability means a big bet is finally paying off, whereas the main importance of ramen profitability is that it buys you time. [1]

In the past, a startup would usually become profitable only after raising and spending quite a lot of money. A company making computer hardware might not become profitable for 5 years, during which they spent $50 million. But when they did they might have revenues of $50 million a year. This kind of profitability means the startup has succeeded.

Ramen profitability is the other extreme: a startup that becomes profitable after 2 months, even though its revenues are only $3000 a month, because the only employees are a couple 25 year old founders who can live on practically nothing. Revenues of $3000 a month do not mean the company has succeeded. But it does share something with the one that’s profitable in the traditional way: they don’t need to raise money to survive.

Graham believes that companies that can become ramen profitable quickly have a better chance of success in the end.  So does Mark Cuban.  Cuban puts a huge emphasis on cash flow and profitability and getting there quickly.  Cuban says:

Business is a very simple concept.  You have to pay your bills.  If you have anything left over, you get to smile and spend it as the principals of your business see fit. If you don’t have enough to pay your bills, you either have to raise money to cover the deficit, file bankruptcy and try it again, or go out of business.Simple.

…[I]f you talk to any company I have ever invested in, the only thing I care about are profitable sales. What are you selling?  How hard are you working at selling? What are your revenues ? Why are you paying yourselves a salary rather than a commission ? What unique initiatives are you working on to generate sales TODAY.

When I invest in companies, I expect 100pct of them to be successful and grow and QUICKLY be profitable.  I may  not hit many homeruns, but I sure hit a lot of singles and doubles and rarely strike out.

Both Graham and Cuban put an emphasis on having a clear revenue model from the start that is designed for quick profitability.  This attitude puts them at odds with many VCs who are happy to invest large sums of cash in companies that are not going to be profitable for many years or do not have a revenue model other than “ads.”  This is not to say that a VC will not fund a company because it has a well defined plan to become profitable and has a revenue model from the start. VCs are mostly interested in upside, ie how big will it grow at exit, rather than can it be profitable from start to finish.

Ramen profitability is a great goal for startups to have at their inception.  It forces them to think long and hard about their revenue model and how they will actually get customers to pay for their service.  It’s a delicate balance between profitability now or growth now.  I see it as a continuum.  On one end is the Facebook Method of extreme growth without much time spent on the revenue model.  On the other end is trying to be profitable from day 1 and believing that growth will come with a good product.  Founders should balance quick growth with a revenue model that generates profit as quickly as possible.  I know this sounds like having your cake and eating it too, but it is possible.

If you are thinking about starting a company or have started a company, take a step back and think about how you will actually get someone to pay for your service and how you plan to get that money into your bank account.  I know it seems simple, but many startups raise round after round without thinking about how they will become profitable, until the funding dries up and you are done.