Money Losing Startups Are Cool Again - And We Should Be WorriedKevin McPartlandContributorOpinions expressed by Forbes Contributors are their own.I write about the ongoing evolution of financial markets.Oct 30, 2018,05:00am EDT|This article is more than 4 years old.
Thoughtful young businessman standing in[+][-]chalkboard interior with business sketch. Success and plan concept
Fall is budget season. This is the time when most of corporate America spends countless hours making educated guesses as to how much money they can generate in the coming year, and how much money they need to spend to get there. When your business is good and conditions are ideal, the former should go up and the latter should go down. The result is an increase in both revenue and profit.
In the alternate universe of startups, the process is much easier. Determining how much money must be spent in the coming year remains an important exercise. That analysis drives hiring, expansion of the WeWork space and how hard the executive team will have to work searching for the next (or first) round of funding.
The revenue conversation is quite different, however. Different in that it doesnt exist. Revenue? Who needs revenue? And talk of profits its just heresy. For those of us that have spent our careers working for companies that need to make money to continue operating, this way of thinking feels downright crazy.
Unprofitable startups arent anything new of course. Every investment in a business even established ones needs some time to bear fruit. For instance, I might hire two new people this year with the expectation that they will more than pay for themselves by the end of the second year. In the land of startups, these assumptions are often much bigger, often with new investments being made before the previous ones have paid off.
But we seem to have moved to a place where there is no plan to become profitable. Ever. Even in cases where the road to profitability is defined, its so long and filled with aggressive assumptions that it can barely even be seen as a plan. The hope is that if you can generate enough pageviews, build a big enough community, demonstrate a growing user base or print enough trading volume that someone bigger will buy you despite the constant money burn.
The fact that 80% of IPOs in 2018 have been formoney-losing companies is a case in point. So too are the numerous conversations Ive had with smart and successful startup founders and employees who just arent worried about the company becoming profitable.
The last time this mentality was rampant was in the late 1990s. To be fair, that period did leave us with Amazon, Google and countless other world-changing companies. But it also left us with a market crash that ultimately contributed to the years later housing bubble.
Today is different. Most of the profitless companies are private (think Uber). And despite the aforementionedno-profit IPOs, most have hopes of staying private until someone bigger (and potentially profit generating) buys them.
The big question is should we be worried about this? Startups fail all the time, and most private equity, venture capital, and angel investors simply cut their losses and move on to the next one. In fact, they expect a certain percentage to fail (which is often most of them) knowing they only need a small number of huge wins to be profitable themselves. If you were an early investor in Facebook then who cares about anything else in your portfolio? Further, venture capital and angel investors dont generally use leverage, so any losses they sustain are contained. Private equity investors do often use leverage, and that can, in fact, end poorly for the target firm think Toys R Us.
The worst case scenario is that PE-backed firms start defaulting on their debt, which has a ripple effect on the capital markets by starting a broader panic. If VC backed startups also start failing in a big way, or valuations of successful startups aggressively come back to earth, we could see access to venture money become strained limiting the number of new startups. These failures in and of themselves are unlikely to cause a recession. But if they are seen as a leading indicator of the broader market, catalyzing speculation that the entire economy is also struggling alongside the highly glorified startup world, than we could all see our portfolios move in the wrong direction.
Im not trying to predict a broader market crash. I have no idea how or when that will happen. However, out sized valuations driven by continuous fundraising from from profit free companies creates an eerie sense of deja vu. And we do not want history to repeat itself.Get the best of Forbesto your inbox with the latest insights from experts across the globe.Follow me onTwitterorLinkedIn.Check outmywebsite.Kevin McPartlandRead MoreRead LessEditorial StandardsCorrectionsReprints & PermissionsLoading ...