The rise of the ‘pre-profit business’: when does the fundraising end?

With a proliferation of pre-profit businesses receiving investment, BLM looks at what lies beneath the headlines and asks the question: where is the tipping point for investors funding good ideas that are not yet making a return? And should entrepreneurs always celebrate an investment?

University of Florida professor Jay Ritter recently published research (December 2018) that showed that 83% of all new US public listings were from ‘pre-profit’, i.e. unprofitable, businesses – the highest on record since 1980.

So why is there an increasing appetite for pre-profit investments? If a company does not turn a profit but is valued in the billions, where does that value reside? What are the potential consequences of this patient – or perhaps misplaced – capital? And are entrepreneurs becoming more focused on raising cash than turning a profit?

THE CULT OF FUNDRAISING

There has no doubt been a shift of focus in the start-up and scale-up landscape, with founders increasingly celebrating fundraising milestones rather than traditional measures of business success such as profit and customer acquisition.

“Empty vessels make most noise,” says Paul Brown, CEO of Mail Handling International (MHI) and an active investor. “When founders are raising funds, they bang the drum to get people excited and project success. But you have to think: is this a real celebration or just a noisy one?”

A fixation on fundraising is a distraction for both founders and investors. Mark Pearson, founder of Fuel Ventures, says: “You tend to find that founders who celebrate fundraising as a success are the ones who have their focus on the wrong places. If you’re spending all of your time and energy on fundraising, you’re not spending time on your business.

“My view is that real, business-minded entrepreneurs are the ones focused on celebrating other business-related milestones, such as revenue targets, client wins, or new territory launches over raising money.”

Of course, early-stage investments have always been made based on a promise. At a later stage, there are accounts and revenue – concrete measures of business performance.

The cult of fundraising comes in when companies, particularly further down the line, are valued highly despite a failure to ever turn a profit. This is a different story to the newly born entrepreneur, excited by the first validation of his or her business.

Paul Brown says: “All public listed companies are valued by realistic potential and actual performance. The challenge for privately held companies is when there is a lack of measure of whether the promise made at pitch has been delivered.”

Peter Cowley, serial entrepreneur, angel investor, and author of The Invested Investor, says: “The hype comes in when you get these big numbers – the unicorns valued at over a billion dollars – when the company may still be losing money.”

THE UPSIDE OF PATIENT CAPITAL

Pre-profit companies are not all bad news. Some early-stage companies follow the ‘Amazon model’, declining to draw a profit and instead plowing revenue back into the business to facilitate long-term growth.

Others may be research-oriented, developing worthwhile products or technology which will take decades to complete.

Peter Cowley offers the example of drug development. “There’s no way you’re going to get a customer for a drugs discovery company until the drug is discovered and checked – and that takes a lot of time and money. So clearly you need investors before there is really a business in place.”

Chris Olds is the CFO of Ultrahaptics, a company which is focused on developing the next stage of virtual reality technology by creating tactile sensations in mid-air. Ultrahaptics has raised over £60m in equity finance from a range of investors since inception.

Chris says: “The shift to pre-profit investment doesn’t mean that investors’ expectations have changed, it shows that their perception and appreciation for value has changed. Investors only back pre-profit organisations if they can see a strong growth and a returns strategy that warrant the additional investment risk.

“The clear benefit of long-term investors that we’ve experienced is that from the very beginning you can make decisions that benefit the group long-term, rather than focus on short-term gains that would be at the expense of the bigger growth opportunity. The potential downside of a more aggressive growth model is that you will probably have to give away more equity to fund that strategy.”

Investors must strike a delicate balance between patience, faith and due diligence. “Patience is a key factor in the venture capital technology space,” says Mark Pearson. “Investing in younger, fast-growth potential companies isn’t a quick win.

“Investors should be in for the medium to long term if they believe in the founder’s vision, while at the same time doing all reasonable diligence to validate that the business and its key people have the ability to deliver on future plans.”

THE TIPPING POINT

When does a business cross the line between ‘pre-profit’ and outright failure? As mentioned, a lack of initial profits does not automatically mean a lack of potential.

Mark Pearson points out: “A lot of famous investments in the big tech companies we know today wouldn’t have been made if based on metrics or revenue alone. It takes an accurate foresight combined with a realistic sense of commercial opportunity to find the best investments.”

So how can investors separate the genuine prospects from the empty hype?

Paul Brown suggests reading into the pitch and the organic growth of the business: “Every time I hear the word ‘pivot’ in a pitch, I think ‘failure of the original business model.’ Better to look for rounds of funding based on an evolutionary journey, a funding round to accelerate a proven profitable model, or ideally, organic internal accelerated growth after round one.”

If already invested, Peter Cowley says the difference between pre-profit and failure comes down to the investor’s faith in the founders.

“There’s no set tipping point between pre-profit and outright failure,” Peter says. “It generally comes because founders have not been able to break-even and the investors have lost faith in the team. There are three options at that point: go bust, sell the business, or reduce the business size until it can break-even.”

Ultimately, investors need to separate fantasy from reality. Which companies, even if unprofitable at present, have a reasonable chance of long-term growth and a secure market share? Is the internal logic of the business model sound? Or, like Lyft, is the business predicated on undercutting its own profits in a sector with low barriers to entry?

Paul Brown says: “Rather than talk about specific companies perhaps we could be asking: When is tech just a fantasy? When is investment just a combination of tax efficiency and a lottery ticket? When are investment pitches more like the emperor’s new clothes? With complex software and virtual businesses that even sophisticated investors sometimes don’t fully understand, there is a very real risk of investors being misled by a company requiring funds to pay the salaries. Due-diligence and trust is key.”

THE INVESTMENT RELATIONSHIP

Fundamentally, investors need to trust that the founders they place their capital with have sound business sense and the right intentions. A culture of hype means that founders and early investors profit on a promise, and the true value of a company does not come into play until further down the line. At some point, however, when a company has been overvalued, someone will get burned.

Peter Cowley says: “There’s no doubt that raising money at a higher valuation is positive for the founder. If the valuation is higher, the founders lose less of the company when selling equity. It’s also beneficial for early shareholders as their shares are effectively worth more money.”

However, the value placed on these companies is completely abstract. Peter says: “The issue is, what use is that money? What does a high valuation mean? And, it means nothing until an exit of some form. Usually a trade sale, sometimes a floatation, an IPO, or occasionally a private equity house might buy the shares. So higher and higher valuations are positive for all those insider parties, but the negatives come at the exit.”

Do you have faith in the fundamental concept of a business? Do you trust the founder to pursue a commercially viable path? And crucially, do you have faith in the person pitching to you?

Peter Cowley is an experienced angel investor. He recommends thoroughly considering who to get into bed with: “I used to evaluate pitches based on tech and markets, but now I evaluate purely on people. I’m effectively buying an option in the future of that entrepreneur. I give them some money to get on and trust them to do prudent, scaling things.”

He adds: “The bond between early-stage shareholder and entrepreneur is stronger than a marriage. You’re stuck together on the journey, so you have no choice but to be patient until something happens.”

LONG TERM CONSEQUENCES OF PRE-PROFIT HYPE

The gradual warping of the investment landscape raises a slew of unanswered questions. For example, what does it mean for the future of fundraising if valuation becomes more about visibility than profitability? If strong publicity becomes more important than the long-term viability of a venture? What kinds of businesses will dominate the start-up economy, and which business models will perpetuate?

Perhaps fears of increasing economic instability are overblown. But when an unprofitable company like Lyft is valued at $24bn (£18.8bn) despite slowing growth and a flawed business model, the concept of ‘valuation’ itself seems to be in flux. And with billions of dollars’ worth of capital being siphoned into black hole businesses each year, something – at some point – has got to give.

Paul Brown says: “When there are significant failures there will be calls to regulate and consequences for mis-selling investments. This will inevitably stifle the opportunities for the genuine risk-takers.”

In the meantime, investors must tune out the hype and focus on the potential behind the pitch.

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