Malice in Wonderland: down the rabbit hole of start-up profitability

With the latest easing of covid restrictions, there is a growing sense that business is back. Economists are predicting that the UK economy will return to pre-covid levels by the end of the year. Business confidence is recovering from the nadir of 2020. The Federation of Small Business’s The Small Business Index increased by 76.6 points in Q1 2021, taking it to its first positive score since mid-2018. A net balance of 27% firms are expecting an increase in gross profits (the highest level since 2012), and a record 52.7% say they are aspiring to grow. Game on.

And yet in this week of antediluvian-esque downpours, Hubspot chose to rain on every founder’s parade by sending out a marketing email with the headline: ‘Only 2 out of 5 startups are profitable.’ The implication is clear. 60% of start-up founders are not performing. Are they right?

This caught our attention because start-up profitability is rarely discussed. Spend all the time you want reading the whopping start-up surveys from Start Up Genome, Tech Nation and Atomico, but you won’t find much mention of profitability. Well, any actually. So this is a topic worthy of further investigation.

The Hubspot email was unsourced, but is clearly a reference to this page, which indexes highly in Google: https://smallbiztrends.com/2019/03/startup-statistics-small-business.html. Quote: ‘40 percent of small businesses are profitable, 30 percent break even and 30 percent are continually losing money’. The source for this is a US infographic dated from 2013. So a little disappointing if you want to understand current trends.

We did a bit of digging and soon stumbled into a methodological minefield. What exactly is a start-up? Definitions abound and none of them tally with traditional methods of statistical reporting, which instead focus on business type and size determined by employee headcount: small (0-49), medium-sized (50-249) and large (250+). Needless to say SME categorisations vary by country making comparison impossible.

SMEs are though, generally profitable. In the UK there are 5.9m SMEs (ONS). According to the latest BVA BDRC survey, in Q4 2019, 84% of SMEs reported making a profit in their most recent 12 month trading period (ignoring those that did not know). This is a misleading benchmark for start-ups. There is clearly overlap between start-ups and SMEs: by definition every start-up is an SME until its headcount exceeds 250. But this is far too limiting. Most people would agree that ‘start-ups’ are founded to grow quickly. This makes them categorically different to someone creating a new gardening business with no ambitions to grow or ever hire anyone. There are up to 700,000 new businesses started in the UK each year, but only 20,000 of those are technology companies (ONS). There are also non-technology driven start-ups that are harder to identify. Who is tracking and reporting on start-up profitability? The publicly reported data simply isn’t there.

Perhaps a better question is how long does it take for a start-up to become profitable? This is another methodological tangle, as you have to navigate business type, sector, ambition, growth, remuneration and accounting practices. General business wisdom is somewhere between two and four years. Yell Business did a survey in 2016 in which 79% of small business owners reported making a profit in their first year (27% within two months). This was contrasted with the nine month timeline it takes ‘the average entrepreneur’ to make a profit. Both these figures sound very high, but they were echoed by a survey by a company called Kabbage (I kid you not, and they are quoted by Mastercard, who clearly don’t have any better data). They found 84% SMEs reached profitability within four years, with 68% in their first year. Compared to this level of SME profitability, 40% of start-ups turning a profit is poor.

A better insight comes from the European Start Up Monitor. Note that all the companies listed below can be classified as start-ups ( <10 years operation). The difference between Startup, Steady and Growth is the amount of growth that follows a launch:

Source: European Start Up Monitor, 2019

A clear picture emerges: ~5% pre-seed and ~11% early stage start-ups are profitable, and this increases with subsequent growth. Over 40% of fast growing start-ups are still up to 2 years away from profitability, either because they are searching for their model or investing in growth. Judged in this sense, 40% of start-ups being profitable is pretty good, especially if another 30% are already breaking even.      

This leads us to the most important question: should start-ups even aim to be profitable? Profit does not matter if someone else is paying for your growth. The absence of profit is not a barrier to funding or even IPO. Only 17% IPOs in 2018 and 24% in 2019 had positive net income. Profits are often undesirable because money should be re-invested into the business to fuel ever more rapid growth. What investors want to see is a path to profitability. That plan is very, very important. If you don’t have one, it means your business model is flawed. Eventually investors will choose to fund someone else’s dream rather than yours, in the hope of securing better returns for their LPs.

If you have to pay for your own growth, or indeed your own survival, profit becomes vital very quickly. We encourage a profit-focus from day one. Understand your cost base and how this will change as you scale. Focus on products and services that generate the highest returns. Do everything you can to optimise marketing, and cut frivolous expenditure. As you can see from the data above, it is possible to generate profit quickly. SMEs do it. Start-ups can as well. ~18% pre-seed companies are break even or better. The first priority should always be to stay in business. What start-ups can’t usually do is generate enough profit to fuel all their desired research, product development and growth marketing. But you shouldn’t have to. If you can bootstrap your way to a successful proof of concept and find a short path to profitability, you will be in a strong position to seek outside investment to cover your growth.

So if you are one of the 40% founders who are already generating a profit, well done. If you are one of the 60%, come up with a plan soon. How will you raise funding? What will you do if you don’t? Is there another, less risky bootstrapped alternative that doesn’t bet the house? Ignore Hubspot’s churlish take on profitability. The economic winds are now blowing in your favour. Use them to fly and see just how much money you can make.

UP AND TO THE RIGHT.