There are Generally Accepted Accounting Principles. Lots of startups whine that GAAP accounting doesn't represent their coolness, disruption, clicks, and general greatness. In hindsight, the GAAP numbers usually mean more than the vaporware numbers used for PR purposes.
If you go public, you have to show GAAP numbers in your financial statements. While private, you can sell to "sophisticated investors". These are like "whales" in the gambling industry; it means they can afford to lose money, not that they have a clue.
Most of the trouble comes not from companies that need a long period to do R&D or build up manufacturing capacity, like Space-X. It comes from companies that are losing money by buying market share, hoping that, in the end, they achieve a monopoly position and can make it back. Like Uber.
Funny accounting anecdote of the past: remember AOL disks, given out in vast quantities for free? AOL treated those as a capital expense and depreciated them. AOL was losing money for most of a decade while showing numbers that indicated profitability.
Exactly. This isn't a NP-complete problem waiting to be solved in a lab. It's a problem with a common set of standards honed by decades of thought and battles to produce a good baseline for measurement. It's also something people learn in community colleges. The kind of "brilliant," "visionary" people that are involved in these startups could probably learn and use it. ;)
Irrelevant nitpick: NP-complete problems aren't "waiting" to be solved by anybody. In a strict theoretical sense, if a problem is NP-complete, there does not exist a polynomial time solution (assuming P!=NP).
That having been said, researchers are still interested in algorithms for many NP-complete problems that are of practical utility. They often involve approximations, randomization, parameterizations, and heuristics to solve some/many problem instances in a computationally tractable amount of time.
Irrelevant nitpick 2: we seem to have two, different definitions of solution. You must read a lot of math and NP-complete articles where you think solved means something only in the most technical sense. Whereas, a solution for the rest of us is an answer to a NP-complete problem that works effectively. The methods behind good ones take considerable brains to develop.
Is it right that viewing the full GAAP documentation costs $895/yr?
Can you link to the Principles you are referring to? Also, Wikipedia makes multiple mentions that SEC has moved to abandon GAAP in favor of better alternatives. Why would I want to report in a legacy format?
GAAP contains a whole host of components that describe the company, not just profit. The reason they have that market valuation is because investors can see all of the other components of their business which describe a much more favourable outlook.
I can make any company's market value look ridiculous if I hand pick just 1 component in GAAP.
It makes the company look like they are doing poorly when they are not recording GAAP profits but are increasing things like their user base and intellectual capital which are not reflected in the GAAP profits and losses. Say you start from nothing and get a million users paying you $10 each for some info service and you spend $10m in advertising to get there which you expense. That will show, roughly speaking, a GAAP profit of zero but your user base of 1m people paying $10 will be worth ~100m ($100/paying user) so you really will be wealthier by nearer $100m than $0.
Basically change in intrinsic value of the business is often a more useful measure than GAAP profits (or EBITA or all the other stuff). It's what counts to a business owner. GAAP profits are what the government forces you to declare so they can charge corporation tax on them and smart CEOs like Bezos will often try to keep the GAAP profits down so as to pay less tax while maximising the intrinsic value of the business which is what makes you rich.
This goes under the name of "Unit Economics" and is reasonable for small startups to use. It's VERY hard for a potentially high growth startup to cover their overhead costs. (If they were already cash flow positive, most likely they wouldn't be talking much to VCs anyway)
Companies go through stages:
1 - "Can we build something"
2 - "Will anyone pay for it?"
3 - "Can we turn a profit on each unit?"
4 - "Can we grow profitably and eventually cover our fixed costs?"
Generally you want to know #3 before tossing bags and bags of money at a company, but it's ok for startups to ask for money without having it answered. It's also ok for companies to ask for money without having covered their fixed costs yet.
To oversimplify...
Let's say my fixed costs are $10mm. Let's say each delivery I make turns a profit of a dollar, and each customer uses me for 20 deliveries over the course of 4 years. (Lifetime value of $20, which I get $5 per year) Let's say that it costs me $10 to acquire a company. (Customer acquisition cost)
Then in year 1 I'm $5 behind on each customer, but by year 4 I'm $10 ahead.
If I'm reasonably confident of these #s, then it pays for me to get as much investment money as possible to invest in customer acquisition. From a current cash flow (and potntialy from GAAP [0] earnings too) perspective I am losing money, but this will maximize the long term value of the firm.
This goes under the name of "Unit Economics" and is reasonable for small startups to use.
That's fine. But I think the meat of the article is that there are startups/businesses out there that are using so much smoke and mirrors with financial reporting that it has become a ridiculous process to read a "we are profitable!" press release.
I get it - there is an arms race out there to get funding for the "next big thing" which will require hundreds of millions of dollars to get off the ground. But whatever happened to a sound business plan, an experienced team, and a sound business idea? And the "next big thing" is now so saturated by so many players that the arms race seems to be exponentially increased for any possible idea that might have some traction. It is a race to the bottom.
Facebook and Google are such outliers that VC has resorted to throwing cash at the next 1,000 Mark Zuckerbergs, which only one or two probably exist in the next 10 years.
Capital is chasing returns that are not sustainable.
But whatever happened to a sound business plan, an experienced team, and a sound business idea?
Those exist, and they are all over the place. Ostensibly most quality startups have those things too. The majority never make big headlines - and as far as I know never really have. They generally just chug along and comprise the majority of "small businesses."
Facebook and Google are such outliers that VC has resorted to throwing cash at the next 1,000 Mark Zuckerbergs, which only one or two probably exist in the next 10 years.
Right, well that's the whole thesis of Venture Capital.
Well put. That is one of the fundamental problems with the economy of the current tech startup boom. There is too much of a winner-take-all dynamic. From the VC's perspective, it doesn't matter whether the portfolio is 10 or 1000 companies, as long as you get that home run. But to each individual founder, it's the difference between a 1/10 and 1/1000 shot at success.
Staying at Facebook/Google/etc seems to be the way to go these days...
The other alternative is to come up with an idea that doesn't require scale, that can become cashflow positive more quickly.
You can do this in software by attacking a very narrow niche, or by doing a services-heavy business. Neither creates a unicorn, but both can be stable.
But whatever happened to a sound business plan, an experienced team, and a sound business idea?
If most of the risk has been taken away, then you don't need high-risk venture capital.
In many cases, the business idea only seems Sound in hindsight. Google == "Yet another search engine with a crazy valuation run by two very arrogant prima donnas" AirBnB == "Some crazy idea contingent on strangers opening their houses to each other."
Capital is chasing returns that are not sustainable.
If this is the case, then people will lose the capital. That's the price of a free market, and the occasional Zuckerberg returns.
> If they were already cash flow positive, most likely they wouldn't be talking much to VCs anyway
Didn't you talk about high growth startups? Do be "high growth" their profit would need to be in the four digit percentage area or more. So just writing black numbers is that not enough. So yeah, even if they are profitable, they are probably still talking to VCs.
Yes - 0 through 2 can be shuffled. Sometimes you can just ask questions and get answers. Sometimes people can't visualize the need until you put something in front of them. Those first few steps are also more iterative than I showed, though 3 and 4 are more sequential.
The fact that they opened the article with the example that they did is absolutely ridiculous, considering there are significantly better examples that didn't even receive their own complete sentence. Contribution Margin is a metric that all VCs should keep an eye on. It is a scalability metric: before CM positivity, you are lose money with every unit sold. After you are CM positive, growing sales will only ever help you. The only mistake the SpoonRocket management made (at least as far as referenced in the article) was trying to expand to new cities before they were CM positive.
The absolutely moronic-bordering-on-Bernie-Madoff example was Instacart. Instacart told Bloomberg in February that it was profitable in its biggest markets and that 40 percent of its volume was profitable. The company later clarified that it meant gross margin profitable, which is usually limited to direct costs such as supplies and delivery labor. Instacart's calculation leaves out other costs, such as customer service, central office salaries, rent, and the cost of acquiring its workers. Instacart also said it is gross margin profitable, on average, across all its markets.
I certainly hope the Bloomberg writers actually clarified (and just made it sound like they were assuming) how Instacart is calculating Gross Margin, because delivery costs are typically only included on the inbound side, which is a cost that Instacart doesn't manage. Outbound delivery costs are very rarely included, and that is Instacart's whole fucking business. It would be like a grocery store claiming profitability as long as you exclude COGS.
In other words, if Instacart is including their delivery costs in their GM calculation, they might have a sustainable business (they'll never be as profitable as their valuation assumes, but at least they could stick around after the VC dries up). If they aren't including delivery costs in their GM calculation, then Instacart is so laughably unprofitable that they don't have a snowball's chance in hell.
"Profitable profitable" - I, I just can't even understand why someone would say something like this.
What's next? "We're negatively profitable right now but hope to swing to an evenly profitable state and then turn positively profitable profitable in Q2 2017"
Ah! reminds me of the dot com bubble where everyone was profitable! ... uh by EBITDA [0]. A measure that caused all sorts of problems since a bunch of companies also manipulated their Earnings [1]. For every cycle, the line swings back and forward between "grow at all costs" and "profit, profit, profit", with the associated attempts to create "silk purses out of a sow's ear" by using bad definitions. Not that this fools VC's or investor high-net-worths, since they know (and create) many of these games themselves.
Every business should know profit by product/shipping-unit, line of business/division and overall (gross/net). If we don't know them, we're not running a business, we're running an experiment.
Though I much prefer the phase when the industry is talking about "profit" at some level, rather than just buying temporary growth and selling it as "innovation".
> A measure that caused all sorts of problems since a bunch of companies also manipulated their Earnings
Just to be clear. EBITDA itself is not the problem, but rather the calculation companies themselves use to derive it. EBITDA is generally regarded as a very good metric to value a company (with a multiple of course). Any smart investor who gives a damn about their private company investment sniff shady EBITDA numbers out pretty quickly. The problem is, very few VCs actually go through this scrutiny or have incentives to provide a true indication of EBITDA. On the other hand, PE firms, who take a large stake in a business, typically do.
> EBITDA itself is not the problem, but rather the calculation companies themselves use to derive it.
Heh, I find it a bit difficult to consider it a useful measure, when (as you point out) you have to immediately clarify how it's calculated. It's like me saying "I'm a world champion sprinter" and then mumbling "as measured by positions in races between my desk and the downstairs loo". There are contexts for specialist use, but overall I'd avoid it.
The article was referring to more general business use - PR & investment - I guess another situation where profitability comes up is candidates discussing whether an organisation they might join is profitable. I would argue that if someone uses EBITDA then it indicates that you should be asking lot more hard questions. Not that it's even the worse, as the article points out - my broader point is that every era comes up with new pet terms and ways of manipulating them for PR.
Take two identical companies in the same business line in the same jurisdiction. One got a less favorable interest rate on the same amount of debt, and also has a higher effective tax rate.
On a GAAP basis, these companies look very different. They should. They are.
But, to someone trying to compare different companies for purposes of M&A, EBITDA can provide a nice way to normalize these factors. Debt can be refinanced. Effective tax rate != current tax rate. And that's just the EBIT part of EBITDA.
You can't say EBITDA itself is not a useful measure. It is, when it's used properly and understood. However, I do agree with your overall sentiment re: manipulation. It's misused and misunderstood.
The problem with EBITDA is that it excludes any consideration of capital expenditures. Of course you can take that into account by tuning the multiple accordingly, but the same can be said of any valuation metric.
A big company that is profitable is invariably found to have evolved from a small company that was profitable. A big company created from scratch is never profitable and cannot be patched up to become profitable. You have to start over with a profitable small company.
With apologies to John Gall ;) I feel there's some truth to it.
That's only partially true. A big company that is profitable is invariably found to have evolved from a small company with profitable unit economics. That company may have run at a loss for many years to grow market share, though.
The counterexamples that other people are mentioning here actually all have secret histories that showed they tested revenue models early on. Amazon.com started as a couple Perl scripts to sell books online; Jeff Bezos tested it out to make sure that a.) people would buy books and b.) he would make more money on each book than he spent before seeking massive funding to grow the business. Google had about a half dozen plausible ways of making money in mind at the time they hired Urs Hoezle (employee #9 and their first VP of engineering). Facebook ran experiments with local business ads when they were a bunch of guys in Palo Alto, before they took VC. Twitter had periodically run experiments with ads & sponsored tweets starting in 2008, which had shown they could be instantly profitable if they were willing to sacrifice user growth.
But there's a very big difference between knowing you can be profitable and being profitable. You should definitely verify the former before scaling up massively. But if you know that you can be profitable, it is often more profitable in the long run to run at a loss and build up market share.
There are plenty of examples of large companies losing money, getting acquired by other companies and getting turned around to be profitable.
Sometimes (not always) the acquired company goes through downsizing led by the new owner before it starts turning profit. Very often this is more of a restructuring move by the new company as the acquired company can in some cases outgrow it's pre-acquisition size. Happens in automotive business all the time with higher-tier companies acquiring their own struggling suppliers.
> A big company created from scratch is never profitable and cannot be patched up to become profitable. You have to start over with a profitable small company
Is this true? You mean you are sure Uber will never get profitable?
What would "A big company created from scratch" even mean? With the exception of a spin-out from an existing large company (which can arguably still count the history of that company back to its formation), under what circumstances is a company "big" when initially created, rather than starting small and subsequently becoming big (quickly or slowly)?
It's been too long since I thought about that book! It's packed with with great stuff, even though the name incorrectly gives the impression that it'll be fluffy and light on content: https://en.wikipedia.org/wiki/Systemantics
Amazon is one of the most frugal companies I know, penny-pinching is built into their DNA and one of the reasons IMO they're not a pleasant place to work. Amazon actively chooses to invest every cent they make into expansion (with great results) instead of hoarding profit.
That's a huge difference to most companies mentioned in the article that essentially sell $10 bills on the street corner for $9: "Oh, another flyer for a free meal delivery service, why thank you VC-man for paying for my lunch once again. No, I will not ever pay for your service."
You hit the nail on the head. I've always thought ofvthem as a more diverse and digital Walmart. Bezos wasn't coasting on a nice stream of profit: he was building an empire.
But the point is that at the very beginning of their company, Amazon was most definitely NOT profitable. They took in a huge amount of investment money to be able to grow their business quickly - exactly what all these other companies are trying to do.
An an European startup I had a bright smile when reading this article. Always fun to see how out of touch can startup founders be too often led believing that VC money without balanced revenue/expenses is "normal".
They'd certainly be quick to get some cold shower around here. Too often a startup already needs to be profitable in most cases and have some heavy references before even getting 500k of funding, if at all.
I would like to disagree with that thought because neither are good options, but regrettably agree.
Would kind of prefer to see more bubbles because then at least you increase the odds of more companies/people to deliver innovation (in the true and non-cliché meaning of the word).
Twitter still seems a more interesting company than most startups I read about across the pond. I can't think of the last say UK based startup that drastically changed my life. I am sure they exist, but I can't think of one right now...
If you're looking from an investor point of view (the audience for different profitability metrics) then even the most vague measure of profitability is more relevant than whether it drastically changes the life of users - it you would want that, then you'd look for the charities with most impact per dollar instead of gifting that money to finance the burn rate of an unprofitable (but interesting) tech startup.
Did I read the article correctly that uber, lyft are not profitable yet? That's news to me as I thought they were very profitable given the amount of media attention and visibililty they gave got. Are companies like say slack and github profitable? They also get so much attention (atleast here on HN).
Github interestingly used to be profitable "We bootstrapped the company on a few thousand dollars and became profitable the day we opened to the public and started charging for subscriptions."
They seem to have ditched that for the VC funded, hire loads of people, swing for the fences model.
A few months ago I was told by a former employee that average LTV in the US is $15. First-time ride credit is more than that ... plus all other expenses.
I have a feeling this isn't about averages, though. Some people use every so often, some make it a way of life.
To be fair, so do "real" companies like Tesla, which like to use alternate accounting systems to report profitability while being unprofitable in accordance with GAAP. I like to think that investors who actually do their homework can see through the nonsense in both cases.
It is much harder for investors to do their homework on private companies, because (as described in TFA) many private companies selectively disclose metrics that paint them in a positive light. And there are no requirements or standardized metrics of disclosure.
I think this is why regulators are concerned about the steep drop in "startups" going public. You have these huge companies with enormous valuations, and they arent subject to the disclosure and reporting requirements that regulators have designed for public companies...
The most ridiculous recent example was Morgan Stanley marketing Uber to high net worth individuals. [0] Potential investors were not even allowed to see the financials! You just had to take Morgan Stanley's word for it that the valuation was "reasonable".
Well I think that makes a good place to put a hard rule if you're considering investing in a startup: don't hand over a single penny unless you can see their actual financials. Of course very few people are going to do this instead of just hopping on the startup bandwagon, but it's easy to not play the game.
you know, i would have thought investors on that level were doing their homework too, but look at Theranos... raised a unicorn level valuation without ever really proving their product worked at all. Isnt Palantir in trouble too?
Investors change the game theory in company's model. A company without VC doing the exact same thing as with VC will perform and act differently. Pretty much all we hear about in the news is that VC money is good for startups, founders, employees, the scene in general here and the tech economy. In reality, I doubt that's true long term. My rationale is that the WHOLE game is significantly altered when people who have stored trust get involved in a big way. Stored trust being capital, money or stored work. The game being the market we entrepreneurs look to game in moving forward.
The effects of these consolidated investment cycles result in bubbles. The more stored trust involved, and the more systems put in place to bring more stored trust to bear on an idea, market, company, etc., the more disruption there will be on the changes in the cycles. Cycles are a thing with technology, probably due to the discovery phases of market bubbles. All theory, of course. I'd like to see it put to analysis though.
There are investors and then there are investors. Seems a lot of VC type investors are happy to go along with that nonsense as long as they can get out early and dump their stuff on another investor, often the retail investor.
One way for companies to game the system is to be late in paying their employees & contractors. If these expenses don't show up in the books, then the company can appear to be in a better financial situation.
I believe that GAAP requires accounting for work expenses at the time when the work is performed - e.g. the salary due for last week of March must be counted in March, no matter if you issued a paycheck right at the end of week or haven't paid it yet for whatever reasons.
Though, one way for companies to game the system in GAAP is to be late in paying their employees & contractors by having part of their renumeration be in stock options - people perceive it as compensation, but it can be excluded from GAAP since the value technically doesn't come from "within the company" but from reducing the value of other shareholders.
There are Generally Accepted Accounting Principles. Lots of startups whine that GAAP accounting doesn't represent their coolness, disruption, clicks, and general greatness. In hindsight, the GAAP numbers usually mean more than the vaporware numbers used for PR purposes.
If you go public, you have to show GAAP numbers in your financial statements. While private, you can sell to "sophisticated investors". These are like "whales" in the gambling industry; it means they can afford to lose money, not that they have a clue.
Most of the trouble comes not from companies that need a long period to do R&D or build up manufacturing capacity, like Space-X. It comes from companies that are losing money by buying market share, hoping that, in the end, they achieve a monopoly position and can make it back. Like Uber.
Funny accounting anecdote of the past: remember AOL disks, given out in vast quantities for free? AOL treated those as a capital expense and depreciated them. AOL was losing money for most of a decade while showing numbers that indicated profitability.