This blog is an excerpt from a white paper by the Market Creators Lab. To view the paper in full, visit the link below.
The venture capital approach to creating new, disruptive companies is not for the faint of heart, nor wallet.
Venture capital funds assume over two-thirds of their investments will either be a total loss or return no more than the principle. To diversify away this extreme risk, a venture capital fund invests in 30-80 startups, on average.
There’s also the cash needed to innovate and build the ventures. The lean startup approach championed by VCs—rapidly launching a minimum viable product (MVP) into the market; acquiring customers while experimenting with different features and value propositions; and then trying to discover a profitable business model while operating a loss-making business—is cash hungry.
Consider the data. At the end of 2020, only 6 of 73 unicorns— startups achieving a valuation above $1 billion—were profitable, and most were more than ten years old. Twenty-one had annual losses greater than 50% of revenues and another 13—including Uber, Lyft, Pinterest, and Snapchat—had annual losses greater than 30%. When their annual losses are totaled, five of them had deficits that exceeded $3
billion dollars; eighteen had total losses between $1 billion to $2.5 billion; seventeen accumulated $500 million of losses; and another eleven had total losses greater than one year’s worth of revenue.
That’s a deep financial hole: Simply repaying the face value of losses equal to just one year’s worth of revenue would take 10 years of sales at a healthy 10% net profit margin, assuming sales stay consistent. If today’s 9% average cost of capital is factored in, it would take about 27 years.
Venture capital funds can flourish despite these sobering statistics because they can sell their portfolio companies based on a multiple of their revenues. That lets them monetize a venture’s potential future profits. It’s how famed venture capital firm First Round Capital could turn a $1.5 million seed investment in Uber into a $2.6 billion exit, even though Uber had amassed 10 billion dollars of accumulated losses and was suffering annual operating losses close to $1 billion at the time of the IPO.
However, to offset the mountain of losses, the revenues on which the exit multiple is based must be very high—the same way pharmaceutical companies need billiondollar blockbuster drugs. Which is why accelerators and venture capital funds exhort startups to get quickly into market with an MVP and demonstrate product-market fit through a growing customer base–it’s their investment strategy for
generating profits in a fund’s 10-year life. It’s not an innovation strategy for creating new, enduringly profitable companies.
That misconception has led the startup world to mimic venture capital’s lean startup approach. But, when venture builders can’t place dozens of bets, and depend on real, sustained profits to pay bills and deliver shareholder returns, it’s a strategy that invariably ends badly.
For a self-funded entrepreneur who has scraped together $50,000 to build a software MVP, sustaining a 30% annual loss on even $100,000 of revenue for several years can be crippling. It explains the consistent research finding that the most common shared trait among entrepreneurs is being wealthy or connected to wealthy people.
Even Fortune 500 corporations are vulnerable, as stock prices are significantly driven by annual growth in profits, particularly now that interest rates have risen from near-zero lows. So, while a $20 million loss for a corporation that generates $250 million in profits sounds trivial, it’s not. Assuming a 10% targeted growth in profits or $25 million, a $20 million loss erases 80% of the growth target.
It explains why so many new ventures by corporations are shuttered within five years. Recent corporate casualties include Disney’s “Disney+” streaming service, which reported a $1.5 billion quarterly loss in November 2022 three years after launch, and Goldman Sachs’ mass-market digital bank “Marcus,” which was launched in the US in 2016 and 2018 in the UK and generated a loss of $1.2 billion in 2022.
It’s also why Amazon and Google, whose profits count in the tens of billions of dollars, both announced in 2022 that most of the projects in their loss-making new ventures units would be shuttered.