Tag Archives: Private companies

Profitability

Back in 2015 (I couldn’t find a more recent study with the same data),¬†The Information¬†released a study of the percentage of US tech IPO’s in a given year where the company going public was profitable at the time of the IPO. The graph shows that 11% of tech IPO’s in 2014 were from profitable companies. This is the lowest level in history, even lower than that in 2000 before the dotcom bubble burst.

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Since this percentage is unlikely to have grown much in 2015 and 2016, The Information uses this figure as a potential signal that we’re facing a bubble similar to 2000.

Looking at the data as a tech investor in Turkey, I think there’s a much more interesting takeaway. Specifically, the percentage of tech companies in the US which were profitable at the time of IPO has averaged around 50% since 1980, and around 30% since 1995.

This data shows that even US public market investors who invest in large and mature tech companies don’t look for profitable income statements. We already know that early stage investors don’t, but the fact that public market investors don’t either is a very strong statement. The reason is because what matters is not a company’s current profit level, but that it has a path to profitability.

For example, a tech company that can acquire customers much more cheaply than the gross margin that it produces from serving these customers during their lifetime may be spending a lot on customer acquisition to take advantage of this positive unit economics dynamic. The result is that although the company is unprofitable for the time being, it has a clear path to profitability in the future.

Investors in Turkey often dismiss tech companies because their income statements show that they’re not profitable. This is the case not only for large and mature companies but even early stage companies that are growing very fast. This can be short sighted. There’s a difference between companies that are unprofitable without a path to profitability and those that are only unprofitable for the time being because they’re investing heavily in their future.

US public market investors show that even large tech companies that are unprofitable can be very attractive investments when you examine the reasons behind their unprofitability. If this is the case, the same must be true to an even greater extent for smaller and faster growing tech companies.

When you don’t know what’s going on at a company you invested in

From the outside, one might think that venture investors know about all of the important developments at their companies before those developments are made public.

Very often, this is the case. For example, when you’re the largest investor in the company’s most recent funding round, you know about most of the company’s financials and key metrics, the important product features that the company is working on, and the important hires that it’s looking to make. It also helps if the entrepreneur believes that you’re likely to invest in their next round as this gives them a greater incentive to share this information with you.

However, if you’re a smaller investor in a specific round, or if you were the largest investor in an earlier round but new rounds have taken place such that the new investors have a greater financial stake and rights in the company, and the entrepreneur believes that you’re unlikely to lead a future funding round, you may no longer know about what’s going on at the company before the public does.

As an investor, this takes a while to internalize. After all, even if you invested just a small amount in a company in an earlier round, you could readily make the case that you expect to know about what’s going on at the company in near real-time because of the impact that these developments will have on the value of your investment. However, that’s not how things work.

If an investor doesn’t have information rights (which are usually round-specific and go only to major investors), an entrepreneur running a private company isn’t obliged to share information with that investor. And even if the investor does have information rights, there’s a wide range in the extent to which entrepreneurs actually share information.

Given that that’s how things are, you need to operate with that reality in mind. Whenever you’re making an investment, you need to foresee that there may come a time when you don’t know what’s going on at the company any more than the public does.

And that’s why an entrepreneur’s ethics and judgment are so important. If the time comes when you don’t know what’s going on at the company, are you still going to be comfortable that the entrepreneur is acting ethically and making good decisions? Or are you going to have trouble sleeping at night?

Answering that question before making an investment makes you a better investor.