It was the year 2000 when a venture capital firm first told me “No.”
I was 26 and I thought I’d done everything right. I had an idea that could change the way the world does business (OK, guilty of a little hyperbole). I left my job and began assembling a great team (No hyperbole there). I invested most of my own money (and some money from friends and family) in the company. We made what we thought was a solid presentation.
And they said “No.”
I don’t mean “No” in the literal sense. Unfortunately—at least back then—VCs did not actually say “No”. They claimed they would “ponder it and get back to [me].” No one ever did. It was frustrating and distracting.
In retrospect, I can’t blame them: I had never started a company before, the product had no traction, and the Internet bubble was bursting. But I never considered closing up shop. The venture capital industry did not really even exist until the 1970s, so why should it be a requirement to build a successful business? For most of human history, bootstrapping has been the way to go. So that’s what we did.
The Rise of VC
Over the past fifteen years—given the nature of Capterra, an online marketplace for B2B software—I’ve had the benefit of spending nearly every business day on the phone or meeting with software companies, frequently the founders. And throughout these conversations, I’ve noticed a bit of a dichotomy between those who have bootstrapped and those who have raised VC. The former often play it too safe and don’t invest enough of their profits in growing the business. The latter have the exact opposite problem. They are so aggressively focused on revenue growth that they never learn how to operate a profitable business. And while revenue growth is great—and the only metric that VCs seem to care about—operating a business within the constraint of making a profit can lead to greater creativity, focus, and more sound business decisions.
Three realities lead me to think that venture capital has become a bad addiction for most business software companies, and its overall effect may actually be negative for the industry. (And this isn’t just sour grapes; we had the opportunity to raise venture capital later on and we said no thanks.)
An Increased Risk
The first one is a data point. According to the Bureau of Labor Statistics, about half of all new companies fail to reach their five year anniversary and about two thirds never celebrate ten years in business. However, an even higher percentage—an estimated 75%—of VC backed companies fail, and they usually fail quickly, as in a few years. This means that raising venture capital, while increasing your chances of hitting a homerun, also materially increases your chances of failure. Not that longevity is the only measure of success, but it seems to be a pretty objective one. How many software CEOs realize that raising venture capital actually reduces their chance of remaining in business?
A Decrease in Efficiency
Secondly, while it stands to reason that promising B2B startups may require sizable investments early on in order to afford all-star developers, marketers, and salespeople to go to market with a great product, I think it also stands to reason that, capital intensive exceptions aside, by the time their growth begins to subside, likely somewhere in the $50 to $100 million revenue range, that they should probably not be so reliant on outside funding anymore. But recent IPOs of some of the highest flying B2B software companies show otherwise. Take three examples.
HubSpot is ten years old and has become one of the clear market leaders in marketing automation software. They now have an annual revenue run rate of $160 million and are growing at a 50% annual clip. Yet they continue to lose almost a million dollars per week—largely because the company takes a staff of over 900 employees to operate. That’s just $175,000 in annual revenue per employee. Last year their operating loss was 42% on $116 million in revenue.
Box, another decade-old software company, competes with Dropbox, Microsoft, and Google to manage content and files for businesses, and is currently growing at a rate of 45% annually. They operated at a loss of 77% on $216 million in annual revenue. Their current run rate is around $270 million putting their revenue per employee at around $220,000.
A third example is Cornerstone OnDemand, the 16-year-old market leader in the talent management software sector. They did $264 million in revenue last year with a 19% operating loss. Their current run rate is $300 million with about a 30% growth rate. Revenue per employee is around $210,000.
All three of these high-flying B2B software companies (they really are stars in the industry) have blown by the $100 million revenue milestone with growth slowing down to the 30-50% range. That remains solid, healthy growth, but it’s a far cry from the triple digit growth rate they experienced in their early days when it made sense to continue to invest heavily. So, in theory, with the more modest growth rates they are experiencing, they should be at the point where they have learned to operate more efficiently and become profitable. Yet their operating margins remain deep in the negative, and revenue per employee for all three is under a quarter million dollars—all surprisingly low stats for the software industry. It’s as if those early years of venture capital made them soft; they’re struggling in the transition to profitable enterprises.
A Skewed Reality
HubSpot, Box, and Cornerstone (and many others that have gone public recently) believe that profits lie ahead – maybe once they reach $500 million or surely a billion in revenue. And the market clearly believes them with valuations of 7-10x their current run rates. Enter the third reality: Salesforce.com, the pioneer of Saas and the software company that Hubspot and the others try to emulate, has yet to achieve profitability. Certainly at annual revenue north of $5 billion and growth slowing to 25% they should be generating profits, right? Unfortunately, in each of the last three years they have recorded operating losses of 3-7% of revenue, while surpassing $3 billion, $4 billion, and $5 billion in annual revenue, respectively, in each of those years. Fortunately, it finally appears that they are on track for profitability this year, after they cross a whopping $6 billion in annual revenue.
How could this be? Microsoft, Oracle, and seemingly every other high flying software company of the late 20th century had incredible margins – 25%, 30%, 35%. The software industry has built a reputation for it: Build a great product along with a sales and marketing engine, bring it to market, and reap the rewards of having low cost per unit economics. So what happened? Venture capital happened. And the stock market has supported it, at least for now.
Planning for VC in Moderation
This isn’t to say that venture capital is necessarily bad. I am convinced that many of today’s leading technology companies—started by people often still in college, with little business acumen or experience—would have had no real chance of success without turning to venture capitalists. Their money, relationships and guidance can be critical to success. What I am saying is that a good thing can turn bad—and become an addiction—when moderation is neglected. I fear that is the case, and the only solution I can think of is to continuously remind software entrepreneurs that raising gobs of venture capital is not the only viable path to a thriving business.
Here’s a possible goal for business software startups: If/when you emerge from your meteoric growth and come back down to Earth in the land of double digit growth rates (sub 100%), start to think about how you will operate within the constraint of profitability. Make it your goal that by the time you slow down to 50% growth that you will be at least breaking even by that point. Then as your growth continues to slow to 25% make it your next goal to expand margins to 25%. For most software companies this will require a severe reduction in sales and marketing payroll as a percentage of revenue. Be creative and figure out a way to make it happen while remaining innovative.
Profits are not everything, but in the long run they remain the best single measure of a company’s ability to deliver a great product, delight customers, satisfy shareholders, and help the world become a better place. With that in mind, profit should not be the bad word that it seems to have become.