Getting to profitability is sometimes like seeing a mirage on the horizon in that very same desert. But Capshare (now Shareworks by Morgan Stanley) just did it.
It’s been a 3+-year slog through long and stressful nights, fights with coworkers about resources, hard conversations with family about salary, and agonizing decisions where we knew we were sacrificing growth.
Three years ago, we decided to keep our headcount flat while pouring all our efforts into growing our customer base by over 3x. While that’s not the whole story, it is a major factor that took us from burning about $1M / year to beautiful, glorious profitability.
Here’s a graph of our burn rate over the last 12 months.
Since you’re reading a post titled “Getting to Profitability”, we'll show you how we did it with an eye toward helping you do the same.
Below are the sections of the post to help you skip to the sections that are most relevant for you:
- Why Profitability?
- Defining Profitability
- Steps to Profitability
- #1 Instrument for Profitability
- #2 Cut Fat, Muscle and (Maybe Even) Bone
- #3 Restricted Stock Purchase Plan (RSPP)
- #4 ROI and Payback Period
- #5 Growing with Almost No Investment: Infinite ROI
- Ongoing Discipline
- Raising your Series P
It seem like a strange question to ask: Why profitability? Isn’t it obvious? Well, for many of the most promising startups, no, it isn’t obvious.
Some venture investors scoff at profitability (this is definitely more common in the Bay area than other regions). Because profitability is such a rare beast in the startup world, many investors scorn profitability in favor of rapid growth. This often requires the opposite of profitability: spending more than earning.
Many startups have a “land-grab” mentality. Rather than push for profitability, they spend like it’s Cyber Monday to “lock up” large portions of their market and keep it out of the hands of would-be competitors. The reasoning is that this will create a more valuable company in the long-run than one that focuses on profitability.
Sometimes companies don’t need profitability because, for whatever reason, money has yet to become an obstacle for them. But it’s important to keep in mind that that may not always be the case. One day money may be hard to find.
It’s also crucial to avoid the trap of overlooking bad unit economics while ignoring profitability and continuing to raise funds.
Some of the reasons that entrepreneurs choose to drive toward profitability include:
- Eliminating risk of insolvency
- Maintaining fundraising options
- Decreasing risk
- Avoiding equity dilution from fundraising
The bottom line is that profitability decreases the risk that a startup will fail. While the rumors of startup death rates have been greatly exaggerated, it’s true that ~50% of startups die before turning 5 years old.
So the primary reason a lot of startups turn to profitability is to decrease risk of death.
What is profitability? It’s a deceptively simple question.
For starters, there are really two kinds of profitability that are most important for startups: monthly profitability and cumulative profitability.
Monthly profitability means that a company’s revenue in a given month exceeds its costs for that month. Cumulative profitability means that a company’s total all-time revenue exceed its all-time costs.
It’s probably easiest to visualize startup profitability with a graph called the “J-Curve.”
In the J-curve graph above, the yellow line represents cumulative profit. The blue line shows monthly profits. The white x-axis represents break even–the point of zero profits.
In the early years of a startup, monthly profits start negative but climb until they cross over the breakeven line. There is a white circle on the graph where monthly profits reach breakeven and then climb to profitability. This is where most startups would probably consider themselves profitable.
After a startup achieves monthly profitability it is no longer adding to its all-time (or cumulative) losses. However, it needs to generate profits for some period of time to pay off accumulated losses and achieve cumulative profitability.
In the graph above, cumulative profitability happens when the yellow line crosses over the white line.
We’ll talk more later about how and why cumulative profitability might be important, but for now we’ll just say that most startups should focus on monthly profitability. This is the exciting turning point when your bank account balance will start to increase each month!
How to Get to Profitability
Now that you know the why, let’s talk about the how. Specifically, how do you get to profitability? In the next few sections, we’ll walk you through how our company did it and highlight the steps that can help you do the same.
This article assumes that most startups are obsessively focused on growing revenues, so we're going to bet you’re among that group. We’ll save the topic of growing revenue for another day and instead focus on how to manage your costs or continue to scale affordably so you can achieve profitability.
We did the following 5 things to get to profitability:
- “Instrumented” for Profitability
- Cut Fat, Muscle and (Maybe Even) Bone
- Launched a Restricted Stock Purchase Plan (RSPP)
- Focused on ROI and Payback Period
- Found Ways to Grow with Almost No Investment: Infinite ROI
#1: Instrument for Profitability
We believe one of the most important aspects of startup life is the concept of instrumentation. Instrumentation applies to all startup goals and it’s crucial for profitability.
Let’s define instrumentation as the art and science of measuring progress toward goals.
We’ve all heard the platitude, “you can’t change what you don’t measure,” but instrumentation goes far beyond that. In a fairly recent article, Bill Gates, the founder of Microsoft, said:
We can learn a lot about improving the 21st-century world from an icon of the industrial era: the steam engine.
Harnessing steam power required many innovations, as William Rosen chronicles in the book “The Most Powerful Idea in the World.” Among the most important were a new way to measure the energy output of engines and a micrometer dubbed the “Lord Chancellor” that could gauge tiny distances.
Such measuring tools, Mr. Rosen writes, allowed inventors to see if their incremental design changes led to the improvements—such as higher power and less coal consumption—needed to build better engines. There’s a larger lesson here: Without feedback from precise measurement, Mr. Rosen writes, invention is “doomed to be rare and erratic.” With it, invention becomes “commonplace.”
In the past year, I have been struck by how important measurement is to improving the human condition. You can achieve incredible progress if you set a clear goal and find a measure that will drive progress toward that goal—in a feedback loop similar to the one Mr. Rosen describes.
Gates’ idea that “All progress is doomed to be rare and erratic without precise measurement” is worth highlighting.
This is especially true in startups. With no previous model to guide them, startups are often born without the ability to measure their progress.
Startups typically develop their measuring systems incrementally.
So, the first thing we did to reach profitability was to determine how to instrument for profitability.
Of course, profitability is not strictly straightforward, so learning how to measure it was tricky.
Since our company is a SaaS business with recurring revenues, we tend to measure all of our SaaS metrics in monthly terms. Like most startups, we religiously track monthly recurring revenue (MRR). It made sense, then, to track our losses using a similar measurement, which we called monthly recurring burn (MRB).
We used these two metrics in favor of net income, for example, because of misleading data like non-recurring expenses. As you know, it’s actually possible to be profitable but decrease your cash balance.
We also smoothed out annual expenses by converting to a monthly equivalent figure. This allowed us to consistently measure our progress toward profitability without worrying about misleading and noisy data like those pesky non-recurring expenses.
In the end, our measurement for profitability looked something like this: MRR – MRB.
#2 Cut Fat, Muscle and (Maybe Even) Bone
Venture investors often use diet analogies for portfolio companies trying to get to profitability. The most common analogy is to compare cost-cutting to losing “fat,” “muscle,” or “bone”:
- Cutting “fat” is cost-cutting with no risk of hurting the company’s growth prospects or viability
- Cutting “muscle” is cost-cutting that helps you get to profitability but hurts the organization in significant ways – growth rates, culture, recruiting, etc.
- Cutting “bone” is cost-cutting that hurts the company so much that it puts the company at significant risk of failure
Since cutting fat has nothing but benefits, this is the first place you want to start on your quest for profitability.
Our team reviewed all expenses line item by line item looking for unnecessary lipids, and discovered that we were already pretty lean. It turns out that the vast majority of a software company’s burn rate is tied up in people costs. In our case, approximately 85% of our budget related directly to compensation.
When you do this exercise yourself, one of the things you’ll find that the management team might disagree on the categories of certain expenses. Some might feel the snack budget is pure “fat” while others might view it as “muscle,” etc. These discussions are healthy and show that you are doing the exercise right.
After some discussion, we found the following categories could be filed as “fat”:
- Software and data services we were no longer using
- Costco and snack expenditures (though we didn’t cut that budget entirely – startup life isn’t worth living without some Costco snacks, right?)
- Some other perks – our Friday lunch budget had ballooned and we trimmed it back
Click here to download our complete cost-cutting guide and checklist.
Our muscle turned out to be employee costs. Because they were such a large part of our company's expenses, we knew profitability would be impossible without taking some cuts to our healthy bulk.
While some may immediately think that cutting employee costs translates to layoffs, I’m here to tell you that there are other employee costs that can be slashed instead of the employees themselves during the “cutting muscle” phase.
But it doesn’t mean the decisions are easy. We faced our own tough decisions when we decided to let one underperforming employee go or significantly cut back contractor budgets. We also asked a few employees if they would be willing to take a pay cut. (We turned the pay cut problem into an opportunity through an RSPP which we will discuss below.)
It was agonizing cutting muscle because we knew it would hurt our growth rate. In the end, we decided to cut:
- One underperforming employee
- A few contractors
- Salaries for a few employees
- A few moderately performing sales and marketing expenditures
Cutting bone involves making cost-cutting decisions that put the entire company at risk. Some of these might include:
- Large-scale layoffs
- Eliminating any critical team or team member
- Missing payroll(s)
There are many other non-cost-cutting initiatives that can have the same effect:
- Large-scale pivots
- Shutting down business units
- Changing customer focus
We obviously wanted to avoid these kinds of decisions, so we weighed all our options and sought out every alternative. During this period, we also discovered that some of our best and most creative innovations happened when we had our back against the wall. What doesn’t kill you makes you stronger, right? In our case it made us profitable.
#3 Launch a “Restricted Stock Purchase Plan (RSPP)”
We should all be grateful to the Bay Area because it has trailblazed startup culture for over 40 years now. The Bay has also pioneered stock compensation. But our creativity for stock-based comp often stops with stock option plans and incentive stock options (ISOs).
In May of 2016, we felt a desperate need to get to profitability. Our main competitor was bigger and had raised over 10x the capital we had. Investors we spoke to were reluctant to offer funds, preferring to see how the market would shake out.
We reviewed the income statement ad nauseum looking for ways to get our burn down from its high point of about $80K mperonth. As mentioned above, we didn’t feel like we could lose any of our people because we were already supporting nearly a thousand paying customers on what felt like too few resources.
With our back against the wall, we came up with one of our most brilliant ideas to decrease burn. Using Employee Stock Purchase Plans (ESPPs) as a model, we invited employees to participate in a unique stock purchase plan, essentially creating a salary-for-stock offer.
Traditional ESPPs provide a similar alternative to ISOs but have some additional benefits relative to ISOs in terms of giving employees stock at a discount. ESPPs tend to be highly regulated for two reasons. First, they risk constituting a public offer of securities. While selling securities publicly is possible, it is highly regulated by the SEC. To avoid this risk, most ESPPs adhere to strict rules offer dates, subscription timelines, etc.
Second, ESPPs qualify for some unique tax benefits under IRC Section 423. To get these benefits, companies have to structure the plans to comply with a long list of conditions.
We wanted to create something like an ESPP but we didn’t have the time or money to create a complicated structure. Also, since employees were getting equity in lieu of compensation, we wanted to give them common stock not common stock options.We ended up creating what we called a “Restricted Stock Purchase Plan (RSPP).”
Click here to download our RSPP template documents to use at your startup. Remember: when you are issuing securities, you should talk to an attorney. We are happy to answer questions about our RSPP and once you talk to your attorney, we can help you get set up on Shareworks Startup Edition.
Our RSPP had only a few key provisions:
- We offered the ability to buy common stock at the 409A price
- We allowed employees to decide how much to invest up to a cap of 20% of their salary
- We allowed employees to buy into the RSPP over a 6 month period
The plan was oversubscribed. One employee even asked to contribute 70% of his salary. The plan was so popular and helpful for our burn that we extended the plan for an additional 6-month period.
The RSPP became the single biggest contributor to our burn reduction.
Keep in mind, our revenue was growing very fast. We ended up hitting profitability on target and we were able to return payroll to its former size. If your revenues don’t grow as fast, you may need to extend your RSPP more than once.
We built Shareworks Startup Edition to handle this kind of stock option plan and more. If you’d like to get started with our equity and cap table management software, it's free to try and forever free for companies with fewer than 20 shareholders.
#4 Focus on ROI and Payback Period
Return on investment, or ROI, is: (Gain from Investment – Cost of Investment) / Cost of Investment.
ROI is your bread and butter in regards to profitability. An investment with positive ROI creates more revenue than it costs–resulting in profit. You can’t really have one without the other.
Every business decision you make has an ROI component associated with it. Should you hire a new account rep? Should you invest in a new automation system? Should you hire more developers?
All of these questions are just variations of a bigger question: Will the money you make from this decision result in profit (i.e., have positive ROI)?
If you hire a new account rep, the value she creates over time should offset her cost. The same goes for a dev. The value she creates should offset her cost as well.
So should you invest in every positive ROI opportunity you can find? For example, if you hire a sales rep and they give you a positive ROI, should you hire a dozen more to bolster your profit? Unfortunately, it doesn’t quite work that way. The major buzzkill on ROI is often timing. Let’s break this example down.
Example: Hiring a New Sales Rep
Let’s say you hire a sales rep with a base salary of $3,000 / month and 15% commission on all sales. Now let’s assume your sales rep doesn’t have a successful close for 3 months but then begins to bring in $1,500 of new MRR (monthly recurring revenue) every month after the initial learning curve.
The math looks like this:
In the example below, you’ll see a few acronyms:
By month 6, the sales rep has achieved MRR that exceeds their MRB. So for each month after month 6, the sales rep is profitable on a monthly basis (see the yellow lines on the month 6 row above).
However, the sales rep has cost you a cumulative total of $19,350 by the end of month 6 and has only brought in cumulative revenue of $9,000.
At this rate, the rep won’t achieve a cumulative profitability until month 10 when they’ve repaid your investment and continue to be profitable (see the yellow lines on the month 10 row above).
This scenario is a mini example of profitability as a whole. Whether we’re talking about an entire company or one single rep, there are always two profitability points for companies with MRR: a monthly profitability point and a cumulative profitability point. When cumulative profitability has been achieved, it also means the payback period has been reached.
Payback period refers to the amount of time it takes for an investment to recuperate its own cost.
The payback period of the rep is 10 months, but what about the rep’s ROI? For that we have to look at the total cost of the rep over the total return. We could get really complicated here but we’ll keep it simple.
Let’s say your average rep costs an average of $150K per year and creates $400K of annually recurring revenue in a year. Since the revenue is recurring it might be worth something like 5x its annually recurring annualized value, or $2M.
So a simplistic ROI would be:
($2M – $150K) / $150K = 1567%
If that seems insanely high to you, you’re spot on. To keep the scenario simple, we ignored the full cost of acquiring, onboarding, and supporting customers, and the time value of money. We also assumed that the only business cost of the sales rep’s revenue is his or her salary.
A truer ROI calculation would be much more complex and significantly lower… but still high (I’d hope).
ROI, Cash Balance, and Payback Period
The answer to my previously asked question about ROI opportunities should be clear at this point. Although in theory you should greenlight every positive ROI opportunity that comes a-knockin’, factors like time and money will force you to slow down or break.
The reality is that a sales rep like the one mentioned above will hit your bank account by approximately $20K before recuperating cost.
If you had $100K in the bank, then in theory you could afford to hire 5 new sales reps. Number 6 would be the tipping point that would send you headfirst into bankruptcy, missed payroll, or some other kind of dire cash crunch.
There are other scenarios, as well, such as a poor performing rep that could push the breakeven point farther back or possibly indefinitely. For this reason, it’s wise not to stretch your budget to the limit, hiring 2-3 sales reps instead of 5 with a budget of $100k.
When you are in a really tight cash crunch, ROI be might less of a good thing in comparison to say, the payback period.
During our most severe cash crunch, we were totally confident that we had ~30 immediate and incredibly high-ROI investment opportunities.
But our conundrum was that we didn’t want to raise more money (i.e., we wanted to get to profitability over a short-term period), so we took the ~30 investment opportunities and sorted those by payback period.
We only greenlighted investments where we were convinced we could get a payback within 1-2 quarters max so we could get to profitability faster.
#5 Grow Like a Weed
This article isn’t about how to grow revenue, but we would be remiss if we didn’t mention the interesting problem we had regarding growth. Our business was growing at over 100% per year, but because we wanted to get to profitability ASAP, we couldn’t invest much money to support it.
In a nutshell, our problem was this: how do we grow really fast without increasing cost?
We ended up almost tripling our client base while decreasing our headcount by 2 people over a period of 2 years, and it was incredibly hard.
Some amazing things happened when our back was against the wall, though. An Aeschylus quote from John F. Kennedy’s funeral service comes to mind:
“He who learns must suffer. And even in our sleep, pain that cannot forget falls drop by drop upon the heart, and in our own despair, against our will, comes wisdom to us by the awful grace of God.” –Aeschylus
It's dramatic, but there are no more precise words to describe what it was like for us during this period. But through the pain and sleepless nights, and the hours, days, weeks, and months, grinding on the profitability / growth problem, we found strength and an incredible scrappiness that allowed for the growth we needed without the investment we couldn’t afford.
We called our methods “weed strategies.” Weeds can grow anywhere in the hardest of conditions and are nearly impossible to kill. We could certainly relate.
Yes, we worked crazy long hours, but we also ended up finding several low-cost (or almost no-cost) strategies to continue to grow. We called these opportunities “infinite ROI investments.” With enough time, patience, and pain tolerance, you’ll do the same.
”Infinite ROI investments” is a term we coined for investments that have a strongly positive ROI and almost no cash cost. There are a surprisingly large number of them available for most startups. In fact, they are often the core of the most successful startups. And, in our experience, they are almost a prerequisite for startups that want to achieve profitability within 3-5 years of founding.
Is it really possible to find infinite ROI investments? We think you can get pretty darn close. Here are few examples from our experience:
- We hired a sales rep with effectively no base salary but a very large commission
- We cross-trained our head of chat support to take on some additional sales work
- We cross-trained another sales rep to add several channel selling opportunities
- We found that at our lead volume and with our sales commission schedule, simply hiring another sales rep had almost no cost because it temporarily decreased the higher commission tiers most of our other sales reps were hitting
- Generally increasing capacity utilization of any of your assets is a huge area for no-or-low-cost productivity gains
- Implement an RSPP. This definitely has cost but its “cash” cost is zero since it substitutes equity for cash. Ultimately our team viewed this as a big positive not a sacrifice.
- Ask several people to take pay cuts
If you’re going to succeed, you need to have a solid team behind you. For our part, we had a heroic and dedicated team. If you have a team like that, you can weather the worst of it.
Maintain Ongoing Discipline
If you want to get to profitability, you’re going to need “Medieval ascetic monk” discipline. Every time you think about spending money you should whip yourself.
It’s hard to overemphasize how enticing (maybe even addictive) spending money in pursuit of growing your business is. After all, you started your business because of your immovable belief in its enormous potential. So what’s a few bucks compared to the inevitable payoff?
The thing is, you may not ever reach that payoff if you spend your way into bankruptcy. Scores of potential investments or spending opportunities will present themselves weekly, like sirens calling you to shipwreck. If your goal is profitability, you’re going to have to get good at saying “no,” at least until you can raise money again.
Startup failure is totally within your control. As long as you can stand the pain of hard work with little or no salary, your startup will continue to survive. And as Paul Graham has said, the best advice for startup success is “Don’t Die.”
Raising Your Series P
What if you could raise capital every day without giving up any equity in your company? What if that funding source just got bigger and bigger every day?
It turns out, you can. We call it “raising your Series P” with the P representing profitability. While there are tradeoffs you should consider, including growth and the overwhelming desire to bang your head against the nearest wall, raising your Series P could end up being much more worthwhile than spending 12 months trying to raise a Series A, B, or C at a ridiculous valuation. In fact, we believe the percentage of successful startups would be much higher if new companies focused more on profitability.
Being on the other side of the grind, we can say that there’s nothing quite like hiring new employees knowing that our monthly profits covers their cost.
We want you to achieve profitability to, so we’ve created a profitability checklist:
Download our profitability checklist here to make sure you have turned over every stone in your quest to raise your Series P.