The Lottery of Scale And Avoiding The Revenue Trap

Startup Resources

The Lottery of Scale And Avoiding The Revenue Trap

The title of this article may raise a few eyebrows. After all, paying customers and revenue are considered the clearest signal of traction by entrepreneurs and investors alike. Why would one want to avoid making revenues, of all things?

The reason is that the irrational pursuit of revenue and scale are, in my opinion, the # 1 reason for post Series A failure… why startups who have raised a Series-A still fail to be that lucky 10% who are achieving what Americans call a “home run”, and what we Indians in the IPL season might like to call “hitting it out of the park”.

The Lottery of Scale
The Lottery of Scale

I call this approach the “Lottery of Scale”, and it emerges as follows:

  1. Once you reach Series-A level, Venture Capitalists don’t want near-term profitability. They want a big bang exit where they can get a “10X return” (of course what they secretly wish for is a 50X). Exits generally happen over a 5-7 year period with a large acquisition or an IPO. At that time it may be useful or necessary to be profitable.
  2. But much before that, the company needs to gather sufficient capital resources to survive and grow. This requires multiple rounds of funding, which generally is calculated based on revenue, topline and GMV (Gross Merchandize Value) numbers, not on EBIDTA/profits. This means that companies which want to be funded are motivated to trade off profits for scale, and margins for growth. A clear example is discounting and price wars: I may not make profits selling Rs. 199 t-shirts, but I sure as hell will sell a lot of t-shirts. This will also make it far more likely for me to raise more money. And thereby increase my perceived chances of survival. This in essence is the Revenue Trap.

  3. In theory, you can take $2M from a VC and become profitable making let’s say 20 Crores annually. However, this doesn’t serve the VC’s “rational interest”. He (with due regards to the few women in this industry) wants a big bang EXIT, not to run a profitable business.
  4. So in order to put the business in orbit, VCs as well as entrepreneurs end up playing this “Lottery of Scale”, and in most cases end up giving away products at unreasonable discounts and prices, or using very expensive customer acquisition techniques. This often leads to unviable businesses, who are seeking “the next Series-X round” every 6-12 months, and face the “or else” question constantly. The hope is that you will be one of the tall towers in the landscape, and someone will be dazzled by it and put in more money before the basement sinks in.

The “Lottery of Scale” is a manufactured gamble. It often ignores business fundamentals while burning a lot of rocket fuel behind your business. Of course, if you put enough rocket fuel behind it, virtually anything will go a certain distance. The question is- are you maximizing the expected value of returns through this approach?

I’d argue that both entrepreneurs and investors need to avoid the Lottery of Scale approach for most of their businesses (there are cases where it’s needed). The details probably justify another article, but the highlight is this: The above logic works on the underlying assumption that exits can only happen at a very large scale (Rs. 1000 Crores / $200 Million and above topline).

If exits were possible at mid-level scales of Rs. 100-500 Crores ($20-$100 million) topline, VCs could invest a smaller amount of money ($10-20 Million), and instead of demanding humungous scale, expect more rational growth backed by business fundamentals. There is less pressure to raise larger and larger sums of money every 12 months- a difficult thing in any case in the current climate. Whether such mid-scale exits are possible or not depends on the size of the market, the sector dynamics and the observed behavior of potential buyers (including the IPO market).

Revenues are great, but post Series-A, business viability and exits also depend on fundamental differentiation, and profitability is a great signal that you are doing something unique and making some set of customers excited about you. Parting piece of advice for entrepreneurs: a lot of this is driven by what you put in those amazing spreadsheet projections and pro-forma statements. Be careful what you wish for.

P.S.: I think this post by Mark Suster captures the balance between profits and growth very well, worth a read if you reached this far.

[About the author: Amit Sharma is the Founder/CEO of Genesis Online Commerce, which runs specialized lifestyle eCommerce destinations driven by proprietary private labels. He has 10+ years of experience in technology and general management, and an MBA from the University of California, Los Angeles.]

Leave your thought here