Disclaimer: In this post, I describe business models of tech companies where I hold positions. Don’t use this to draw conclusions about any specific company or rationalize any particular investment. Follow your own investment strategy, not some knucklehead with a blog.
In the last few years, we’ve seen a variety of major tech companies go public or IPO. It’s been educational and exciting to watch from both the inside and outside but one question has come up time and time again:
“How can a company go public without making a profit?”
With the exception of Zoom, most of the tech companies that have IPO’d were not profitable at IPO time. In fact, some of them have had growing losses since their big day. To understand the mechanics, let’s lay out the basic model that underlies most of these businesses. To start, there are some key terms to understand:
- It costs some amount of money to acquire a customer. This could be reflected in marketing, sales, promotions, and a variety of other things. We call this Customer Acquisition Cost (CAC).
- Next we have Churn which is how long a customer is a customer. We measure this as a percentage where 20% churn means they’re a customer for 5 billing cycles.
- Next, we have Average Revenue Per User (ARPU) which is generally the subscription cost.
- Finally, we have the total amount a customer will ever pay us which is the Lifetime Value (LTV). In SaaS businesses, this is calculated by ARPU * 1/Churn.
Caveat: The numbers here are made up and the math is over-simplified. Get over it and watch the trends.
Step 1: Basic Revenue Model
Let’s start with a simple scenario where is costs $10 to acquire a new customer, they pay us $5 each year, and subscribe for 5 years. That trend looks like this:
In this case, we have a net loss the first year, break even during the second, and are profitable from then on. Unfortunately, we lose that customer after year 5. Fundamentally, we spend $10 to make $25 for a net profit of $15.
“But there’s profit! I thought this was about unprofitable companies going public!”
Step 2: More Customers
In any business, you want to make more money in year N+1 than you did in year N. One of the many ways to do that is to acquire new customers. In this model, let’s acquire 2x the customers in year 2, and 2x that in year 3 and keep other assumptions the same:
Once again, we have a net loss the first year but it doesn’t stop there. In fact, our losses increase year over year! It isn’t until year 4 that we start making money but we make back all of our losses in that year alone. We still lose the customer after year 5 for a $25 LTV and we spent $70 to make $175 for a net profit of $105.
That’s our baseline. Now let’s change our assumptions..
Step 3a: Reduce CAC
One of the great things about a business is that as time goes on, you learn more about your customers, what they do and don’t care about, and how to describe, position, and sell your product better. As a result, we can often acquire customers for less tomorrow than we did yesterday. If we reduce our CAC from $10 to $8, what happens?
Once again, we have a net loss the first year but it peaks the second year and is gone by the fourth again. We still lose the customer after year 5 and we spent $56 to make $175 for a net profit of $119 or 13% over our baseline.
Let’s tweak a different assumption..
Step 3b: Increase Average Revenue Per User
To be clear, increasing your prices is hard. That said, you can often upsell or cross sell other products and services to address complementary or adjacent use cases. Alternatively, if your pricing is consumption-based, as your customers grow and their usage increases, you make more money.
If we can increase our annual revenue per customer from $5 to $6, what happens?
As before, we have a net loss the first year but it peaks the second year and is gone by the fourth again. We still lose the customer after year 5 but our LTV has increased to $30 so we spent $70 to make $210 for a net profit of $140 or 33% over our baseline.
Let’s adjust another assumption..
Step 3c: Decrease Churn
Regardless of the other variables, acquiring customers is always hard. But if we can keep an existing customer longer, that’s great because it’s “free” according to our simple model. While you can often do this via contract terms or minimum purchase agreements, simply making a sticky product can accomplish the same. That stickiness can come from a great product, deep integrations with other systems, great customer service, or a variety of other things.
If we decrease our churn from 20% (5 years) to 16% (6 years), what happens?
As before, we have increasing losses but our revenue continues for another year. We lose the customer after year 6 but our LTV has increased to $30 so we spent $70 to make $210 for a net profit of $140 or 33% over our baseline. This looks like the last model but took an extra year.
Fundamentally, all of these have an impact but which one should you do? Which is the most important? The answer is easy: Do all of them.
Step 4: Improve all Three
The good news is that these three variables – CAC, ARPU, and Churn – are all independent and often the responsibility of different groups in your company.
- As your Marketing and Sales teams know your customers better, they can improve targeting and close customers faster and cheaper which decreases CAC.
- As your Product and Development teams make the product better, faster, and address more use cases, you can sell more or charge more increasing ARPU.
- As your Customer Success and Support teams make customers happier faster and keep them happy, your Churn goes down.
So let’s combine all three variables together:
This time it’s a radically different picture. We still have minor losses in year 1 but break even in year 2 and have profit in year 3. We lose the customer after year 6 but our LTV has increased to $36 so we spent $56 to make $252 for a net profit of $196 or 87% over our baseline.
But wait? What about those IPOs?
The important part to remember is that each of those variables move constantly and independently of each other. In established industries with incumbent players, each company may only be able to tweak and optimize their process by percentage points. Alternatively, in new markets with new approaches, use cases, technology, etc, etc, a company may be able to make step-wise improvement driving CAC and Churn down quickly while pushing ARPU and LTV up quickly.
That’s why companies can IPO without having a profit.
Fundamentally, investors are making the bet that those companies have massive growth, major improvements, and the profit coming eventually and long into the future.
But how can we improve this model even more? The most impactful – but slowest – way is to reduce churn. In the above example, we started with 20% annual churn and reduced it to 16% meaning customers leave us after 6 years. In most SaaS businesses, you want to have churn of under 5% but even if we only drive it to 10%, here are our new numbers:
Our losses start the same but we’ve driven LTV to $60 so we spent $56 to make $420 for a net profit of $364 or 247% over our baseline and making more money at every stage. Here’s how it compares with all our previous approaches:
As noted, this is a massive oversimplification but the principles stand. When you have a company executing well in at least one area, you can make more money. When a company is executing well in multiple areas for long periods of time, the sky is the limit.