It’s common knowledge to many: Tech companies don’t have to be profitable to be considered successful early on, and sometimes for years. Instead, success often is measured against building blocks toward profitability, such as continuing to grow customers, market share, or revenue.
“It’s very counterintuitive that a company that loses money, technically, is continually going up in value” for people not ingrained in finance or venture capital (VC) technology investing, said Cameron Stanfill, a VC analyst at Seattle-based PitchBook, a financial data and software company.
Companies aren’t spending money on things that go away, but are spending it on technology and infrastructure, developing more important software, and software that does more important things, he said.
“They’re investing in people; they’re investing in the software that does create value for people and the company in general,” Stanfill said.
In a March 2019 report, PitchBook examined 146 venture capital-backed startups (tech and nontech) worth at least $1 billion that had completed initial public offerings since 2010 and found 64.3 percent were unprofitable on an EBITDA basis (earnings before interest, taxes, depreciation, and amortization) at the time of IPO.
In 2020, looking at all VC-backed IPOs, not just those worth at least $1 billion, 51.6 percent were unprofitable as of July 7, PitchBook found.
Amazon — which incorporated in 1994, opened “Earth’s Biggest Bookstore” in 1995, and went public in 1997 — didn’t record its first annual net profit until 2003, as it plowed revenues and investments into the business to improve and grow.
“That company is a poster child for the tech industry, because the pitch is not to customers; the pitch is to investors,” said Michael Schutzler, CEO of the Washington Technology Industry Association (WTIA).
“The pitch to investors sounds like this: I have a different way of doing business, or I have a different product, and the marketplace doesn’t realize that it needs this different product or the different way of doing business,” Schutzler said. “But once the marketplace catches on to what I’m doing, my revenues will dramatically exceed my expenses, but it’s going to take a long haul to get there. And so I’m going to try to convince you investors, or bankers, or some combination, to essentially lend me money for a long time until my theory is proven true.”
In Amazon’s first letter to shareholders as a public company in 1997, founder and CEO Jeff Bezos wrote: “We believe that a fundamental measure of our success will be the shareholder value we create over the long term.” He emphasized long term with italics, adding later that because of that focus, “We may make decisions and weigh trade-offs differently than some companies.”
The wait was worth it.
In 2019, Amazon reported $280.5 billion in net sales and $11.6 billion in net profit. Amazon’s market capitalization was $1.6 trillion on Aug. 19.
Google and Facebook are two other examples of wildly successful companies where investors were willing to wait for future profitability, Schutzler said.
Kellan Carter, who recently co-founded Fuse Venture Partners in Seattle and is a former partner in Ignition, a Bellevue VC firm whose success stories include backing DocuSign, put it this way: “You invest to go win in a market — and sometimes that means burning money upfront to go capture market share.”
That also means backing phenomenal teams that see that opportunity and know how to go navigate that market, said Carter, general partner in Fuse with co-founder Cameron Borumand.
It takes venture capital for the engineering resources to build a software product before it can be sold, “But once you have a product, it doesn’t cost anything to really deliver because software has very, very high gross margins,” Carter said. Also, a common and attractive business model with software, especially Software as a Service (SaaS), includes annual subscription contracts paid up-front, so the working capital model is conducive to a great business, he added.
The time horizons for venture investments can sometimes be elongated, he continued, noting DocuSign as an example. Ignition backed that company about 14 years before its IPO. It took time for the market to warm up to signing important legal documents electronically, but once it did, there was a major behavioral shift, creating a massive win for investors, Carter said.
The Pacific Northwest’s role in technology is significant, he said, noting the Seattle region’s hosting of critical cloud infrastructure like Google Cloud, Amazon Web Services, and Microsoft Azure, which is fundamentally driving the internet and how software is consumed and built.
Asked about tech companies seemingly getting a pass on profits for a while, PitchBook’s Stanfill said the concept of growth recently has been more important to many capital allocators and investors in the public and private markets. They’re looking for companies that can grow revenue from things like sales of more product or software subscriptions.
“Whatever the company is spending money on, that has been somewhat overlooked as long as the growth is continuing for the revenue, and as long as they’re kind of continuing to hit targets,” he said.
Since the financial crisis of the Great Recession, as interest rates went to near zero, growth in investment categories like traditional bonds or even some public market stock didn’t produce the growth returns a lot of people look for, he said. So investors started looking at tech companies, and money flowed into venture capital.
Biotech and pharmaceutical companies are good examples of sustaining losses early and sometimes for long periods as new drugs make their way through the clinical trial process.
Biotech companies make up perhaps 35 percent to 40 percent of total VC-backed IPOs in a typical year, and the biotech business model tends to be unprofitable until clinical trials are concluded and the drug can be sold, Stanfill said.
Tech companies often will make a case that they can create a better long-term return for investors by pumping money back into the business, he said.
“While that drives accounting unprofitability from a net income perspective, it ends up creating value potentially for holders of the equity or investors in the company,” he said.
VC has grown to cover a large universe of companies, from startups to private companies worth billions of dollars, but it tends to back more tech-based, nascent business models, buying equity in the companies in return for the investment and looking for continued growth in the business. Eventually, VC backers will exit by selling their equity into future VC rounds or when the company goes public or is bought out.
In general terms, a VC fund typically runs for about 10 years, with five years generally spent investing in the business, and about five spent harvesting those investments, although it doesn’t always work that way in practice, Stanfill said.
Through mid-July, about 32 percent of all VC capital in the United States had gone into software, which covers most of what one would think of as tech companies, Stanfill said, adding that the percentage has remained fairly constant.
WTIA’s Schutzler said typical investments in tech startups don’t rise to the size of those made in Amazon or Facebook.
“Generally, it’s very unusual for companies to raise more than $100 million in tech these days because there isn’t as much infrastructure cost necessary to develop whatever it is they’re building,” he said. “If you’re just building software or just building an application that’s on the internet, they typically don’t need to raise more than that. It’s very unusual.”
And investors will typically see a return on equity sooner than hitting that threshold, he said.
“It’s only in these very large global, many billions of consumers, or many billions of transactions required before you get somewhere, then you’re going to require a larger investment,” Schutzler said. “But most applications, I mean the vast majority of the applications that are invested into by angels or venture capitalists, they don’t raise much more than $100 million, maybe $200 million if you’re really big.”
Even among the largest VC-backed startups (from all sectors, not just tech) in the Seattle metropolitan statistical area (MSA) over the last 20 years, the majority showed less than $300 million in VC raised to date.
From 2000 through July 9 this year, almost two-thirds of the 25 top VC-backed startups from all sectors — ranked by amount of VC raised to date in the Seattle MSA, which includes Bellevue, Kirkland, and Redmond — had raised between $155 million and $289.4 million, according to PitchBook data.
Nine of the 25 are software companies, and nine have Eastside headquarters.
PitchBook also looked at the top Washington-based companies considered unprofitable by business status at the time of IPO (for IPOs from 2015 through July 7, 2020). Four Seattle MSA companies made that list.