Easter Hunt: where is the profitability?

An area that is often lamented by European entrepreneurs is the conservative approach that their target investors take to achieving profitability relative to their American counterparts. Whilst I don’t dispute a difference in attitude and appetite for risk, if you read some of the underlying thinking behind these investment theses and think through the logic behind investing in Fred Wilson’s “large networks of connected users”, I don’t believe American professional investors are discarding the importance of commercial success to the extent we may believe, rather they have changed their metrics. Anecdotally it is also interesting to hear that companies like Facebook were actually profitable at a very early stage which is probably a departure from conventional thinking.

The first implicit assumption that our US contemparies have become comfortable making is distinguishing bottom line profitability from unit economic profitability. It’s clear to me that the value of an Internet/software company should derive predominately from its ability to grow extremely rapidly (accompanied by potential to sustain/accelerate this), closely followed by the underlying unit economic profitability and its future prospects. That being the case “Net Profit” is no longer as relevant a measure of value in a startup or even developed Internet/software business, but financial guidelines are still needed to help steer the business.  Bessemer’s 6 C’s of cloud finance do a good job of this (http://www.bvp.com/cloud).

It’s not just the software markets that are being disrupted, it’s the way these companies are being valued too.

Take the large networks of connected users. By 2001 it was clear that Google had stumbled upon a way of effectively monetising an internet service that drew in the attention of millions of users. That monetisation has clearly been spectacularly successful. Is it really so difficult to believe that Facebook, Twitter et.al will be able to capitalise on user engagement to achieve significant commercial benefit?

The ability of US investors across the spectrum to appreciate and adopt a shift in valuation metrics, from investors in Salesforce at 10X revenues to start-up investors, creates the funding eco-system that is necessary to provide these companies with an unfair advantage in financing their quest to capture global markets.

That unfortunately is where we Europeans come unstuck. Much as we’d like to build the global Internet and software companies of tomorrow, unless those that advise the larger providers of capital this side of the Atlantic wake up, early stage investors in Europe have little option but to raise growth capital in the US (and hence start to migrate West) or sell early.

Big market or mid-market?

As we develop our Trans-Atlantic growth model, investing in businesses with some UK traction and expanding them into the US, my mind is constantly being drawn to competitive advantages/disadvantages of the respective geographies. One of the advantages that is often quoted but I’ve never really heard explored at a more granular level is the size of the market, and I’ve been thinking about this particularly in a B2B context for SaaS or cloud companies. The fact is that US SaaS companies of a similar vintage seem to be an order of magnitude larger than our European companies, which often gives them access to more firepower in terms of financial resources, people on the ground, marketing spend etc.

While the fact that the US market is bigger is not disputable, my thoughts are drawn to the key aspects of the US market that provide an advantage to US start-ups versus their European compatriots, and whether we can consistently take advantage of those characteristics.

While I’m no expert in the vagaries of the mid-market itself I do get the sense that UK SaaS businesses tend to rely on big name companies and/or government for their business, while US businesses of a similar vintage seem to amass huge numbers of customers, most of them from the mid-market. Closing deals regularly is excellent for providing that drum beat that dictates the cadence of an organisation, irrespective of the size of those deals.

Some of the key advantages of the US mid-market appear to be:

  • Its big enough to provide a segment that aggressively adopt new product
  • Procurement is simpler
  • Getting to the relevant buyer is easier (though he/she isn’t always thinking so clearly about what they want)
  • The balance between getting things done and protecting your job is more favourable for suppliers
  • The American culture of risk-taking is conducive to adopting new products and services

Now clearly there are risks that go with these advantages – some good points here http://bit.ly/xF5eeI, notably it’s big so “aim before you fire”. But if we Europeans want to compete head on, we need to master selling into this segment quickly.

It was interesting to hear Eric Reis defining the three engines of growth (viral, paid and sticky) – but there are other ways of thinking about engines of growth – the British middle class driving consumer spending, the German Mittelstand driving their economy (arguably Europe) and today, the American mid-market driving efficiency and hence innovation through their demand for start-up products and services. We should be proud of the innovation coming out of this country, but the best way to shine a light on it is to turn it into big valuable companies exploiting the best markets to sell into that are out there.