At a loss? There's always the 'path to profitability'

Singapore

THESE days, talk about the slew of loss-making tech firms headed for public listings invariably triggers the buzz phrase "path to profitability".

With public-market investors lacking the patience that private-market investors need, startups are increasingly under pressure to show a viable plan that enables the business to staunch the bleed.

But what exactly is a "path to profitability"? While the jury is still - and might always be - out on the exact definition, there is some common ground for people to understand what a startup has to do to be on that path.

South-east Asia has yet to see the bout of listings that would be on the region's wave of blockbuster exits, but the term "path to profitability" has been tossed around since startups such as Uber and WeWork faced backlash for wanting to list at sky-high valuations despite burning through millions in cash.

And with the recent spread of Covid-19 causing startups to hit the brakes on some of their expansion and fund-raising plans, it is timely that companies take a harder look at the resilience of their business, including how close they are to financial independence.

On a fundamental level, it means taking steps to turn the company's "unit economics" positive. Unit economics refers to the revenue and costs associated with a single unit in a business model.

In e-commerce marketplaces, for example, a typical unit is one customer. Revenue includes the cut of the e-commerce transaction the marketplace gets to keep. The costs associated with the customer include marketing expenses, also known as "user acquisition cost".

The challenge with evaluating unit economics is that the conclusions one can draw depend on several factors.

One factor is timing.

Hian Goh, partner at Openspace Ventures, said: "If you pay, say, 30 per cent of your costs to marketing, but you acquire a user that has a very long lifetime value, then the long term profitability is good.

"But in the short term, it looks like you are unprofitable."

"Customer lifetime value" refers to the revenue that a customer is expected to generate over his or her entire relationship with the company.

To have a better sense of their unit economics, startups often use a metric called CLTV/CA, or customer lifetime value divided by the cost of customer acquisition. The higher the ratio, the less the company is spending to acquire a customer that will generate a higher revenue.

The tricky part about calculating the ratio is that it is sometimes more an art than a science. "It's hard, for example, to determine the lifetime value of a customer if you have only been in business for nine months," said Mr Goh.

To make more accurate assumptions on the CLTV/CA ratio, some startups use a method called "cohort analysis", which breaks down users into groups based on when they first engaged with the product or service, and then measures the rate at which the users stop using the product.

Restaurant-booking and food-discovery platform Chope, for example, uses cohort analysis to judge the success of its user-engagement efforts.

Chope chief executive Arrif Ziaudeen said: "Our approach is data-driven: We segment Chope's users into cohorts at a high degree of granularity, tracking retention and frequency to ensure each segment's economics are sensible."

The company has been turning a net profit in its largest market, Singapore, since Q1 of 2017. It ended last year "very close" to profitability in two of its four other markets.

Mr Ziaudeen believes a "path to profitability" can be achieved if revenue can grow without extra marketing or manpower.

Indonesian logistics startup Waresix, which turned a positive Ebitda (earnings before interest, taxes, depreciation and amortisation) after two years, uses data on trucking costs to keep an eye on unit economics. In the unit economics of its business model, the revenue per tonne transported is compared to the cost per tonne transported.

The startup's platform aggregates logistics orders and places them with transporters. In a simplified example, an 800km journey transporting fast-moving consumer goods (FMCG) from Surabaya to Jakarta would yield a revenue per tonne of US$12 to US$13. This revenue comes from the fee charged to the FMCG company.

The cost per tonne depends largely on how much it costs to run a truck for the shipment. Assuming the truck is six to seven years old and leasing payments have been settled, and taking into account direct costs such as driver and fuel costs, Waresix can typically fix its trucking cost at 70 to 75 per cent of revenue. It keeps the rest as commission.

Andree Susanto, founder of Waresix, said: "By understanding the transporters' cost structures, I can better derive my commissions. And my value proposition to the (small and medium-sized) transporters is very clear - you can get quality orders."

Waresix's platform is also aimed at eliminating middleman brokers that add costs and reduce transparency.

Even if a company has charted a path to profitability, the startup world is never so clear-cut. For instance, the entrance of a new competitor can significantly drive up user acquisition costs. A "black swan" event like the Covid-19 outbreak could derail cash runway plans, and cause startups to lay off staff in an attempt to do more with less.

Then there is the common criticism directed at loss-making companies for their rapid cash burn. The reality is, startups often burn through heaps of money to acquire users or merchants and build their network.

Most often, they are counting on "network effects", where the more people are using the service, the more valuable the service becomes. A greater network effect drives down the user acquisition cost and makes the service more sustainable.

Among the most prominent South-east Asian firms that have benefited from this are the ride-hailing and e-commerce players, which have been able to reduce promotional expenses. The trouble is, startups that have lost out to competitors still have to pay the cost of attempting to build a network from scratch.

Overall, a key financial metric to judge the prospects of profitability would be the contribution margin percentage to cover fixed costs, said Chua Joo Hock, a managing partner at Vertex Ventures. Contribution margin is revenue minus variable costs.

"If it is positive, then it is a matter of increasing the revenue, since fixed costs do not grow proportionally to revenue growth," he said.

Jenny Lee, a managing partner at GGV Capital, said the firm looks at whether the startup can develop multiple revenue streams to beef up the company against unexpected events.

"In today's highly uncertain environment with a lot of macro-industry, geopolitical and environmental risks that are usually beyond the control of many startups, we advise prudence and encourage an effort to develop at least one near-term profitable cash stream that can sustain the business, while these startups experiment and search for a larger revenue or monetisation opportunity," she said.

With the greater emphasis on future profitability, a startup needs to be aware that rapid topline growth does not necessarily mean that it is on the yellow brick road to El Dorado. After all, a truckload of revenue can be worth a lot less if the company is losing money on every transaction.

It all goes back to fundamentals. Recall Juicero, the swanky and well-funded Silicon Valley startup that sold US$400 juicer machines and packets of diced fruits and vegetables - only to find itself ridiculed and shut down when it was revealed that one could easily create juice by just crushing the juice packets with one's bare hands.

Tan Choon Hong, managing director of private equity firm Northstar Group, said: "Growth for the sake of growth is a path that a lot of startups have followed over the past five years or so. With enough capital available as support, these growth numbers can sometimes be almost exponential and often look very attractive.

"But growth can be distracting. Growth alone does not necessarily ever lead to profit."