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Companies that strive for profitability realize early that it requires a tight balance between earning and spending, a focus on marketing and customer relationships, and a constant dialogue with the market to ensure product-market fit.
It goes without saying that a company that loses money has a limited lifespan.
Let’s begin with the example of a typical Startup with around 50 employees. Most of the staff are engineers and product people, and the company has yet to earn sales revenue; however, they have just raised $10 million from investors. The Startup’s expenses, their so-called “burn rate” (i.e., their average monthly spend), is approximately $1 million per month.
Simple math tells us that in 10 months, the company will be unable to pay its expenses and will be forced to close. Raising an additional $10 million takes at least half a year, so management will begin the next round of fundraising immediately upon completion of the previous round.
But this strategy begs the question: who has time to concentrate on customers when all the attention is focused on raising money?
The answer is: they don’t. Ultimately, companies that focus on raising capital at the expense of their customer relationships will fail quickly.
What is Profitability?
In this context, profitability means positive cash flow. Simply put, to be profitable, a company must earn more money from customer purchases than they spend on expenses such as salaries, rent, cloud services, marketing, etc. Excess funds should be reinvested and used for future growth and expansion in the market.
It’s important to notice the close connection between money and time.
When a company is not profitable, the amount of money saved and its burn rate accurately determine how much time it has to crack the formula for profitability.
A company that loses $10,000 US a month has a fixed lifespan, and how long it can survive is determined by dividing the money in the bank by 10,000. Like in our example of the Startup, this simple calculation gives us the exact number of months a company will last until it starts making money (i.e., becomes profitable) or raises more capital.
The phrase “burn rate” – especially the word “burn” – should describe how management feels if the formula for positive cash flow is unknown.
The most famous contemporary example of a giant company that has not cracked the formula is WeWork.
WeWork was founded in 2010 by Adam Neumann and, until September 2019, raised a cumulative sum of $12.8 billion US. In September 2019, the company attempted to go public on the New York Stock Exchange with a market value of $57 billion and was forced to publish its financial statements.
It became clear to potential investors that the company was burning cash at a dizzying rate. As a result, the IPO was canceled, Adam Neumann was pushed out of the company’s operations, and WeWork’s market value was estimated at below $10 billion US – less than the money raised for the company.
The lesson is that no business plan survives its first encounter with reality. In the case of WeWork, its ‘encounter with reality’ showed that its business model could not support its spending, and ultimately the decisions of its leadership led to major restructuring.
A company’s revenue depends first and foremost on its ability to reach potential customers and persuade them to purchase its products. However, this is the central problem for any business.
To overcome this, a company’s management needs to understand, in-depth, who potential customers are, how to reach them, how to ensure marketing is effective, how to explain what the product is/does, how to convince customers that the price is worth it, how to face competitors, etc.
Unfortunately, it is almost impossible to answer these questions without lengthy processes of trial and error.
It is also fundamentally wrong to assume that the product you have worked so hard on will immediately attract the customers you need to turn a profit. Except in isolated cases, no prospective customer is looking for the solution you built for a problem they may not know they have.
Moreover, even if a company makes a product everyone needs, it must still reach its target audience. The best real-world example of this is the pharmaceutical industry.
There is no doubt whether a sick and suffering person will seek a cure for their illness, and pain and there is no need to “sell” it to them. Likely, the patient will search for the necessary treatment, and their doctor will prescribe the best available medication for their condition.
In practice, however, 19% of spending at pharmaceutical companies is on advertising and marketing, with the ten largest US drug companies investing $47 billion US in 2019. This reality is apparent as it’s difficult to watch television in the United States without being bombarded with drug commercials.
The takeaway is that companies still need to invest in marketing even when a product is necessary – just because a product solves a problem does not mean it will immediately boost sales.
The art of building a profitable company is a long process of dialogue with the market. This conversation allows a company to find its foothold in the market segment of customers willing to buy its product or solution.
It also profoundly affects defining the product and tailoring it to customer needs.
Understanding product-market fit focuses a company on the select number of essential features that motivate customers to purchase the product. When a product or solution is smaller and narrower in scope, it takes less time to develop and lowers the cost.
Think for a moment about the vast capabilities of Microsoft Word beyond word processing and the small fraction of those features you actually use. For you, those other capabilities were a waste of development resources.
However, for other customers, these features are essential to how they use the product, and Microsoft would not have added them had they not understood what customers needed from their software.
The old cliché is true: time is money. Unfortunately, trial and error take time and cost companies money. Therefore, a company that strives for profitability should live by two hard and fast rules:
Profitable companies also understand the needs of their target market and strive to keep their products lean and efficient to reach the largest pool of customers possible.
In an upcoming article, we will discuss effective and inexpensive ways to develop a dialogue with target markets.