Companies must have profits, or they die. Those simple laws of corporate mathematics haven't applied for many tech firms on the other side of the 2008-2009 financial crisis.

March 24, 2017

4 Min Read
Key to Control in Silicon Valley Is Simple: Make Money

By Bloomberg

(Bloomberg Gadfly) — Silicon Valley technology executives tend to be control freaks. Snapchat's founders made sure they didn't have to listen to stockholders when deciding how to run the company. When Marissa Mayer was a senior Google executive, she instructed her staff to test 41 shades of blue to find just the right color for a website toolbar. Jack Dorsey made sure Twitter headquarters were stocked with coffee from his favorite Bay Area spot. 

And yet too many young companies are ignoring a step that could ensure they stay in control of their destinies. They could turn a profit. 

This isn't exactly a novel idea in business. Companies must have profits, or they die. Those simple laws of corporate mathematics haven't applied for many tech firms on the other side of the 2008-2009 financial crisis. And that has been perfectly fine. Investors in the go-go years have been willing to allow tech companies — both young public companies and private startups — to spend big and sacrifice profits to fuel expansion and sales growth. Yes, that has made many young tech companies riskier, but the potential rewards are greater, too.

It's true that many startups and young public tech companies have rethought the growth-versus-profits seesaw. Tech companies — particularly the business software firms — have gotten higher valuations if they have a healthy mix of growing sales and reasonable profit margins. Startups including Dropbox and HotelTonight have turned themselves inside out to stop bleeding cash. 

But the profit-loving trend hasn't reached everyone. Among U.S.-listed tech companies with at least $100 million in annual revenue, about 23 percent posted negative free cash flow in their most recent fiscal year, according to a Gadfly analysis of Bloomberg data. Nearly three-quarters of the 27 tech companies that have held IPOs in the U.S. or filed to go public since the beginning of 2016 were free cash flow negative, Bloomberg data show.

Among startups, it's also safe bet that the vast majority of tech unicorns — private companies valued at $1 billion or more — are losing money. One of Uber's (recently departed) senior executives joked that he had expected a profit-and-loss statement, or P&L, but found only the "L," my Bloomberg News colleague Eric Newcomer reported this week. 

In an industry optimized for growth, there is a huge downside: When there is a slight hiccup in business, the pain inflicted by investors can be excruciating. 

Flashback to a year ago at LinkedIn. It was a company built for growth. LinkedIn was in the black on the basis of free cash flow, and revenue was booming, but it had been net-income negative for a couple of years. Then in February 2016 it warned investors that growth wasn't as promising as expected.

Investors had a change of heart about the wisdom of plowing money into unprofitable and richly valued tech companies. LinkedIn's share price fell 44 percent in a single day. Microsoft and other suitors came calling after the market panic, and LinkedIn said yes. It's impossible to know for sure, but if LinkedIn weren't so jury-rigged for growth, its shares most likely wouldn't have plummeted so much, and maybe it never would have sold to Microsoft. LinkedIn's losses helped trigger a stock panic, which led the company to sell.

Tech valuations are more sane now than they were during LinkedIn's fear sale. But companies once in control can still find themselves short of options. GoPro became unprofitable when its camera sales slipped, and the company was forced to change its strategy and slash jobs to pare losses and avoid borrowing money. That is the cost if the quest for growth fails.

Recently Tom Kemp, CEO and co-founder of business software startup Centrify, said the 2016 market panic that hit LinkedIn was a wake-up call. Centrify scrapped a sales growth target of 40 percent or higher and opted not to take as much money from outside investors. Kemp said Centrify was operating cash flow positive under generally accepted accounting principles in its quarter that ended in September, more than a year earlier than the company had mapped out at the beginning of 2016.

Yes, Centrify isn't as big a company as Kemp had planned, but he reduced the risk he'll be forced to sell his company or try to take it public before it's ready in order to pay the bills. If Centrify does go public, Kemp thinks he'll have more breathing room if something goes wrong a few quarters after the IPO.

Kemp's attitude was refreshing. Not every tech company needs to plan world domination and growth rates to the sky. Even in technology, sometimes the tortoise wins the race. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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