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Sizzle and Steak: The Importance of Profitability

The management team of one of my venture capital backed companies (pseudonym “Hermes”) recently floated this trial balloon: “We’re now profitable at reasonable scale [Ed: after years of hard work and much investment]. We have the beginnings of a great company. We should raise a big venture round and use the money to develop new products and enter adjacent markets, so we can reinforce our position and expand our market.” To do this Hermes would need to sell a big piece of its equity and go back to losing money with a large negative cash flow.

I asked, “Perhaps this means it’s time to get acquired? Then the acquirer could use its deep pockets and sales/marketing resources to exploit this opportunity?” The team said, “No, we don’t think so, we’re concerned the acquirer would not want to spend money that would cause us to report losses, but venture capitalists would do that.”

Isn’t venture capital wonderful? It’s just about the only business where you don’t have to make a profit!

Or not. I think there are two main ways you create value in a venture capital backed business: you create sizzle, or you create steak. [Acknowledgement to my partner Scott Johnson, who introduced me to this idea.]

Sizzle is great, because it creates value very fast. When we invested in Massive, Inc., a company building a network that puts live ads in videogames, everyone knew advertisers were eager for a better way to reach console gamers, who are mostly young males, a valuable, hard-to-reach demo that ad agency types call “the lost boys”. If this worked, it would create a big, new media channel. But, there was deep skepticism that gamers would accept ads. A year later Massive proved that its model worked, and although its revenue was modest, Motley Fool began beating the IPO drum. Sizzle had been created. A year after that Microsoft bought Massive for an attractive [undisclosed] price.

The other good way to make money in venture capital is to build a company that, after a moderate initial investment, grows rapidly with little or no external funding. This requires an incremental ROI of at least 100%: every additional $ million of business has to generate enough cash profit to fund the investment needed to support the additional business. If the ratio of incremental return to incremental investment (incremental ROI) is over 100%, then the company can fund its own growth.

And, after a while high incremental ROI becomes high cumulative ROI for founders and investors. This is “Steak”: a business that delivers real nutrition. Of course, the hard part here is making the company big with limited investment while maintaining good margins. That’s where great ideas, great technologies, and great entrepreneurs come into the picture.

Sizzle is rare: many aspire, but few succeed in creating it. That’s doubly true in a depressed exit market like we have today. So most of the time we need to create steak. This is why VCs are talking [once again, belatedly] about capital efficiency. And this is why it’s a good discipline to ask, “What is the incremental ROI of this business?”

Some companies have a mixture of steak and sizzle: they grow the top line fast to impressive levels, but are slow to become profitable and require a lot of money to grow. This can work, but it’s very risky: the company needs to keep raising money, and if it falters, founders and investors get wiped out. Our portfolio company EnerNOC, founded in 2003, is now a $150m public company (NASDAQ: ENOC), but not yet profitable. Luckily, EnerNOC is a clean-tech company and was able to hit the 2007 IPO window, go public, and raise a lot of money. When EnerNOC reported a weak quarter in February 2008, the stock crashed from a high of $50 to $9, and later down to $5. If EnerNOC had needed to finance at this point, the founders and investors would have been wiped out. But, the company had cash, continued to operate well, got its stock price back up, and expects a profit in 2010: a wild ride with a happy ending.

Companies that get a high ROI business model rolling and scale to $ billions of revenue on their own cash flows are the venture capital equivalent of beef tenderloin. Well-known examples are Microsoft and Google, which grew large with very little financing and were great exits for both entrepreneurs and investors.

Venture capital backed companies do not get an exemption from the discipline of profitability. Just the opposite: to be “steak” they need to be highly profitable. But they do get a deferral: private companies with patient-money investors can lose money for a few years while they get the high-ROI business model rolling. So the question for Hermes is the classic one: would this be a high-ROI investment? Where’s the beef?