The Hidden Metrics That Make Investors Fund Loss-Making Startups
Good morning savvy entrepreneurs and tech enthusiasts!
Lately, I’ve been fielding an intriguing question from our readers: Why do venture capital firms invest in startups that may not turn a profit for years, if ever? Today, we're diving deep into the world of startups, exploring what they are, who funds them, and why certain regions see a flood of investment. We’ll unravel the economics of venture capital and their powerful influence in the startup ecosystem, shedding light on the hidden metrics that drive these high-stakes bets. Buckle up for an exciting journey through the high-risk, high-reward world of startup funding!
What is a Startup?
In its simplest definition, a startup is a newly established business, often in the tech sector, focused on innovative solutions and rapid growth. There are two types of startups that founders can set out to create: 1. Lifestyle Startups and 2. High-Growth Startups. The former is usually a bootstrapped business aimed at providing sustainable income for its founders, often driven by passion and personal interests. Founders usually fund it themselves. The latter is a business focused on rapid expansion and scaling, typically seeking investment to achieve market dominance. Today, we will learn as much as possible about high-growth startups.
What are VCs and Their Role?
A venture capital (VC), as they're popularly known, is a form of private equity and a type of financing for startup companies and small businesses with long-term growth potential. Think of it as a fancy name for funding coming from investors, investment banks, and other financial institutions. Startups go through several funding rounds. There are four official funding rounds: seed funding, Series A, Series B, and Series C.
These funding rounds raise progressively more money. Keep in mind, these rounds usually occur over years. Also, less than 10% of startups that receive seed funding go on to raise capital in Series A funding. This is where statistics such as 90% of startups not surviving more than five years come from. We're not going to discuss the nitty-gritty of the different funding rounds; what you need to keep in mind is that seed funding is the official first stage of the funding process. Participants usually include the founders and family members; however, angel investors and venture capital firms join in as well. Investors get equity in exchange for capital.
What’s Special About the Startups That Do Get Funding?
Investors have a lot of checklists when evaluating whether they can invest in a startup or not. This checklist includes the team, market size, business model, risk awareness, traction and proof of concept, scalability, financial projections, and more. We will look into the topmost of these.
The Team
Investors prioritize the founding team, often believing that the people behind the startup are more crucial than the idea itself. For those who watched the series Silicon Valley, you may remember Russ Hanneman saying to Richard Hendricks, “I don’t care about the idea, Richard. I’m investing in you.” A skilled and passionate team with a proven track record can significantly enhance investor confidence.
Investors assess whether the founders are committed, trustworthy, and capable of executing the business plan effectively. This is why over 80% of startups in Africa that receive funding are founded by individuals who received Western education from Harvard, MIT, Stanford, etc. These are credentials that investors trust.
Market Size
The potential market size for the startup's product or service is critical. Investors want to know if the market is large enough to support significant growth. A startup targeting a small or niche market may struggle to attract investment, as investors seek opportunities with broad, scalable market potential. This explains why the top four destinations in Africa that receive funding are in the top six most populated African countries and why China is creating new millionaires every day.
Scalability
Investors look for startups that can grow quickly and efficiently. Scalability indicates that the business can expand its operations and revenue without a corresponding increase in costs. This potential for rapid growth is often a key factor in attracting investment. If you can prove to investors that your idea can scale, you’re in money, my friend.
Another Buzzword Lately: Product Market Fit
Investors love startups that have product market fit. Product market fit refers to the alignment between a product or service and the market it serves. Can you think of some crazy ideas that would make a big impact, but just not in your country? I have dozens.
Ok, now that we know startups, VCs, and what they look for when considering investing, let’s talk about why they continuously fund loss-making startups.
Takealot
Let’s take e-commerce giant Takealot from South Africa. They have been in business for 14 years, and they’re yet to make a profit. What is it about Takealot that investors like? The South African e-commerce market is experiencing significant growth, with its valuation reaching approximately R71 billion (around $4.5 billion) in 2021. Looking ahead, the market is projected to continue expanding, with forecasts estimating it could be worth $7.9 billion (approximately R315.8 billion) by 2027. Of that market, Takealot holds a strong 20% market share, though their highest was 25% before Amazon came in earlier this year. The company’s marketplace has 10,000 active sellers, indicating its significant role in the local e-commerce ecosystem.
Uber
Let’s look at another example, Uber. We’ve all heard of them or taken one before; it’s the coolest way of getting to the office. Uber operates in the niche sector of tech that has come to be known as ride-hailing. They don’t own any taxis; their solution is a mobile app that connects drivers with people looking for a ride. The U.S. ride-hailing market is projected to reach approximately $60.56 billion by 2029, growing at a rate of about 2.37% annually from 2024 to 2029.
Globally, that figure will reach $185 billion in 2029. Uber, founded in 2009, dominates the U.S. ride-hailing market, controlling about 65% of the total market share. But are they profitable? They reported their first-ever annual operating profit as a limited company in 2023, generating $1.1 billion in profit, which still pales in comparison to the losses they have made over the years.
More Examples: Amazon, Facebook, and Netflix
There’s no shortage of examples. Many startups, including Amazon, Facebook, and Netflix in their early days, went for many years without making a profit, yet investors still pumped money into them, and their valuations only continued soaring.
Flutterwave
One last example: Flutterwave, the Nigerian fintech startup. We have mentioned them so many times here at Rooibos Radar. Free publicity—they should start paying us. The company has reported losses in recent years, with a net loss of $106,672 in 2023, following losses of $102,093 in 2022 and $61,274 in 2021. Despite these losses, they have received $475 million in funding since their inception in 2016.
Since its Unicorn round in March 2021, when Flutterwave had processed 140 million transactions worth over $9 billion, the company now processes 200 million transactions worth over $16 billion across 34 African markets. They serve over 900,000 businesses globally. They are a Unicorn with a valuation of over $3 billion but aren’t profitable. What?
The Big Question Mark
Clearly, startups have no shortage of services, products, monetization strategies, or customers. So why are they running losses in the first place? Let’s go over some of the reasons why startups often operate at a loss initially, even if they have customers and are generating revenue.
Growth Trumps Profit
When it comes to startups or even innovations within an established company, being first means nothing. Startups know this: if they prioritize profits early, copycats will pop up everywhere, resulting in them losing out. As a result, many startups focus on rapid growth and market share expansion in the early stages. They invest heavily in areas like marketing, customer acquisition, and infrastructure to scale quickly, even if it means operating at a loss in the short term. The goal is to establish a strong foothold before optimizing for profitability. And VCs are very much onboard with this.
Cost of Scaling
The costs associated with scaling a startup can be substantial. Startups often need to invest in technology, talent, and infrastructure to support their growth. These upfront costs can outweigh revenue in the early stages, leading to losses. From a technology standpoint, this means more compute, such as more AWS or Microsoft Azure servers, and investing in skilled developers to build and scale the product or service.
Pricing War
Some startups use aggressive pricing to gain market share and attract customers. They may offer products or services at low prices, even below cost, to undercut competitors and build a customer base. Wave, a mobile money startup in Senegal, has employed an aggressive pricing strategy by charging a fixed transaction fee of just 1%. This was to undercut the pricing of Orange, the largest telco in the country, forcing them to lower prices to remain competitive. Get users loyal to your product or service, then, and only then can you hike the price.
Long-Term Investments
Startups in certain industries, like technology, often invest heavily in research and development to create innovative products and services. These R&D investments are critical for long-term success but can result in losses until the products generate sufficient revenue. Investing in R&D enhances competitiveness by helping startups stay ahead of the curve and adapt to changing market conditions. This also attracts talent and funding, as startups with a strong R&D focus are more attractive to talent and investors who recognize the value of innovation. Some companies that have done well with long-term investments are SpaceX with reusable rockets and Google’s moonshot projects like self-driving cars, which have resulted in Waymo.
The Big Why?
Well, as we see, investors fund loss-making startups because they see the potential for massive returns, strategic market positioning, and rapid scalability. These startups prioritize growth over immediate profits to dominate their markets and innovate within their industries. VCs are confident in the skilled, passionate founding teams and share a long-term vision of success. Ultimately, the hidden metrics of market potential, team strength, and scalability drive these investments, betting on future profitability over short-term gains.
Catch you on the next one, and stay caffeinated.