Why Investors WANT Startups to Lose Money - Startups 101

[Music] better okay so we we made this video a couple weeks back on how equity works at startups but there's this question that kept on coming and that honestly we needed a whole video to answer which was how to distribute profits and what about profits in a startup does anybody care about it and it is a very fair question like business school 101 we'll teach you that for a company to thrive you need profits that's that you generate more money than you spend but i mean business 101 is right but that doesn't exactly apply to the dynamics of startups so let me give you let me give you an example when facebook acquired instagram this back in 2013 they paid one billion dollars to buy the platform instagram a company with only 13 employees bought today by facebook for 1 billion why did you do it and what are you going to do with it when you look at a company bought for a billion dollars that has no revenue you have to step back and say wait a second at the time instagram had not generated a single dollar of revenue this was all expenses and yet instagrams founders investors ideally employees as well with stock options walked out with large very large paychecks out of that exit a billion dollars by any reasonable metric it would have to be worth somewhere between probably 50 and 200 billion so an amazing acquisition so why do these crazy numbers happen for a platform that generated no revenue well after it got acquired instagram has generated billions of dollars in revenue for facebook and well since facebook's stopped being cool you could argue that instagram is all that mata has got to lure young audiences into their data capturing empire instagram did make a profit eventually except that the original founders and investors they never really collected any of the profits from instagram they made a lot of money but not from these profits and they never wanted to they never intended to collect profits but why so in this video i want to explain that i want to explain how this profit model works i want to run through some scenarios of profit-based businesses and startups and clarify why for venture capitals the truth is that profits are just boring okay so i'm going to start with a very traditional very common type of business marketing agency you can apply this to any services type of business so this company will probably have two very important departments which are growth that means the people who do the sales and the marketing and the business development and essentially that get the new customers and then the costs that means the people who are in charge of doing the actual labor the work that's the designers and the marketers now in a financial model the expenses that scale with your revenue should classify of costs as cost of goods sold and as the company gets more and more clients it obviously makes more and more revenue but also that cost increases proportionally the more clients the more brains that you will need to deliver work for those clients and there are other costs as well such as admin and hr and they also have to scale more or less proportionately to this stuff to your cost so as your business grows the amount of people grows too and this applies to any i mean to many businesses say an e-commerce platform your costs are the products that you sell let's say that still you managed to scale this company to 10 million annual revenue which is still a pretty big company by many measures this might be an organization with 50 people and they're all well paid and happy and they love working here now while the gross margin on the services might be say 40 but the net margin after accounting for all the over costs and everything the net margin usually ends up being about five maybe seven percent so this company this company made 10 million dollars and after paying for all their staff and all their costs they end up with say seven hundred and fifty thousand dollars in ebitda is earnings for interest taxes depreciation and appreciation so now the company needs to pay taxes on this ebitda on this profit in the us that's state and federal and it varies state-by-state but you can round this up to like 25 so the company is going to end up with 562 000 and 500 in profit after paying taxes now the company can choose to pay that to shareholders and that is usually a decision that depends on the board so the board of directors has to agree and in this let's use this example let's assume that they are choosing to keep the 162k in their accounts as cushion as operating capital you know in case there's a recession or a pandemic and and they're they're going to pay out 400 000 to shareholders let's imagine that this company got started with three co-founders on equal share distribution so each one of them is going to get about 133 000 for the year clean profits right no not really no you've forgotten about taxes wait taxes again didn't we just do the tax math well yes again so you want me to buy this place so i can pay taxes that's the double tax on dividends which applies on many countries around the world so assuming that these guys are single and assuming that they make say 150 000 in salary from the company plus the new 133k that they paid in dividends well that effectively moves them from a marginal tax rate of 24 to the full 35 it just applies as any other income for the individual and it's even worse if you're not a us taxpayer in those cases you are taxed at a flat 30 on dividends if you're collecting dividends from a u.s company as a non-us citizen or taxpayer but anyway let's assume that these guys live here in brooklyn their additional take-home income from this 133k in profits is now down to 74 000 because of all the extra taxes that they'll have to pay but that's the founders we haven't even talked about the investors yet let's imagine that this company raised money on some pretty standard pretty normal startup terms to get off the round so maybe an investor came in they invested 500 000 to get the company started in exchange for that they received 15 again this is a pretty standard startup valuation equity distribution we have a whole video about it that's the one i mentioned before our video in cap tables now i'm going to look at the description anyway the investor will make 150 percent of 400 000 60 000 that's their dividend distribution because of the 50 ownership that they have in the business and this is before taxes now assuming that the company continues to operate in the same way after taxes on 60k a year it's gonna take them years maybe decades to even recoup just one x of that original 500 000 investment and that is honestly just too slow they they won't have liquidity meaning they don't have access to the money they can't use it for anything for years they can't really get the money out it's also very risky because the company might fail as many startups do also they're at the mercy of what the board decides if they own 50 of the company they probably only have one vote in a board of directors of three people or maybe five people which is not enough to guarantee that they have a deciding say in these dividends and they might have preferred stock or some other sort of instruments but the point is that the company might just choose to keep all these dividends or it might need to keep all these dividends for growth so they can't get paid out very quickly and it's not an exciting scenario for investors and this is why traditional businesses that have such slim margins they just can't raise money the way startups do and this is a very common confusion here because collecting profits is not the business of venture capital there are investors that will fund these traditional businesses but the checks are usually smaller the equity stake needed is much larger say for example a restaurant so a restaurant may have a financial or an executive founder they're the ones that bring the capital and then on the other side they have the chef and the operator that the person who runs the business and they're both together they got together to build this business maybe they split 50 50. and the risk is still there as any company but the roi may come much sooner because it's half of the profit so why do tech startups get away with million dollar rounds of funding and fraction 15 equity sticks because taking profits out of a business is not the only outcome for that business it's actually just one and arguably the most boring one because aside from dying which is always a possibility a business can either be acquired or it can ipo and both of those are very exciting because your payday comes really quickly venture capitalists actually expect to get a liquidity event an acquisition or an ipo in seven to nine years from their investment so they can cash out they can take the profit pay their limited partners and whatever but essentially use the money for their next investment i still get the occasional founder that they're they're saying like i want to sell my company i want to own this and want to inherit it to my children and that's that's cute that's great it's totally fine that makes your company immediately incompatible with venture capital because it's a different game it's a different business it's not the game of venture capital and fast scaling startups if you want to own 100 of the business it's not for you you are need to be ready for an exit exits are cool because investors don't have to wait to collect the profits or founders they collect the price per share that the buyer is paying and that means an entirely different ballgame in terms of amount of money and even the fact that you can go and do something else and for many of these acquisitions the money that the buyer is paying is not connected to profits so i'm going to give you a few examples i want to give you a few examples of common acquisition scenarios for a tech startup and why they're so much different so much more exciting than profits but before i do that i want to take a moment to thank our sponsor for today's video which is church mogul as you know we don't make money from this video this is not our business we slide being we're fundraising os for founders that's a software as a service and the platform that we use to track our sas revenue our conversions our subscriptions our cancellations has always been chart model and this is surreal like i've seen sas companies bigger than us with millions of dollars in revenue tracking it on spreadsheets they're just not understanding these metrics at all and on our side we've used chart mogul even long before we started our youtube channel to me it helped me understand how these metrics look how they get calculated they even give you the formulas for them and i genuinely can vouch for their product they are the best sas tracking platform automatically reporting mrr ar revenue customer churn rates you can create cohort tables to analyze how your customer behaves over time or maybe you can break them down by their region or or you can filter them out by the marketing campaign that brought them to you and then figure out which campaign is working better not only in conversion but in lifetime value for the customer a great platform truly they're free for any company under 10 000 subscriptions so you can start using them today if you sign up at yourmobile.com link in the description if you have over ten thousand dollars in subscriptions you can get six hundred dollars off on your annual subscription again using the link in the description so turmoil team thanks a lot for sponsoring all those videos this year let's get back to acquisitions and i'm going to start with aqua hires now the easiest example to understand is this aqua hire this is a startup term that comes from joining the word acquisition and hybrid so an aqua hire happens when a company buys out a startup not so much because of their product definitely not because of their revenue but mostly because of their talent and their team and the first example that comes to mind here is a company i know founded by good friends of mine called fly labs they made this really cool video editing platform for your phone and they saw some success on the app store they raised about 1.5 million in two rounds it was clear they were gonna need a lot more capital to reach market dominance this money was not going to be enough and i'm honestly blurring on what information i know because they told me that i should not be telling you about but i'll do my best to keep confidential stuff the point is they were not a profitable business they were growing they had thousands of users many monthly active users they had a revenue model but they were not profitable not gonna be profitable anytime soon about to need a lot more capital to continue growing various companies larger businesses reached out to them because they wanted to buy them out mostly because of their technology the technology of video editing was kind of useful for the potential buyers for this business but most importantly because the team that had built this very powerful app would be really useful for this organization that was trying to build an app that did something very similar and the buyer ended up being google they ended up buying them out for an undisclosed amount to join specifically the google photos team which at the time was still not the product that it is today now when you have undisclosed acquisition amounts that's usually because the number the amount of money that was paid is not a number that you can brag with the offer that a company like google might make to a company like flight labs of course needs to be enough for investors to accept it so it needs to pay investors back at least what they've invested and a little more and of course it needs to be exciting now for the founders and the rest of the team to be motivated to go work at google because that's what google wants they want you to go work there for a few years so the deal is usually a combination of cash that's mostly going to the investors investing stock or time-based bonuses for the team so that again they're motivated to stay with the buyer for a few years so a benchmark that you will hear sometimes and it's not i mean it's a correct benchmark is paying about a million dollars per engineer which may sound crazy it's not that each engineer gets a million dollars no it's that the company is valued on how many engineers it brings to the buyer because engineers are very expensive very hard to find very scarce talent and they're very hard to recruit just look at them there they are stallions so if you can suddenly go out and buy a team bring a team to your company that already has rapport that has proven expertise and a given challenge that you can bring the whole team together to implement that technology together to your stock maybe even recycle some code well this effectively removes a lot of the costs a lot of the risks of building that team from scratch by just hiring strangers and paying recruiters so investors don't make a whole lot of money on aquahires they usually get paid from 1x at least to maybe 1.5x maybe 2x their original investment aqua hires are cool but they are truly mostly a soft landing for a company that is struggling to find another path another very common type of acquisition is the acquisition that goes relates to customers and audience these are more strategic this is like when hubspot acquired the hustle or when business insider acquired morning beer now these acquisitions are happening mostly to buy out the audience that these companies have so hubspot revealed that when this purchase happened the hustle had about 1.5 million readers per month and they revealed that this is what they cared about the most they care about this access to a new audience to allow them to continue growing on this content marketing game that of course is very profitable for hopspot now we don't know the acquisition price on this specific transaction but internet seems to agree that it was somewhere between 25 and 30 million dollars just google it anyway from this information we can infer some things we can run some map for example we can do math and estimate that hubspot ended up paying about 20 dollars per active reader on the hustle hustle had only raised about 1.3 million dollars in capital so assuming that the investors this is just one round so assuming that that round was a reasonable average 15 well they got about a 2x payout assuming that their stock was common and it was even better for the morning for guys they got acquired for 75 million dollars by business insider so the time of purchase they had 2.5 million readers 500 000 subscribers and 6 million downloads on their podcast alex lieberman who is one of the founders he has talked about this acquisition and the transaction and how that was negotiated in a couple of podcasts i'm gonna link both of those in the description by the way alex followed me on twitter and follows our youtube channel which made me feel very much like a celebrity lately maybe he'll watch today's video but anyway the point is both of these both of these are media companies and they were acquired not so much because of their team i mean a little bit because of their team but mostly because of their engaged audience and definitely or very likely not connected to their revenue audiences are valuable they're very very valuable to the buyers in this case hubspot and business insider this is access to more people to more readers to more audience and they can bring this audience and monetize it in the same effective way with all the experience that they already have as media companies and again they're buying out competitors they're removing competition from the table and they're bringing these new smart brains the organization that were able to engage an audience that they didn't necessarily have access to so back to that instagram acquisition you could compare the billion dollar exit price that facebook paid or made a paid to the 25 million users that instagram had at the time of the acquisition that's about 40 per user but it's not about the users or the revenue definitely not the revenue in this case it's the strategic significance of instagram for meta this is younger users this is fresh ideas and it's even avoiding a competitor buying instagram out and then competing more strongly with facebook and that brings me to the last example that i'll share today which is this company called quip which was acquired by salesforce for about 750 million dollars remember that salesforce also bought slack a couple years back quipped was this simple this well-designed office suite this word processor type of spreadsheets platform we considered them kind of a competitor for a while they were not nearly as powerful as their microsoft office counterpart but it was a simple and intuitive platform that had well product market fit with small businesses well they had revenue and they had users when they were acquired i'm sure the 750 million price might have been a multiplier of their annual run rate but it related more to salesforce strategic goal their end goal of building this operating system for sales at the time of purchase the company had raised 45 million dollars in two rounds of funding a series a and a series b this is all according to crunchbase so let's assume that both of those rounds added up to some 30 of equity of the company that investors owned that would mean that these investors went home with 225 million which means five times what they invested in just four years and that 5x in four years that is the essence of venture capital roi it's not about percentages it's about multipliers and quick in a few years this gets even bigger if the company is not acquired but even goes to an ipo that's when it's listed in the stock market and then in that case the value is defined by the market by people and sometimes those markets value companies well above their revenue we've seen that last year just on their potential to change the world and how much they can grow and whether those numbers are real or not it matters very little to these original investors because as a public company when their shares are publicly traded they can just cash out with time and oversimplifying here the kids just sell them all at once but the point is if they sell them or their net worth essentially goes up by 50 or 100 times compared to what they invested originally especially if they got in early and all of this all of this startup investing is extremely risky extremely risky because most startups fail most startups will fail only a fraction of a percent of them will become unicorns and ipo if they're not generating profits they depend on other investors to also bet on them to continue building their vision but that 100x unicorn as an investor will pay for your 90 of mistakes of companies that didn't make it and that is very cold very hard tangible cash that you can collect from a success a startup win like this is life-changing it's generational life-changing money for the founders for their families and three generations below often of course for the investors especially if they got in early an exit also allows everybody to take what they've learned and apply all this knowledge and some of this money that they've made to a new venture and this new venture will have a much better chance of succeeding of achieving this same feat again and in this world of exits and selling your company and ipo profits well profits aren't necessarily the biggest thing you have to worry about all right i hope this video was was useful guys i hope it answers your questions on profits we are trying to hit again this is not our main business but we're trying to hit a million subscribers by the end of the year so if you want to hit that subscribe button make sure that uh your stay tuned on our startup lessons and our property forensics content see you next week [Music]

Channel: Slidebean

Views: 126,634

Keywords: slidebean, caya slidebean, company forensics, caya, startups, startups 101, venture capital, venture capitalist, angel investing, angel investors, startup funding, initial public offering, starting a business, raising capital, startup investment, startup funding 101, startup funding 2022, startup funding explained, venture capitalist explained, seed capital, series a, startup funding rounds, startup funding pitch

Id: CfPrSTJVGrE

Length: 20min 32sec (1232 seconds)

Published: Thu Jul 28 2022