What are the most common mistakes new businesses and startups make when trying to be profitable? originally appeared on Quora - the place to gain and share knowledge, empowering people to learn from others and better understand the world.

Answer by Mathew Lodge, Startup COO, on Quora:

The biggest error is not thinking about repeatable profitability early enough, which leads companies to raise the wrong amount of funding and build out the wrong organization to be successful.

That is contrarian advice in Silicon Valley these days. Conventional SV wisdom says that the focus should be on finding and solving the problem early on, and that focusing on making a profit can wait until later, after you have established product-market fit. The follow-on theory is that by ignoring profitability, you can build a business faster by putting more resources into it vs. a competitor who spends less because they want to generate cash.

Fundamentally, it comes down to this: the sooner you can get to $1 of free cash flow, the more control you have over your destiny. You can invest every dollar beyond that first $1 in growing your company, but until you get to that first dollar the people who fund you have ultimate control, regardless of the equity position.

Why? While I totally agree that finding product-market fit deserves most attention early on, I have three problems with the conventional wisdom of ignoring profit:

  1. The price and cost of an offering is part of product-market fit, and it also tells you what kind of selling approach is viable (i.e. can it sustain the cost-of-sale or cost-of-acquisition?) The price point has to be acceptable to customers and high enough to sustain and grow the company behind it -- not just the R&D team, but sales and marketing too. This is especially vital in B2B businesses where cost-of-sale may be 2x cost of R&D, a fact which many engineering-minded founders don't realize until they no longer have the cash they need to build it out. Savvy founders raise more money if they know they will have a high cost of customer acquisition.

    Hardware companies get this instinctively because they will quickly go bankrupt if they get it wrong -- building a physical thing forces you to think about how much it will sell for, what the cost per unit has to be, and what sales model the margin can support. That has a huge impact on how the product is engineered. Software companies don't face the same immediate extinction threat, so they often ignore it at their peril. SaaS companies should be looking hard at price and ARR (annual recurring revenue) vs. CAC (cost to acquire a customer) and what that means for how the product is engineered.

    Thinking about this trade-off may lead you to take different product decisions: pick a higher price point, add a secondary product you can sell to increase deal size, make a product that can be sold without a sales call, simplify install, eliminate professional services etc. It's hard to retro-fit these solutions later. And if you get them right, you have a huge advantage over competitors that ignore them because they'll be distracted fighting the inevitable fires that will flare up along the way.

  2. The problem with ignoring profitability because your investors say so is that they can quickly change their minds. This applies to professional investors like VCs, but even more so for new businesses funded inside larger organizations.

    The only way to become profitable quickly is to cut quickly and deeply, damaging your ability to execute and taking a hit to morale. The closer you are to achieving profitability, the more insulated you are from the slings and arrows of outrageous investors.

    There are all kinds of reasons why investors change their minds, especially in a market downturn. One VC put it succinctly when he advised me you can tell what a VC's priorities are by knowing where they are with their fund. For example, the VC may need to placate anxious general partners or close out the fund.

  3. Ignoring profitability so you can invest more only makes sense if you think profitability implies returning cash to shareholders. The case for delaying profitability to invest in sales or product is only sound if you are confident you can raise more funding. However, this argument is deployed to excuse companies that simply do not make money at the unit level and which have no coherent plan for how they'll raise prices and/or introduce new products that customers want, and/or grow sales.

    Twitter fell into this trap: militantly proclaiming in early years it was deliberately not thinking of how to make money, just building a great platform. Twitter is now struggling on multiple fronts: growing sales, introducing new features to sell more ads, trimming the fat from a bloated R&D org, and employee churn. It's a case study in how not to be profitable that almost writes itself.

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Published on: Jul 20, 2017