Should VCs invest in profit making companies or loss making companies.
For any seasoned VC – the answer is obvious. Loss making company investments can be very profitable. And profit making companies don’t need risk capital – they need growth capital from banks and public markets. The core business of a VC is to provide risk capital.
But for the public at large or newborn VCs – this may seem counter intuitive. This is also a question that an ai system may not be able to answer. Nor will you find an answer on Google. MBA schools don’t answer such questions. Don’t ever make the mistake of asking your CA. If he actually knew the answer, he would not be wasting his time in practice.
First point is that as a VC, you are concerned with your own profit, not the profit of your portfolio company. So your job is to buy a share for say Rs 10 and sell it for Rs 100. Your profit is now Rs 90. As long as you make a profit, the portfolio companies profit doesn’t matter.
Second point is that profit is an opinion. That opinion depends on the accounting policy, the taxation laws, revenue recognition, owner intent, accountant competency and several other considerations. Suffice to say that profit is determined by CAs and most CAs don’t understand business at all. Or accounting for that matter. Business is a continuum. It doesn’t end in a year. If a business started and ended within the year then you would know the exact profit. For other businesses, profit is the CAs guesstimate.
Third point is understanding the difference between a startup and a business. Suppose you open a shoe shop. It is a business and not a startup – in the VC sense of the word. A startup has risk and needs risk capital. A shoe shop like any business may have risk – but is unlikely to be able to raise risk capital.
Fourth point is liabilities. Revenue is usually accompanied by legal liabilities. Customers may sue you. Or not pay. Or make you liable for non performance of your product. Selling free is also easier. The radical new price of the Internet is free. But nothing is free to manufacture or bring to market. So when anything is free – it loses money – but it also captures market share. Often very quickly.
Fifth point is that losses today will save tax tomorrow. We can carry forward losses in India. A profitable company on the other hand loses liquidity by paying taxes. Ideally you want a surplus but not a taxable surplus.
Sixth point is that the definition of assets and properties is changing. Is intellectual property or customer ownership any less of an asset than say an oil refinery or a hotel.
Seventh point is the saleability of the shares bought by the VC. Flipkart was sold was I think 8x of accumulated loss. The issue is not the loss in your books – but the amount of time and money it would take to replicate the loss making company.
This is not a topic for a post.
You don’t deserve to be a VC if you didn’t know the answer.