In hindsight, I realize I was wrong, but I was very skeptical of social networking websites in the early years.  I even wrote a blog post about it back in 2009 (see: Are Social Networking Websites the Next Bubble?).  The source of my skepticism was around their attitude toward growth and profitability.  I don’t remember whether it was Twitter or Facebook – but around 2008 I remember reading a statement about how they were optimizing for “growth” over “profitability.”  This fascinated me.  How could a business not care about profitability?  Wasn’t the whole purpose of a business to generate value for its shareholders in the form of profits?

In my mind, optimizing for growth above all else evokes horror stories from the dot.com era where companies like pets.com would sell products at a negative margin to grow their user base.  Ironically, since they lost money on every item sold, the success and growth of pets.com actually accelerated their demise as they quickly burned through $300MM of invested capital.

It seems to me that the early 2010’s have brought about a renaissance of venture-backed businesses and I’ve been thinking a lot about the interplay between growth and profitability. Here is my thesis:

No profits – totally ok
No profitability – really big problem

Allow me to explain my reasoning.

Everyone knows that growing a business from scratch is hard.  Usually you need to invest significant capital to get it off the ground and running.  In the early years it is totally acceptable to see no profits from your business.  However, profits are not the same as profitability.  Profitability is extremely important.

In my mind, the distinction is paramount: profits are the money you’re making from a business at the end of any given period.  Profitability is the long-term ability to generate income from your customers.

It’s totally fine if your business is not generating money right now, but you need to have a thesis on how you’re going to make money from your customers in the future.  In fact, I believe the entire process of starting a business should, at a high level, consist of three-steps:

Step 1) Develop a thesis on profitability
Step 2) Work as quickly and a cheaply as possible to prove or deny your thesis on profitability
Step 3) Repeat steps 1 and 2 until you find success

Now, that being said, I’ve been wrong before…

Thoughts?

Profits vs Profitability
  • I think the focus should be on value, and not profits or profitability. Is your company adding significant value to your customers? If it is, then monetizing that should be possible. But if there isn’t much value-creation going on, there’s no way to monetize it.

    And you can’t really identify your cost base, in a technology company, until you have the product built. This is very different from a non-tech company, where there’s no product creation going on and estimating costs are easier. But in a tech company, there’s no way to identify profitability (i.e. potential revenue minus cost of service) prior to constructing the firm. Therefore, the focus needs to be on value – tangible or intangible – added.

    P.S. Social networks are a special case, because their value increases at an increasing rate the higher the penetration. So the focus should almost always be on increasing user base over profits, if you have liquidity available, until network penetration hits rapidly diminishing returns.

    P.P.S. Reminds me of Kathy Sierra’s old phrase – “How does this get them laid?” (Under the principle that fame, money, interestingness, whatever value you’re providing would help get the user laid. Or do it directly, like Facebook).