How to assess profitability of Startups?

This IPO market frenzy is expected to continue even in 2024, with prominent startups like Swiggy,  Oyo, Mobikwik, PhonePe and PharmEasy set to debut in the primary market. This brings up the age-old question of the profitability of startups. Sure, a startup burns cash to grow and we expect that going ahead, the company will become profitable, thereby compensating for all its losses. However, there is no guarantee for this. Sometimes, we believe that if a startup caters to a growing industry, then it’s a sure-shot bet, but growth attracts new players which propels brutal, cut throat competition.

So, in order to assess the potential profitability of presently loss-making startups, you can consider the following 3-point framework.

1) Consumer stickiness: 

Startups employ various strategies to attract customers. While this is very critical, what is equally necessary is to have an effective strategy for retaining customers. If customers choose to stick with the company despite other alternatives, then no matter how intense the competition, the firm will be able to save its fort. This is the issue with companies like Zomato and Paytm. No doubt they are attracting customers, but their customer stickiness quotient remains in question. So, keep a close eye on the incentives that the company is doling out in order to retain customers.

2) Efficiency

In the initial stages of a company, innovation holds immense importance. However, as the company progresses through its corporate life cycle, managerial intricacies become paramount in determining its efficiency. This involves managing relationships with various stakeholders in the company’s broader ecosystem. This includes ensuring employee satisfaction, establishing positive connections with delivery personnel, addressing legal issues, and managing the company’s public image. The company’s corporate governance, organizational structure, and incentive mechanisms become central to navigating such complexities. Furthermore, these factors also play a pivotal role in shaping the company’s approach to research and development. Byju’s fiasco is a case in point where exiting of its board members and resignation by company’s auditor (Deloitte Haskins and Sells) created havoc for the company.

3) Cost Economies

 While a startup may not initially record net profits, it is essential to assess its profitability at various other stages. Examining whether it is EBIT (earnings before interest and tax) positive, EBITDA (earnings before interest, tax, depreciation and amortization) positive, or has positive gross profit levels, can offer valuable insights.

The closer a company is to achieving net profitability, the more promising its overall financial outlook become. Additionally, identifying all sources contributing to this profitability is equally crucial.

In case of a company with substantial fixed assets, growth allows for the spreading of fixed costs, resulting in a decline in average costs and the realization of economies of scale, which ultimately leads to increased profitability. Scaling up enables the hiring of specialized employees and the implementing division of labor, further contributing to economies of scale.

For startups operating in complex industries, time becomes a critical factor. Over time, the company acquires expertise and greater specialization in the domain, enabling it to provide products or services at a comparatively lower cost, thus achieving economies of learning. Additionally, the company’s debt obligations should also be given paramount consideration. Debt can be a deadly sin for startups, potentially engulfing all of its success

This framework can give us a good idea about the profitability of startups.