Earning revenue is a great business benchmark but every startup needs to be profitable to survive. As a founder, it is reasonable to ask when will my startup be profitable? Consider these 3 factors when reviewing your startup profitability.
In this article:
- What is the average time to reach profitability?
- How does a startup fail?
- Do I have a product-market fit?
- How to measure startup profitability
- Poor leadership in startups
What Is The Average Time To Reach Profitability?
A question that comes up with every novice business owner—When will my startup be profitable? The short answer: it takes 3-4 years for startups to be profitable. The long answer, not all will come out on top, and startup success is influenced by a number of factors like industry, financing, and concept.
How Does A Startup Fail?
Fire is raging in the beginning stages of a company. For reasons unbeknownst to many CEOs, the venture fails. With startups you assume a level of risk, not to mention the business world runs full speed, making it easy for important details to go astray.
Here are the 3 most common reasons why startups fail:
- Lack of product-market fit
- Financial trouble
- Poor leadership
If you resonate with any of these reasons we are here to help you change course. Let’s deep dive into each of these factors and how they affect startup profitability.
1. Do I Have A Product-Market Fit?
Product-market fit is business lingo for an audience that is doing the selling for you. First, you have a minimum viable product (MVP), beyond the prototype, that is selling in the market. Second, part of the equation—the market. A targeted niche finds value in your product, and sustainable sales either via your advertising efforts or word of mouth.
Many startups have a hard time breaking into a market. As a little fish doesn’t make waves in a vast ocean. It is not for lack of will, but lack of resources to perform substantive product testing and market research. Having a clearly defined customer profile before throwing down money on advertising, makes startup profit margins within reach.
Who is my target customer?
What is my unique value proposition?
How is my solution better than competitors?
Arguably the most important thing you can do for your company is continuous competitor research. We are nearing 8 billion people in the world, something similar to your concept is likely out there or pending launch.
Delve into the saturation point of the market. When there are 2-3 easily discoverable competitors, there are 20-50 less conspicuous small brands vying for trickle-down sales. Don’t be dismayed, the point of a product-market fit is formulating something to top other brands ex: be in a strategic location, have better pricing, better materials, better branding and advertising, etc.
Research your idea on Google, marketplaces, and social channels. Spend time with other brands offering the same selling point and see how you can be different. It is fair game to click around sites, follow social profiles, Sign up for emails, and/or buy products. Even better, try a competitor researching tool to compile search data like market share, and in-demand pay-per-click (PPC) keywords.
Before finding your product-market fit you will have bonafide testing and refining phases. During testing give out samples, freebie trials, and perks in exchange for reviews. Reviews, reviews, and more reviews are going to be the best way to cater to an audience. Feedback helps you with out-of-the-box thinking and opens you up to new possibilities.
Startup profitability is intertwined with sales. High sales are proof that you have product-market fit. Over time your sales history will help you determine market share.
What is market share and why is it so important?
Market share is the percentage of sales you own in your industry. It is directly correlated to profit, so the more you own, the higher your startup profit margins will be. Market share is calculated like this:
Percentage Of Market Share = (Total Revenue/Industry Total Revenue) x 100
Be specific when inputting revenue into this formula. For example, if you are a SaaS company offering fitness subscriptions, you want to fine-tune revenue to the fitness industry, not to SaaS tech.
If market share is low, it can mean a couple of things: your startup just launched, the industry is saturated, or there’s no product-market fit. If it is the latter, do not worry. Adjusting your target customer and entering a new market is less expensive than creating a new product.
2. How To Measure Startup Profitability
Recall a scene in The Office called “Broke,” episode 25, season 5. The Michael Scott Paper Company meets with an analyst to crunch the numbers on growth. Ryan expertly creates a fixed revenue model showing the company is in a good position to hire a delivery driver. The analyst informs them they will be broke in a month if their revenue doesn’t increase.
So you have a product, sales, and your market share is increasing. Yet your startup is still not profitable. We’ll be the analyst in this situation and say review your finances. It’s a most basic business tenet—with more revenue, comes more expenses. Startup profit comes when you consistently earn enough revenue to manage your costs, plus have more leftover.
Here is the difference between revenue and profit. Revenue is everything you are bringing in before expenses are accounted for. Profit is your take home after expenses are paid.
How do you calculate startup profitability in accounting? Grab your balance sheet and begin with your company’s book value aka net worth. Subtract your total assets from your total liabilities, the result is your book value. A positive number signals you are earning enough revenue to cover all expenses in the short and long term.
Don’t stop there! That is a quick snapshot of how you are doing right now. If this is a negative number, move over to your income statement for a more thorough evaluation of your accounting. On your income statement let’s start broadly, then go more and more granular.
Gross Profit =(Revenue – Cost of Goods Sold) / Revenue
Gross profit is your highest profit potential. This gives you a startup profit figure for how much you could have earned—not considering fixed costs. Fixed and variable costs have a different effect on your profit. There are costs you can control (fixed) and casts that fluctuate (variable). For most startups, COGs are variable and are the largest expense to affect your revenue model.
Gross Profit Margin =((Revenue – Cost of Goods Sold) / Revenue) x 100
Gross Profit Margin is a percentage of revenue. It is a great figure to look at when you are measuring a change in profitability over a span of time. Observe differences each month in the last quarter, or the past year, to determine whether your startup is a success.
Note: When COGS are low and the price is justifiable to consumers, you have high startup profit margins. Fluctuations in this percentage signify your cost per unit is changing. Worse, is a large dip, which means there is a lack of product relevance to your audience.
Net Income = (Total Revenue – COGS) – Operating Expenses + Non-Operating Expenses
Next look at how much money you are keeping after all expenses. Net income goes into the penny jar. It is the key indicator of your viability to outside investors and lenders.
If net income is consistently negative, then you aren’t earning enough revenue to manage your expenses. There are only two ways to increase net income: increasing sales, and reducing expenses.
Solutions for reducing expenses:
- Shifting to a localized supply chain. Shipping materials around the world chip into your profit margins. Only opt for this if it is one of your most valuable products.
- Invest in your in-house manufacturing. By owning every part of your product you incur fewer expenses than contracting or purchasing from external parties.
- Automate tedious manual workflows to increase productivity in operations. Some things are inhibited by the human touch and therefore increase payroll spending.
- Pay off your business loans. Financing will pull you under, so get on top of them sooner rather than later. Only apply for financing if you need it, and have a plan to pay it back.
ABC Analysis For Startups
Increase net profit by assessing the profitability of your products/services SKU by SKU. An ABC analysis allows you to compare and visualize your product offerings. This analysis classifies all SKUs on a high-low value system. The system is based on the Pareto Principle that 20% of your products are worth 80% of your business value.
Using the classification rules below, perform an ABC analysis by organizing products from high value to low value:
ABC Classification Rules
- A: smallest category with the most valuable products/services.
- B: larger category in terms of volume, product/services of mid-value.
- C: largest category of products/services that contribute the least to your business
Businesses will perform an ABC SKU analysis for a variety of reasons. You can survey metrics like annual revenue, sales velocity, or annual consumption value. In this case, we want to calculate the gross profit per product:
Gross Profit Per Product = Annual Revenue Per Product – Total COGS Per Product
Doing this will help you understand which products are the most profitable to you. You can compare how many units you are selling in each product category to see essential business revenue.
Are there areas for improvement? For eCommerce ventures, an ABC analysis is a great way to trim low-performing inventory, make pricing adjustments, and understand your granular costs per product. As well as see where there is an opportunity to drive sales by increasing stock levels.
For a SaaS startup use an ABC analysis of your subscriptions and user activity. By pinpointing hotspots in your service you can create an ABC value model to push new features and add-ons.
Cash Flow Planning vs Cash Forecasting
In essence your startup profitability will change over time. To prevent going broke, project your revenue, forecast your cash flow, and make a budget. It’s not just looking into the future, you need to have an actionable plan to retain incoming money.
Outgoing cash will eat into your revenue. A cash forecast is a cash balance you would like to achieve, to prevent you from overspending. If you are confident that your startup will perform at the same output, estimate cash flow based on past trends. When you understand how cash is moving throughout the business, you can easily establish spending patterns that keep you solvent.
3. Poor Leadership In Startups
When discussing startup profitability, leadership is by far the hardest factor to judge. Poor executive management in operations to general company direction will cause a startup to fail. Fortunately, operational management is easier to solve than creative problem solving; people don’t become thought leaders overnight.
As investors weigh in on the vision, pressure to meet quarterly earnings will cause problems down the line. A lack of foresight, like not investing in startup innovation, is a recipe for failure.
Research and development are critical throughout the lifecycle of the business. If you are not keeping tabs on how your industry and audience are evolving you. will. lose. customers. Time and again the companies that outperform, emphasize research and development over immediate profits.
Research and Development (R&D) Expense
When you have a product-market fit, you have customers that are willing to stick with your company over others. You have likely improved their lives with the fruits of your labor. But what about the customers you didn’t win over? Research and development begins with them.
Any common themes in the bad reviews for my product?
Are there areas on my site where customers are dropping off?
Are my competitors coming out with new offerings?
The goal in early stage R&D is not to come out with a new product. Rather discover ways to bolster what you already have and add value to your brand. Often the number #1 area startups will edit is customer acquisition and onboarding.
When Will My Startup Be Profitable? Soon.
Patience is not the answer when exploring the question “when will my startup be profitable?” Dig for clues into how to make your business function better. As accountants, we take on the challenge of navigating your finances to help you understand your startup profitability. Take a proactive approach to every facet of your operations so you have a better chance of being the 1% that makes it!