Do Tech Investors Care About Profits?

The focus on valuation often takes precedence over immediate profitability, although profits are essential for significant valuation. Tech investors recognize that profits are not always necessary for a substantial valuation. The true goal for investors isn't necessarily to live off the company's profits but to have an exit strategy. These strategies can include either selling the company to another larger player or taking the company public. In either case, the exit goal is to recoup the initial investment and generate profits.

Consider the example of Amazon. The company went public many years before it achieved profitability. However, its initial valuation reflected its massive potential and strong market presence. This illustration emphasizes that the value of a tech company is not always directly tied to its current profits but can be based on its future prospects and potential.

Understanding Tech Investors' Behavior

Tech investors often have distinct expectations when it comes to the timing and likelihood of profits. Many are willing to tolerate low or even negative profits in the short term because they see the potential for significant gains in the long term. This patience is crucial as most tech startups do not achieve profitability; instead, the few that do pay for the many that fail.

The goal is to invest in businesses that are likely to be acquired by larger companies or to eventually go public. For instance, a startup that hasn't yet achieved profitability but has valuable intellectual property (IP) can still attract investors if the future acquisition seems inevitable.

Valuing Tech Startups

The process of valuing tech startups is more complex than valuing traditional businesses. Here’s a closer look at three types of tech startups to illustrate the valuation process:

The Corner Dry Cleaner: This business generates a steady 500,000 in revenue per year with 50,000 in profits and has limited growth potential. It can be valued using standard financial models based on its current profitability. The Zero-Growth SaaS Company: This SaaS company, while profitable, grows at 0 and has no prospects for significant growth. Like the dry cleaner, it can be valued based on its current cash flow and profitability. The High-Growth SaaS Company: This company is also at a 500,000 run rate but is generating rapid growth at 200% per year, and it is yet to penetrate a massive market. However, it is currently unprofitable and is burning through 2 million per year of VC funding.

Complicating the valuation of the high-growth SaaS company is its high risk. While it currently has a negative valuation on a traditional spreadsheet, more nuanced models can extrapolate its potential. In one scenario, it might grow into a business generating tens or hundreds of millions in revenue and become profitable. Alternatively, if acquired by a larger player like Oracle, it can continue growing, making it more valuable.

Despite these high risks, the potential for significant returns is why investors are willing to invest in such companies. The key is the investor’s ability to model the future and recognize the likelihood of these scenarios.

A Closer Look at the High-Growth SaaS Company

The high-growth SaaS company is often a bet on future success. Valuation models take into account factors like:

Market potential and growth rate Acquisition potential and the strategic benefits of being acquired The likelihood of achieving profitability in the future

Even if the high-growth company does not immediately generate profits, investors recognize that it has the potential to become highly profitable. Intellectual property (IP), the promise of future growth, and the strategic fit with larger players all contribute to its valuation.

Conclusion

While tech investors care about profits, the road to profitability is not straightforward. Patience and a long-term perspective are crucial. Companies that can be acquired or have the potential to become highly profitable are often the focus of investment. Investors are ultimately looking for exit strategies that can generate significant returns, making the valuation process more complex than a simple profit-driven approach.