Beyond The Headlines

Not for profit

The last twelve months brought many new exciting IPOs; new companies got listed on the stock exchange and made their shares available to stock investors. Not all of them seem as promising as their prices would imply. They got me thinking of a conversation I had a few years ago when I met an enthusiastic entrepreneur. He started a venture, which provided a service that the local community enjoyed. The economics didn’t work, though. There was no profit. His solution to the problem was getting more investors. He openly admitted that profit is not the goal of this particular entity. Hearing that, I suggested he turns it into a non-profit and accepts donations. He laughed and said – “No, no, I want to grow it and sell it.” Interestingly enough, I believe that’s the mindset of too many entrepreneurs these days. Why earn a profit if you can grow it and sell it?

Whether it is a cupcake shop with whimsical frostings or a cloud computing service provider with a cheeky name, a venture becomes a business if it currently makes a profit or has a clear path to profitability in the not-so-distant future. If profit is not the goal, it’s either a hobby or a non-profit. There is nothing wrong with that. The former gets funded from the hobbyist’s pocket, and the latter – the non-profit lives off donations, often tax-deductible donations. There is a whole variety of non-profits providing services to communities around the world, from organizations buying books and pencils for students in need to major museums and more.

In this new brave tech world, though, we have a whole new breed of ventures that disguise as businesses, but when you look closer, they resemble more non-profits. In the very competitive, very innovative world we live in, all entrepreneurs have a significant challenge in front of them. They need to identify a new or an existing profit pool. If it’s new, it may be potentially easier to capture it; if it’s an existing one, a battle with an incumbent is inevitable.

There are non-profits in the online tech world, too. Among the most well-known is Wikipedia. An incredible service that took encyclopedias online and made them permanently editable and current. I must admit that I spend a disproportionate amount of time on Wikipedia researching bottomless topics for both work and pleasure. It’s 20 years old and available in 317 languages. Its founders are Jimmy Wales and Larry Sanger. They are no tech billionaires, yet they had done a lot democratizing access to knowledge. Wikipedia relies on donations. Wikimedia Foundation, the non-profit that owns Wikipedia, collected little over $100 million in donations last year.

Wikipedia is more of an exception than a rule in the online world. Judging from a swath of new tech IPOs, there is a theme that repeats a bit too often. Companies are growing rapidly yet not making money. It’s not just that. The faster they grow, the deeper the losses get. Traditionally, companies would go public, offer shares to investors, and raise money to grow. They would add store locations, manufacturing facilities, hire talent. Many of today’s tech IPOs raise money to cover growing losses. If the mindset is that they could grow their losses even faster if only they could go public, then it seems to me that the public shareholder is becoming more of a donor, making a donation, not an investment. The only difference is that there is hope that one can sell his or her participation in the venture (shares) to someone else for a higher price. As long as the stock price is going up and the public is willing to buy into these growing losses, no one cares about profitability, and everything appears to be fine.

If covering losses with newly raised capital wasn’t enough, recent IPOs have another peculiar quality. Their founders can cash out before the company even goes public. They can walk away with over a half-billion dollars before the company developed a business model, turned a profit, or got listed on the stock exchange. If creating a profitable lasting business is the goal of starting a company, then cashing out so early in the race feels greatly premature.

The challenge of the entrepreneur of the venture I mentioned at the beginning, and the many recent tech IPOs, is unit economics. It seems to be a forgotten concept these days, so let’s go back to cupcakes for a minute. If a pistachio cupcake with strawberry frosting costs $1 to make, including all – rent, labor, ingredients, marketing, etc., and it sells for $2.50, we have a $1.50 profit per unit. If we were selling it $0.50 and losing $0.50 on each cupcake, instinctively, we’d know something is not right.

In a phenomenal book “The Undercover Economist: Exposing Why the Rich are Rich, the Poor are Poor – and Why You Can Never Buy a Decent Used Car,” Tim Harford explains: “In a free market, people don’t buy things that are worth less to them than the asking price. And people don’t sell things that are worth more to them than the asking price (or if they do, it’s never for long; firms that routinely sell cups of coffee for half of what they cost to produce will go out of business pretty quickly).”

If it’s an exciting tech company, though, and it’s harder to tell what the cupcake really is, how much it costs to make, and how much we should charge for it, the story appears to get conveniently lost. We are told that losses are an investment in growth. How many cupcakes could you give away, and how fast, if you were “selling them” (translation: giving them away) at half the cost?

Let me be clear: a new business typically goes through a money-losing phase. It reaches a certain scale, figures out its cost structure, tests its pricing power, and eventually turns a profit. Otherwise, it’s a harsh reality check, and the cupcake store shuts down. Many new tech IPOs may prove to have a healthy business model, but others might be permanently not for profit. The latter won’t be worth billions as the market implies today. Maybe they will scale down and reach profitability as much smaller businesses. BlueApron, Groupon, RenRen, and many others among them, couldn’t defy gravity. Groupon was the craze of the day almost ten years ago, the fundamentals massively fell short of rosy expectations, and its stock price eventually reflected that with a 95% decrease since IPO (Source: Bloomberg).

We are always curious to learn about new companies getting listed. We keep reading about new travel sites, online dating apps, big data government contractors, online mortgage companies, food delivery apps, and more. It makes our job more interesting. We get to pick investments not just from the currently available few thousand publicly traded companies but also from all the new ones.

With the abundance of capital and the shortage of yield in the near zero-rate world, stock appreciation appears to have become the main source of returns. If it’s earned and deserved, it will likely last; if it’s only hyped up and inflated with no fundamentals to back it, it’s bound to vanish.

I think the lines between a business and a non-profit have gotten blurred. As long-term investors, we have to pay extra attention and don’t get tempted with any delicious frostings, especially when the cupcakes are given away at half the cost. It pays to know if we are making an investment or a donation, and they are not the same.

Happy Investing!

Bogumil Baranowski

Published: 2/17/2021

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