If you’re projecting more than 30% profits, you’re missing most of your costs

When looking at financial projections of early-stage startups, it’s not unusual to see expected profit margins of 40% or more, often 50% or sometimes even 60%.

Last week I had the honor of reviewing a pitch deck with a profit ratio of 95%. Wow! How do I invest in that?

By profit ratio, we mean the net profit after all operating expenses. EBITDA divided by revenues. This is very different from the gross profit margin which subtracts only the cost of goods sold, which for a software company with almost no production costs, should be close to 100%.

The attraction of software startups is that revenues can grow exponentially while costs grow linearly. With no cost of goods other than cloud hosting, profits seem limitless.

Except they aren’t.

The net profit for the S&P 500 averages around 12%. These are the most successful companies in the country. If we narrow the list to only software companies, the profit ratio is close to 25%.

You probably think that once software development is done, other than customer support and a few developers to add an occasional new feature, and perhaps an extra sales person or two, you won’t have any other costs. Profit ratios will expand inexorably towards 100%.

Let’s look at a few examples, though. Google is probably the most profitable company in history. They created a search engine 30 years, sell ads, and watch the cash roll in. Despite almost no marketing or support, Google’s operating margin is 34%. But sure, they make phones and robotaxis, too, so let’s look at some other examples.

Microsoft wrote an operating system and software suite 50 years ago that just about every business in the world uses. Other than a few bug fixes and security updates, they haven’t done anything for 10 years. Microsoft’s operating margin is an amazing 45%. That’s as good as it gets. Facebook is about the same.

As an enterprise IT tool provider, Oracle is a better model for what software startups should aim for. Oracle has sold the same database to enterprises for decades adapted to a variety of use cases. Oracle’s profit margin is 31%. Their giant German competitor, SAP, is at 26%.

If you think you can have higher profit ratios than Google, Microsoft, Facebook, Oracle, and SAP, be prepared to tell me how. Otherwise, I’ll assume you’re missing most of your costs.

What Are All the Costs?

At a small startup, by necessity, cost are kept to a bare minimum. Employees work mostly for equity, the office is a zoom huddle, and no customer expects 24 hour support. Health insurance? Maternity leave? What’s that?

But as the company grows from a dozen dedicated enthusiasts into a $100M business with a staff of hundreds, the costs pile up. As you create your financial projections, be sure to consider the following:

Salaries: In a pre-seed startup, founders and early employees are working primarily for equity. As the company grows, salaries rise to market rate. If Google is paying its data scientists $400K, guess how much you’ll have to pay.

Employees: Those dedicated early employees are followed by a lot of 9-to-5’ers. 18 hour work days — no way. You’ll need at least twice as many employees to get the same amount of work done.

More employees: You’ll need to increase the number of employees by another 2x because at any time, half your employees will be out on vacation, sick leave, maternity leave, or personal time off. Plus, new employees will take 6 months to get up to speed, then quit after 2 years.

Managers: For every five employees you add, you’ll need to add a manager. For every 5 managers, you’ll need another vice president. Good, experienced managers are critical to keep the company on track, but they aren’t cheap.

Support staff: The days of the lone programmer handling the IT chores for the team in his spare time is over. The same for the office manager doing billing with QuickBooks. You’ll need all of the following:

  • IT dept
  • HR dept
  • Legal staff
  • Accounting & billing
  • Investor relations

Sales & Marketing: The biggest costs of most large companies are sales and marketing. No matter how great the product, it doesn’t sell itself. The bigger the company grows, the more competitors pop up. Crossing the chasm from enthusiastic early adopters to slow moving laggards takes time and hand holding. You’ll need:

  • Salespeople. Lot of salespeople. Figure one salesperson for every $3M in sales. The successful ones will be paid well, sometimes more than the CEO.
  • Sales engineers. Someone needs to handhold both the customers and the salespeople. At some point it has to stop being the CTO. Most tech companies have 1 sales engineer for every 2 sales people.
  • Advertising. Expensive and wasteful, but necessary to stay top of mind.
  • Trade shows. Graduating from a cheap tabletop in the back to a 2 story booth in the center of the expo floor with 25 employees and a gold sponsorship package is expensive but necessary.
  • Digital marketing. Social media, SEO, website, etc.
  • Sales meetings, user conferences, customer training programs. All are needed. All cost money.

Engineering: The product is done. Other than adding a few new features, you won’t need to expand your development team, right? Nope. You’ll need:

  • New features: Want to keep expanding? You’ll need to keep adding features or new versions to reach different subsets of users. With new competitors popping up, you’ll need to stay top of the pack.
  • Customer one-offs: Big customers think they’re special. If your product doesn’t fit their workflow perfectly, you’ll have to adapt your product.
  • Customer support: Early adopters are flexible. But when the product becomes mission critical, you’ll need 24/7 support.
  • Quality testing: Even as the software grows into a nasty mess of technical debt, all it takes is one security hole to destroy the business. QA is the best investment you can make.

Other Costs:

Operational costs: computers, internet, software, and cloud resources are requirements for any business. They’re not cheap.

International operations: You’ll need to replicate sales, marketing, and operations in every country. You’ll need local offices with local executives, local lawyers, and local billing. You’ll need to localize the software, the documentation, the website, the marketing materials, and everything else. And you’ll need a team to manage the various territories.

Offices: Zoom is great for small teams, especially while the focus is on development. As the company grows, you’ll need an actual HQ and local sales offices. If customers are coming in for demos and contract negotiations, it can’t just be a WeWork closet.

Insurance: You’ll need liability insurance, worker’s comp, health insurance, D&O insurance, E&O insurance, cyber security insurance. All increase with staff and revenues.

Perks: Employees expect more than a paycheck. They want a fun, social place to work. Health and dental insurance and 401(k) matching are a requirement. Nice offices, free parking, free meals and happy hours, a stocked kitchen, gym memberships, charitable donations, childcare assistance, etc. have become requirements for any self-respecting tech company.

The Pitch vs Reality

Every early-stage startup pitch shows the company reaching break even within a couple of years and rapidly increasing profits thereafter.

The reality is that no startup in the history of startups has ever shown a profit. They’ve all lost money. Lots of money. For years and years. Very few ever reach profitability before the exit. (For this reason, exit multiples for startups should be shown as price to revenues rather than price to EBITDA that’s typical of big company valuations.)

In fact, if the company is earning a profit, rather than being thrilled, investors will insist the management is doing something wrong. Investors don’t want profits. They get no benefit from profits. They want every dollar of available cash to be invested back into growth to reach a bigger exit faster.

Still, investors want to know that the company could be profitable. A startup where costs will always be more than revenues is worthless. So we want to see projections of profitability. The more profitable, the better. Up to a point.

When you cross that fuzzy line from optimistic to ludicrous, you lose credibility. A pitch that shows 50% profit margins makes it clear the founders don’t know how to build a business. And that makes it hard for investors to trust the other critical assumptions, like revenues and market size, in the pitch.

So ditch the 95% profit margins, do a proper financial model that includes all the costs, and show how you expect the business to grow realistically and reach profitability over the next 5 years. Wow us with your financial acumen rather than ridiculous numbers and you’ll have investors on your side instead of running for the exit.

What’s the profit ratio on a teleportation service? Probably extremely high. That’s why the teleportation startup, SüprDüpr, is potentially worth trillions. But are they racing too fast to get to market before the tech is really ready? Find out in the Silicon Valley mystery/comedy/farce, To Kill a Unicorn, the most fun you’ll ever have reading about immoral startup founders.