Benefits of Delaying Profitability
Profitability was always the core reason behind the existence of a company. For many businesses it still is. There is no way that businesses could continue to exist in the yesteryears without generating adequate profits. Only government companies could continue to make losses in the long run. As far as private companies were concerned, the moment they started making losses, they were on probation. They had to turn around the business to become profitable with immediate effect or lose investor funding.
This has changed in the 21st century. The information age has brought along with itself a very different business model. Companies like Facebook. Twitter, LinkedIn, Instagram and Snapchat have generated profits very late. However, their shares not worthless during the years when they were making a loss. These companies were valued at billions even though they were losing millions each year.
In this article, we will understand how the tech industry survives on this delayed profitability model.
Law of Diminishing Marginal Utility
The business that existed in the twentieth century and the early twenty-first century were all industrial businesses. This meant that mass production enabled them. One of the fundamental economic laws governing these businesses was the law of diminishing marginal utility. This meant that every additional unit produced would have lesser and lesser value to the consumers. Hence as the supply increased in the market, the value of each other unit would fall.
However, this is not the case with new age companies. These companies actually benefit when more and more users start adopting the product. Every individual user that logs into Facebook makes it more valuable. Similarly, every new user that starts using Snapchat makes it more valuable for everyone else and the company itself.
The tech industry would therefore not be able to create value if it immediately started charging money. For these companies to gain traction, they have to build some sort of critical mass. For instance, once Facebook acquired a critical mass (lets say 50 million users), more and more people had to automatically join in so that they could connect with those 50 million users. This is the point where revenue generation makes sense. Had Facebook tried to generate revenue when they had 50 users, the whole business model would have failed.
Why Many Companies Cannot Do It ?
However, not every company can adopt the strategies of Facebook or its peers. This is because these companies had convinced their investors that they are in for the long haul. They would not accept money from any and every investor. They would ensure that investors had a vision regarding the future of their company which was similar to the view of the founders.
Growth Over Profits
There are several of these tech companies that have valued growth over the redistribution of profits. Consider the case of Amazon for example. The company has existed for 23 years. However, since its formation in 1994, the company has never paid out a single dollar as dividends. The company believes so strongly in its growth story that it invests each dollar earned back into the business. Amazon is not the only one. Several tech companies do this. This would be unacceptable to traditional investors. However, this strategy has paid off as Amazon has grown from a small time startup to one of the top 20 companies in the world.
How Delaying Profits Can Go Wrong ?
Delaying profits is not always the right thing to do. There have been some instances where delaying profitability has gone horribly wrong. The common causes of this are as follows:
- Running Out of Capital: Delaying profitability means that companies have to operate with losses for several years. This means that the company should have the wherewithal to sustain without cash for several years. Most startups do not have that kind of capital. They are dependent on several rounds of funding with increasingly high valuations to keep the lights running. Sometimes the economy goes into recession, and such funding is hard to come by. This leads to the firm going bankrupt. All the money that was previously invested in the firm to build the network also goes down the drain.
- Bleed by a Thousand Cuts: Companies like Facebook and YouTube have provided free services to their customers. However, other companies have started taking to the extreme. They end up paying users to use their product! They are thus actually making a loss on every product that they sell. Its like getting a small cut on every sale. When thousands of such cuts accumulate, the blood loss is enough to cause the death of the firm. The problem with losing money with each sale is that it is a lose-lose proposition. Each market participant tries to outspend their competition. The result is that several of them go broke. The ones surviving also have very poor financial health and are prone to more price wars from newcomers.
Delaying profitability is therefore not a substitute for having a well thought out business model that provides value to customers. It is just a strategy that can be used to augment businesses that already provide value to customers.
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