Bankers, Startups and the problem with Profit

‘Show me the Profit’ is a pet lament of many ‘experts’ when talking about the new age companies and startups.

Our well entrenched conventional outlook easily corroborates their worry and much of it is for the right reasons.

However, if you are talking about startups, this paradigm needs some recalibration.

By definition startup is a disruptor. Unless the startup idea is demonstrated to be scalable, there is no fun and sustenance. Without scale there is no first-mover advantage or impact either. So, while the world preaches ‘profit’, there is a critical mass a startup needs to acquire, much before they think profit.

Don’t get me wrong. Profit is a good thing but ‘Little profit at Small scale’ isn’t why one jumps onto a startup wagon.

Hence there is a time and place when a startup should start thinking profit and later, also about cash.

(Historically, this chase for small profit has been the bane of Indian entrepreneurs leading to salary-substitution attitude, low risk taking and lack of innovation. Thankfully it has changed for better)

Now there is the chicken and egg problem here.

A startup takes time to build a customer base, strong distribution, suppliers, acquire first few B2B customers, scalable technology or a refined UI and UX. It needs to persistently loop-play release-feedback-iterate aka version updates.

These are foundational building-blocks for innovation and creating a venture for scale. But there is no weightage or recognition of any of these that can be showcased as assets in the Balance Sheet.

The cash outflow to build this minimum critical customer base, salaries to the tech teams, payment to vendors, incentives to early adopters and revenue share with collaborators, are all opex. Add to this the sacrifice of working at noisy coworking space and everyday stretch to minimise opex itself.

None of these are capitalised and everything remains in Income statement, adding to the loss.

Compare this to a manufacturing setup. To start a manufacturing business biggest expenditure is plant and machinery which is unambiguously capitalised and apportioned over long periods to the P & L (and even there as a non-cash expense). Now, its not that Banks line up to fund new manufacturing businesses either but tangibility of initial assets still brings comfort and bank credit in the realm of possibility.

Most startups, contrastingly, require an array of strong ‘intangibles’. Without creating customer preference for a new concept there is no business. But the customer acquisition cost cannot be an asset. A refined UI/UX is what differentiates a startup but that is just a salary spend.

VC evaluation methods are primarily centered around finding surrogates to this lacuna in Financial Statements. Valuation models aren’t perfect, but they do quantify, to some extent, the existing effort, traction and possibility. Aren’t bankers as smart as VCs?

I leave the answer to your wisdom. But while Banks can’t be VCs, they can at least start peeking out of the box.

This starts with recognising that first ‘assets’ that a Startup creates is credibility and ecosystem acceptance.

>A known PE/VC funding them is the first indicator.

>Strong tie ups with large players is another one.

>Collaboration and network leverage with other new age businesses is the third.

>Speed of customer growth is fourth.

In banking parlance all the above will account to ‘Goodwill’. And we know bankers are conditioned to consider intangibles not only as ‘useless’ but in most cases being a tool to raise balance sheet size without real value add. Further the ‘profit’ by way of increasing ARPU will come with a lag.

In short, the old paradigm is simply inadequate.

Its not that banks don’t like startups. Many banks have startups teams but they remain focused on the more convenient transaction banking products- float, cms and remittances. So the same ‘loss making startup’ is still a good customer when banks can get some quick Non Interest Income.

I’m not advocating all startups are great or there is some ‘moral’ obligation for banks to be cowboys here. But convention is no excuse to let go an opportunity to lend or justifying a bias especially with a segment so crucial to solving problems and transforming economy.

There are some green shoots emerging though. A few banks that I know have started taking calibrated start-up exposures relying on the topline traction, ecosystem linkage and strength of investors. Although, credit is given only to a select few who are not too far from turning EBITDA or Cash Flow positive. But that’s still a good start.