The startup ‘growth versus profit’ debate is not a new one. As an entrepreneur, should you keep the profit you make or reinvest it in your business? Should you go after new customers or build your financial reserves? Which course will serve you best in the medium and long term?

Starting out as an entrepreneur, your objectives are to minimise your startup costs. Your business plan will reveal your profit margin. But once you learn how to maximise your profits and as they start coming in, should you hold onto them or reinvest in growth?

Growth versus profitability – What’s the right ratio?

All startup founders want to achieve both growth and profitability. But in the real world, this can be quite challenging. Understanding which one will better work for the company is a tricky decision. But there’s help at hand.

While the right ratio for companies would depend on their stage of growth, market size, competition and cost per additional customer, there’s a widely accepted marker in the startup ecosystem. That’s the ‘Rule of 40.’

Mostly intended for those in SaaS (Software as a Service), the Rule of 40 states that a startup’s growth and profits should add up to 40 per cent. Revenue growth is how growth is measured here and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) is used to measure profits.

According to the Rule of 40, if your profit plus growth is around 70 per cent, you can reinvest the remaining 30 per cent in your company’s growth. Earlier, companies had the leeway to structure this 40 per cent in any way; for example, growth could be 30 per cent with 10 per cent profits or there could be 40 per cent growth and zero profits.

Considering how most entrepreneurs and venture capitalists prefer growth over profitability, a new ratio has gained acceptance in the startup world. That’s the weighted Rule of 40, which states that growth needs twice the weightage in the equation.

Explaining startup growth

To understand startup growth profit, we first need to define growth. Put simply, growth can be gaining more customers, increasing sales or even adding to the workforce.

Growth can happen in two ways. Organic growth is when a company grows on the basis of its product or service and gains more users. The other way to grow is by acquiring another business or partnering with one. Investors usually prefer organic growth to measure the performance of a company.

If your startup makes physical products, growth will require additional investments in manufacturing, staffing and infrastructure. When you manufacture additional units and customers don’t buy them, you’ll be left with inventory and spiralling costs.

In the startup world, the focus has been mostly on high growth. When the product or service gains enough traction in the market, it becomes easier to attract new investors. Even without profits, these additional funds would be able to sustain the operations and expansion of the startup.

Explaining startup profitability

When a startup becomes profitable, it earns more money than is required for its operational expenses. But the unfortunate truth is that only around 40 per cent of startups break even (this is, they meet their costs and start earning profits).

Profits signal good financial health and viability of the business. If the going gets tough due to changing consumer trends, increased competition, higher supply costs or larger economic concerns, a profitable startup would have the financial resources to manage the situation.

Profitable startups also have another advantage. Their founders don’t have to seek outside funding and thereby give up their ownership. With this financial stability comes managerial independence.

While the startup world has historically preferred growth, things have changed in the recent past. Investors are now concerned about the financial health of companies that could be compromised by reckless scaling. In other words, profitability is important now.

How to balance growth and profitability

How to start up a business might seem an easier question to answer when you’re faced with growth and profitability. In the startup growth profit debate, the answers depend on these factors:

Your product or service
The market you’re in
Whether you’re among the first players
Your business model
Cost of customer acquisition
Revenue per customer
Cash flow

Based on the above factors, you can take the following steps to balance growth and profitability:

Ensure that you have enough cash to manage expenses for six months.
Decrease the sales or cash conversion cycle.
Your investments in growth should only happen once you exceed your profit targets.
Be willing to tweak your product or service and its pricing to get the right market fit.
Understand the value of each customer and zero in on those who give you the maximum revenue.
Focus on customer retention and encourage your existing customers to refer new ones.

In short

Managing startup growth and profit by focusing on what’s important both in the moment and for the long-term health of the company is a crucial skill. What’s even more important is the ability to adjust the strategy as the market realities change.