There are very few early-stage European tech firms that can afford to ignore the question of profitability.
Additionally, in recent years investors across the European venture capital ecosystem have found themselves increasingly capital-constrained – whether due to the challenging market conditions, lack of (DPI Distributed to Paid-In Capital), and a difficult fundraising environment.
As such, investors are starting to pay close attention to profitability earlier in the startup growth lifecycle – which means founders need to do the same.
The changing nature of valuations
In the past, tech company valuations were largely pegged to their growth rates and unit economics, hence growth took priority over profitability.
If a startup could show product/market fit and a repeatable sales model, it didn’t matter if they were losing money, as long as they were profitable on a unit economics basis. In many cases, the firms were simply channelling the profits back into aggressive customer acquisition and expansion.
But in the current, capital constrained market, investors cannot afford to sacrifice profitability indefinitely for growth. From Series B onwards, they are now looking for evidence that a startup has a visible pathway to achieving profitability.
If founders can’t demonstrate a credible plan, they could face an uphill battle to hold onto their valuations and livelihood. This is one of the major reasons why the number of down rounds doubled from 2022 to 2023. Founders have been trying everything in their power to conserve cash and cut costs on the pathway towards profitability, but in many recent cases, they’ve been left with no choice but to accept a depressed valuation, down round, or at best, flat round.
The funding gap is growing
Similarly, the time between Series A and B fundraises – typically classified as the gap between ‘early stage’ funding and the start of the ‘growth stage’ funding rounds – is now 28 months, the longest it has been for over a decade.
Almost two-thirds of US startups that closed their Series A in 2020-21 are yet to raise a subsequent round. Many will never do so. In the UK, more than one-third of startups fail between Series A and B.
First-time founders frequently underestimate the journey to closing a Series B, simply because their Series A experience had been comparatively quick and straightforward. However, as the gap widens, the risk increases that they may exhaust their runway before proving that near-to-mid-term profitability is achievable.
Addressing the profitability question from the get-go
Despite paying closer attention to profitability, investors understand that different sectors face radically different challenges to get there. There’s a world of difference between an eCommerce company, a B2B Enterprise SaaS company, and a chipmaking startup, for example, in terms of the time to profitability and the level of investment required to get there.
Likewise, investors are still prepared to take risks on more complex, longer-term business cases that promise the possibility of much greater returns should the startup become successful.
Regardless of their industry or specialism, however, founders are likely to face the same sorts of questions about future profitability.
Series B investors want to understand the go-to-market plan, customer acquisition strategy, projected revenues, per-customer unit economics, and the founder’s overall plan for revenue aggregation and growth. And with each subsequent funding round, investors will want more evidence that break-even profitability is on the horizon.
Forward-thinking founders should prioritise profitability from the earliest stages of their growth journey. Although it may not play a role in early-stage investor conversations, the market always defers to the downstream investors, their expectations, and current market conditions.
Extension rounds can help founders overcome the funding gap
Series A extension rounds allow a startup to raise a small round from its existing and specialised investors based on the same terms of the Series A to extend its runway and allow more preparation time for a proper growth round.
Extension rounds have historically been an underutilised investment tool. But for the thousands of startups under pressure to demonstrate their pathway to profitability before they seek Series B funding, it can be an attractive option for any founder who still enjoys the belief and support of their early-stage investors.
That said, it can be difficult for founders to secure the full amount they need from their existing investors, which is why we’re increasingly seeing VCs looking to specifically target extension rounds and work in partnership with existing investors to plug the capital shortfall.
The winning combination
From a founder perspective, it might feel as though investor expectations for a return on their capital are becoming unrealistic. Achieving rapid, outsized growth is one thing; achieving profitably is another altogether.
Remember – Series B investors are not necessarily focused on immediate profitability, but on clear evidence that a startup is on the right path and actively addressing their industry challenge. Once they’re convinced, these investors will leverage their extensive experience to help the company realise its full potential.
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