In the past few years, there has been an increasing hype about startups in the Nordics and on a global level. As different venture activities become more and more popular, everybody wants to be the founder of the next Spotify or to be somehow involved in the startup scene. However, has anyone considered how startups perform when compared to traditional companies? Are they actually more profitable than other SMEs?
Measuring the profitability of startups is not straightforward.
To discuss whether startups more profitable than other SMEs let’s define profitability first. There are many ways to do it. Here is one example. Let’s say a company reports losses but there are two founders who received a 50k € salary in their previous jobs. After raising money for their new startups, they now receive a 100k € salary. The company is profitable from the founders’ personal point of view.
Another way to look at it is to measure corporate profitability which is all the money what remains after salaries and payments to investors. If profits measured like this are invested the official income statement might show losses. A startup company might be doing really great but it’s not making any profits because the company is investing back in product development or marketing etc.
Apart from corporate profitability, one very important factor to consider is the time frame. Startups usually go through different phases where the profitability changes a lot. Often it takes 2-3 years for a startup to become profitable. At least within this period, you can see whether a startup has a solid case or not.
One way to calculate the profitability of startups is to look at the returns of investors and especially the returns of VCs since there is most investment data for VCs compared to other investors. According to a study by Cambridge Associates in the US between 1981 and 2014, the average pooled return for limited partners in VCs was 23,5%. This is a rather high return for an investor. Stock markets around the globe average returns between 7% and 9%. In a study regarding Finnish SMEs, the average return on an asset was 16%. So it’s a rather good return.
Based on these numbers you could argue that startups are more profitable than normal SMEs but it can’t be taken as the absolute truth. First, even if the valuation of a startup rises so that the company is profitable from an investor’s point of view the company might be showing losses in the income statement. Often for startups in early stages, it’s not essential to show profits in the income statement and for SMEs it might be different. So it is hard to compare the profitability of startups and SMEs. Second is that in our data we are discussing only startups that are funded by VCs and that is a minority of all startups.
It’s also good to remember the Power law when we are discussing startups. Usually, only one or two startups out of twenty succeed and the others fail, so averages don’t tell much.
by Niklas Hellström