Gate #5: Build a Profitable Company

It took me 35 years to discover these Five Gates to Turning your Idea into a Successful Startup. If you enjoy this series, share it with a friend. To catch up, go to paparelli.com.

The email subject read, “Term Sheet.”

Before I opened the email, I knew what was in it. The company I had invested in was raising more money.

“But why?” I thought.

I had just talked to the founder last week, and we agreed he was going to move to profitability. The company was hitting its sales goals and, with a little expense control, they could squeeze their way to cash flow positive.

I liked Tim (not his real name) from the moment I met him. He was a matter-of-fact, straight-talking founder. The kind of person who speaks in simple truths with no hype. He also had tons of industry experience and had moved adeptly through the first four startup gates.

• Gate 1: He clearly defined the problem in the market.

• Gate 2: He knew who had the problem.

• Gate 3: He proved they were willing to pay to solve it.

• Gate 4: He knew how much they would pay to solve it.

He had one gate left: Could he build a profitable, self-sustaining company solving this market’s problem? Over the last year, Tim’s struggle was all about defining and finding the prospect who had to solve the problem today. Once he discovered this prospect, he had to figure out how much he would pay. Sales moved from $80k in 2017 to $500k in 2018. The forecast for this year is $1.9mm.

Tim is making sales. But can he make money?

When we talked the week before the “Term Sheet” email, Tim had a decision to make. He asked me, “Do I hire the people to grow this company quickly or move to cash flow positive?”

Anybody who has worked with me knows I always shoot for profitability first. I believe once you achieve profitability, the whole company changes. Everyone, from the founder to the interns, knows in their heart of hearts, they are part of a successful business. They are no longer haunted by the prospect of going out of business. The possibility of failing is eliminated.

When the business gets to positive cash flow, every employee moves from thinking about survival to thinking about growth. You hear people saying, “How do we make this thing bigger and make even more money?”

When a business moves to consistent profitability, the company’s leadership and employees are in charge of their destiny. There is a new DNA in the business. This DNA of profit is the very purpose of a business.

Tim chose to grow the business.

When I talked to him, he said, “I know what we talked about last week, but I see the opportunity. I am seeing our sales pipeline growing. Besides, there are two monster deals which I know we can close this year. If I don’t have the people in place when these deals close, we’ll get crushed.”

Tim chose to bet on fast growth while continuing to lose money. His expense growth will continue to outpace his sales growth. He’ll cover the negative cash flow by selling more stock.

In other words, he is raising money from his investors. He and his team will take dilution. They will own less of the business.

The founder bets when raising money.

Tim's thinking goes like this, “It is better to own a smaller piece of a much bigger pie than a big piece of a small pie.”

Tim will exit startup Gate 5. He is building a company which will make money.

He hired the people who will make good on the promises of the forecasted sales. This is a big bet. He believes he needs to raise $500k to realize faster sales growth and then achieve profitability. His board is telling him to raise $1.5mm so he has ample margin for error.

Tim will raise the $1.5mm at his desired valuation. He will do it because the current and prospective investors believe in Tim, his market, his results, and his resolve to build a profitable company. It’s a good bet for Tim and a good bet for the investors.

I can hear the last gate swinging shut behind him. Go, Tim!