Profit: the worst way to manage a startup

The startup landscape has been challenging over the past two years. VC funding is down more than 50% since 2022 and falling interest rates is not the panacea that most hope that it will be. Several reliable publications have intimated that funding for startups may even remain constrained until the end of the decade; yes, another 6 years of famine. Even if VC activity picks up, competition for funding will remain fierce. Not every startup will secure the investment they hope for. More importantly, the timeline of the turnaround is uncertain — it may take longer than anticipated for funding levels to recover.

So founders should be laser-focused on maximizing profit right? Wrong.

Profit is a poor indicator of business health, performance, and longevity for startups. While profit works well for large corporations by smoothing out short-term fluctuations and driving shareholder reporting, it doesn't reflect what truly matters in a startup environment: cash flow. It’s possible to be profitable on paper and still run out of cash, jeopardizing the business. Below are key areas where focusing on profit alone can mislead founders. The examples I use are real examples I’ve seen as a startup CFO.

Capex as a cash sink

Capital-intensive purchases can exhaust cash very quickly. I’ve had clients using microscopes worth over $1,000,000, or others with server equipment worth well over $500,000, or an ERP costing well over $250,000. Depending on your cost of capital or debt, this could be a highly efficient way to run your business over the long term. However, once that cash is spent, it’s unavailable for anything else.

• A biotech startup receives a $1 million grant to research a new drug molecule. It uses the grant to buy a $1 million microscope with a 10-year lifespan. From a cash standpoint, the purchase is an even wash. On a cash basis, it’s an even wash. However, for accounting purposes, this transaction will result in a profit of $975,000, assuming it goes into use in October. As a bonus ‘kick to the teeth’, this will create a federal income tax liability of $205k, payable by April of the following year.

Although it may look bad in the short term, leasing or accessing cloud computing services are easily-scalable ways to get the capex or IT infrastructure without massive up-front outlay. Of course, the your provider will be making a profit, but you keep the cash until you have enough capital to buy yourself. It may even make sense to never buy this equipment. A lease vs buy calculation in isolation will often recommend to buy, but this emphasizes the importance of a comprehensive financial plan. A competent CFO should easily navigate this balance.

Revenue recognition

Revenue Recognition can distort your profit greatly. The accounting standard ASC 606 has been around for a while now, but I see many business leaders struggle when deciphering profit from revenue contracts. It is entirely possible to have completed the ‘performance obligation’ but be paid on extended terms, even over multiple years.

• A biotech company provides a 5-year license to access its unique and protected Intellectual Property to another company. Once the license is granted, and the IP database is provided, there are no other obligations under the contract. However. the contract allows the client to pay in equal installments over 5 years. In this example, all profit is recorded up front, but you don’t have the cash in the bank. As a double gut-punch, this is taxable so you may be remitting taxes to the IRS for money you haven’t even received yet.

There are two aspects to deferred receipts of cash. In the short term, it can be as simple as offering short credit terms, and managing to them. 30 days is typical, but some companies can take 180 days to process. This isn’t just because your invoice is ‘caught up in the system’, it’s deliberately designed that way to benefit the customer’s own cash flow. Over the longer term, multi-year platform agreements can mean that provide a license up front are paid over an extended period. Once the agreement is signed, it’s too late. CFOs need to be involved in contract negotiations and drafting to ensure agreements are correctly structured before the problem arises.

Inventory

Inventory can swallow enormous cash reserves. This is a critical part of being able to satisfy client demand. I’ve had many retail clients who have great margins on their product, but have bought far too much inventory, often to get volume discounts. Spending cash on inventory has NO impact on profit; it merely converts one type of asset to another. Inventory is worth nothing to you until it converts to cash, but profit is not impacted at all. You can also lose the advantage of volume purchasing if you have to discount or liquidate your stock.

• A cosmetics manufacturer/retailer purchases ingredients in bulk to reduce its raw materials costs and improve gross margins. It spends $400,000 on a particular ingredient that is very expensive in small quantities. In fact, this is a deal which is 70% cheaper than its usual unit cost. Because so little of it is needed for each sale, they now have a 12-year supply of that ingredient. Although its previous annual product cost of $111k is now down to $33k, that cash won’t return until the final retail product is sold. Worse still, the product is only shelf-stable for 8 years, so the teeth’, this will create a federal income tax liability of $205k, payable by April of the following year.

Debt servicing

Debt can provide much-needed capital, but servicing it is a double hit; not just the interest, but amortizing the principal. Unlike your house mortgage, you don’t get 30 years to pay off business loans. The principal payments have no impact on profit, but can have a big impact on your cash reserves. Once financed cash in on board, it can be easy to spend, but it’s a one-way street. Whatever you spend needs to be backed up with revenue, and not just revenue but only the amount left over once you pay for your product costs and overhead. Even with a 10% net margin, $100,000 in principal payments will require $1m in sales. Debt can crate opportunity but the obligations can erode cash, limiting flexibility to invest in growth opportunities or respond to market changes.

An experienced CFO can navigate finance options, such as revolving facilities, and assess these against business needs.

Conclusion: Planning and cash runway management

Even small profitability gains can extend a startup’s runway and reduce its dependence on external capital. However, focusing exclusively on profit can lead to a false sense of security. Cash flow management is essential. Startups must develop comprehensive financial models, align contracts with cash needs, and manage inventory and debt effectively.

Running lean not only increases the odds of survival but also makes the business more attractive to investors. A lean startup with strong cash management can avoid excessive dilution and preserve founder equity. If VC funding doesn’t materialize, the business has bought itself time to stay in the game. If it does, a well-run business commands higher valuations, reducing the amount of equity the founders must give up.

With the right planning and discipline, startups can emerge from a prolonged funding drought stronger, more resilient, and better prepared to thrive when market conditions improve.