Leibovich’s CRAP Theory: Does a Startup Have to Demonstrate Instant Profitability?

Recently, Co-Founder of Catch of the Day, Hezi Leibovich made a statement by writing that profitability is the bottom-line. But is this really the case, or is his theory – as the name suggests – really just CRAP?

Last week, Catch of the Day Co-Founder Hezi Leibovich described his theory of the CRAP business model in BRW. The entrepreneur attests that there are many businesses in the online space that aren’t generating profit and therefore aren’t successful businesses.

As such, CRAP “stands for Cannot Realise Any Profit”, Leibovich tells us, and it is these businesses that can’t be described as successful.

“Many start-ups today focus too much on generating top-line revenue while behind the scenes the founders have to raise more and more funds to cover their burn,” Leibovich writes. “It looks sexy to have a million-dollar company in a very short time, but it is only if that million-dollar company is not glossing over the $5 million in start-up capital it has not yet paid back to its investors that you could call it successful.”

This sentiment is by no means new, and Leibovich isn’t the first to voice these concerns in the public arena. However, they aren’t necessarily accurate and they even draw very close to echoing the sentiments made by Razorfish Australia Managing Director Doug Chapman at the CIO Summit in Brisbane, mid-2013. The very same statements that prompted Gabby Leibovich (the other half of Catch of the Day’s founding partnership) to issue a direct challenge in response.

“I’ve never heard so much bullshit talked about a business model since the dot com days of the new millennium,” Chapman said at the time, accusing practically the entire e-commerce sector of unwarranted evangelism.

The truth is, there’s plenty to agree with in both sentiments. E-commerce businesses – unless they’re publicly-listed – could easily be hyped by their respective owners and management teams. It certainly wouldn’t be unusual for a business owner to spruik his venture without being completely honest about the details of its profit and loss statements.

Instead, the disparity lies in the sheer irony of the saga. On one side we have Chapman, who, over six months ago accused Catch of the Day – among others – of hyping their success, when in fact there was little evidence to attest for it. Now we have Leibovich, accusing online startups of throwing around large amounts of money and acting like successes without yet being able to return a profit.

The fact that Leibovich ascribes true success to real profit matters not at all in the discussion – primarily because Catch of the Day hasn’t publicly revealed its P&L (I’ll be more than happy to take up Gabby’s offer, however), and also because it simply isn’t true. Immediate profits don’t equate to immediate success and anyone who’s ever thought about starting a business could tell you why.

Just because a company turns a profit in its first year, doesn’t mean it will continue to turn a profit. In the opposite case, it’s equally true that a business which doesn’t earn a profit in its first five years could turn out a massive profit in its sixth. If you need an example, look no further than Amazon to see a massive international business that brings in enormous revenue, but is yet to return any profits at all. Is Leibovich including Amazon in his argument?

Perhaps if the statement was restricted to just the CRAP theory – cannot realise any profit (as in any profit, ever) – it would ring true, but in discussing online businesses that are attracting significant amounts of investment from significant investors, Leibovich’s argument goes wanting. There’s nothing in his article that explains why such a business might not start making huge profits in the future. Is it true to say that the business isn’t a success then?

“I am more enthused by new, technology-led revenue models that don’t even have a revenue stream when they launch,” says Paul Greenberg, CEO of NORA (and Co-Founder of DealsDirect, which just became the first pureplay online retailer in Australia to go public). “Think Google, Facebook, Twitter or YouTube. These are deeply valued business – and in most cases profitable – but when they launched, they didn’t have a defined pathway to profitability. Indeed, they filled a need, then worked on monetising later.”

Greenberg describes a clearly-defined strategy for success that, somewhat ironically, is the exact opposite of the model Catch of the Day was founded on (advertise products that aren’t needed at prices that can’t be refused, then squeeze the buying decision time as much as possible). Is that to say Catch of the Day isn’t a successful model? Not at all – but it is a model that would struggle to generate significant brand loyalty.

“Each business is unique,” Lucas McEntee, serial entrepreneur and CEO of Coupay tells us. “But if you generate sales and profits early on, it allows the founders a lot of scope to bootstrap for longer, protecting their own upside should investors be needed later on.”

According to McEntee, investors tend to look for four main things when investing in a business:

  • Has management done this before – i.e. what’s their track record?
  • Market position – are they number one or two in the market?
  • Does the business have a unique offering – how hard is it to replicate?
  • Are they profitable? If not, when will they start to generate profit?

When applying these questions to either Catch of the Day, The Iconic, or just about any other e-commerce-focused business of the past ten years, there’s some significant head-scratching that needs to be done.

So who wins? Healthy profit or huge revenue? What’s more appealing – a business that’s turning over $100 million with a profit of a million, or a business turning over $5 million with a profit of $1.5 million? “Turnover’s vanity, profit is sanity” so the saying goes, yet still we see smart investors putting their faith and cash into businesses like Amazon and The Iconic – businesses with big scale, big ambitions but scant profitability (if at all profitable). At the end of the day, at least in the niche Australian market, it’s unpredictable which way the trade winds will blow, and a lot of it comes down to the people behind the businesses. Like Bezos the Messiah, investors seem more willing to back in a convincing founder/manager on a mission for world domination over a modest business with a healthy profit.

That’s the debate – early stage profitability and scalable growth versus the highly funded, all-out land grab. Who will be in front five to ten years from now?

Perhaps Leibovich is right in saying that a business itself can’t be considered successful until it demonstrates profitability – but until these businesses go public, the statement is essentially redundant.

Or perhaps Leibovich’s CRAP theory is very much a throwing down of the gauntlet. Perhaps it won’t be long before we do hear Catch of the Day is releasing its very own IPO.

What are your thoughts? Is profit really the bottom line, or is this just a CRAP theory?

 

3 Comments

3 thoughts on “Leibovich’s CRAP Theory: Does a Startup Have to Demonstrate Instant Profitability?”

  1. Steven P says:

    I have to say I’m with Hezi on this one. The purposes of businesses is to make a profit. If profit is not important to you, there are 100s of 1000s of very good non for profits who can do with your help. I think the issue Hezi has is not with start ups that don’t make a profit from day one, but rather those that can’t make a profit (or don’t within a reasonable period in order to give investors some sort of return). Yes, we have a few examples of successful businesses that didn’t know how they would make a profit, but there are many many more examples of those that simply went under, never realising a viable return for investors.

  2. Ted Nugent says:

    Neither profit nor revenue really matters here. You can generate huge profit over certain period of time but if it gets trapped in stock then you are bound to pump up more sales at all costs to avoid cash flow issues. That why all this hype about “being no 1, the most successful, etc.” You MUST project success as this is one of the means of maintaining sales volumes. This is the rule of the game. As soon as revenue growth stalls then the entity will inevitably start facing cash flow problems which will in turn lead to payments delays etc that will again lead to revenue drop and so it goes.

    What I mean is that you can not look either at revenue or at profit and make conclusions whether the company was a success. Balance sheet items like stock, bank accounts, loans are essential parts of such analysis.

  3. phil grech says:

    So is cold hard cash,the only metric we can use to classify a business today? I like what Paul G wrote above. Each one of those businesses stated by Paul were able to monetise down the tract and in doing so, they are changing the world and I will also argue they were all very successfully before their balance sheets confirmed it.

    If we get start-ups to focus solely on the $$$, we are downplaying the scope of the contribution businesses can have on society. Hezi is obviously looking though his paradigm and that’s fine but the thinking is old and probably most aligned to a Bank than anything else.

    In my opinion, what is lacking are true spokespeople for the industry that can assist start-ups by becoming something truly amazing by simply helping them focus on the dozens of other attributes that make great companies. Get those right and the money will come but suggesting a methodology where you need to get to the outcome without going down the paved road just doesn’t sit well with me. The paved road could be a long one and taking shortcuts will eventually see your car stuck in a field covered in mud with no whinge anywhere to be seen.

    Good retailers can sell a lot of goods & services. Great retailers can sell those same goods & services while appealing to the deep emotional side of a client and provide an incredible working environment for their staff, a support network for their families and an eco-system that contributions positively to society as a whole. Why do we need these because the world is one great huge business eco system that impacts all of us, each and every day and have the large eco system focused on money will not meet the needs of tomorrow. Google is who they are today because they ignored the black and white notion of money as stated above and pushed ahead with new age thinking that is much more aligned to the human spirit.

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