Dan Lyons’ theory on startup economics is flawed. Here’s why.

Disrupted, Dan Lyons’ tell-all of his brief tenure at HubSpot, has taken the startup world by storm, and for good reason: in the book, Lyons portrays one of the east coast’s most celebrated tech startups as an organization rife with ageism, and one that sells high-minded ideals and self-praise in one hand while offering a sub-par product and employee mistreatment in the other.

While the majority of controversy surrounding Disrupted has to do with diversity and culture in tech startups and uses the HubSpot anecdote to paint a broad stroke across the entire landscape, there is another argument that Lyons makes in his book which is going overlooked and under-analyzed: one of his big criticisms of the “startup bubble” is that all these companies are unprofitable. He groups together the likes of HubSpot, Twitter and Amazon as representative of a new economic model that has taken hold in Silicon Valley, where reckless and omnipotent VCs back startups with the only goal of generating hype and going public before most people even have time to investigate their business models, so that the investors and founders can sell high before the company goes under.

But is this broad-stroke criticism fair? Here’s what I’ve learned about the VC-backed investment space from my time working for an investment management firm, learning about the VC industry in business school and now working at a VC-backed startup.

The number of VC-backed companies is really small.

Fewer than 1% of companies receive financing through the world of venture capital.  VC firms invest almost exclusively in tech companies that have the prospect of becoming very large (a “big addressable market” is how a VC would put it).  VCs make money by placing a lot of different bets within a sliver of the market in hopes that a few of them hit big. They will invest in, say, 20 startups, and most of them end up being worth nothing (a “donut” or 0% return), a few are mediocre, and then a few account for all of the positive returns. The returns look like a dumbbell, and that’s what they call it. But, ultimately it's based on probability and precedent, not “spray and pray,” as Lyons described it.

VC-backed companies are likely unprofitable, and it’s probably on purpose.

No VC or startup founder wants their company to end up as unprofitable, but being unprofitable is a stage many of them need to go through, and here’s why: a startup’s technology advantage might not exist for more than a decade due to the rapid pace of innovation.  So, they need to scale their key growth metrics (revenue, users, etc.) as quickly and efficiently as possible.  Using funds that the startup does not yet have in order to invest in that growth is the reason that this lack of profitability exists, even if the company actually sells a valuable product that they charge money for (and this happens at many more startups than we all read about in the headlines, because we almost only hear about consumer-focused startups). But the idea that it’s all about scaling quickly is true.

B2C companies are almost always nowhere near profitability at the beginning.

The B2C business model that we should all be most skeptical about is the “user as product” model. That is the model where the tech company, like Twitter, creates a technology that they give away to you and me in the hopes that someday enough of us will use it so that we can be advertised to.  The challenge is that advertising is interruptive to the original consumer experience of their product. Even cash cows like Google have the challenge of selling ads at the top of the page that push organic search results lower down (although it hasn’t slowed down Google’s profitability or created an opening for other search engines, because they established market leadership before turning on the “monetization engine,” i.e. selling a LOT of ads).

The same thing happened with Facebook—it waited until 10% of the WORLD was using their platform before getting serious about selling ads. Very few win this game, and even the companies that have a better shot than others, like Twitter, are struggling to do so.  But the wins are SO huge that the VC money will chase them, based on the small (but not impossible) chance of finding the next Facebook.

B2B models vary, but SaaS is emerging as attractive.

Companies like HubSpot (and Salesforce, Workday and Seismic) are SaaS—meaning that our products are hosted remotely in the cloud and our customers can access them by paying an annual license.  While they don’t generate the sexy user numbers that are found on the consumer side of tech, some VC and private equity firms invest exclusively in companies with this business model because it has inherently attractive qualities: high margins, low overhead and—if you have happy customers that keep renewing their annual license—a steady recurring revenue stream. Ultimately, there is still a lot of interest in investing in an actual product that generates actual dollars!

Not all SaaS is the same.

Even within the SaaS model, the segment of the market that you sell into and the value-add of the product makes an enormous difference in terms of the profitability prospects for the startup. Lyons points out that HubSpot sells into the SMB space and that they have a $6,000 average annual revenue . This isn’t a ton of money, and there’s still a lot of work on the product, sales and customer support teams that goes into delivering a SaaS product. But what if you are focused on selling to large companies, with $100,000 of average annual customer revenue? You’ve got a much better chance of having positive net operating margin (meaning that the business is inherently profitable).  A company in this scenario could be profitable TODAY if it chose to invest less heavily in sales and marketing, but might be burning cash to grow quickly during that short window that it can gain market share.

Lyons’ conclusion might not be wrong, but his reasoning isn’t right.

The vast majority of the startups that make splashy headlines in TechCrunch for raising an early round of funding don’t end up going anywhere. In the process of those failures, and even those that are successful, the small sliver of the investment market that is venture capital still represents a large amount of dollars, and that makes for an easy target and great fodder for satirical shows like the Lyons’-penned Silicon Valley. But that doesn’t excuse Lyons from making ALL startups seem like some form of bubble or scam. Companies have vastly different business models that achieve profitability at different points of time during their lifecycle as companies, based on vastly different circumstances such as potential market share, target customer base, or existing technologies. There is still a place in the market for companies that sell real products for real revenue to happy customers that could choose to be profitable TODAY if they wanted to (and they even might be). They are just choosing to grow more quickly, knowing that the pace of innovation isn’t slowing down anytime soon.