Why growth is the most important thing..
..and why you should not sacrifice growth for better margins
I will show you how an insurance start-up that gets to $100M GWP and profitability within six years might still struggle to attract investor interest
This note is inspired by an old post from Rob Moffat. In his post, Rob discussed the balance sheet requirements for fintechs. Using a simplified financial model, he showed how such businesses might generate attractive returns.
I hope to borrow Rob’s model to illustrate a different point: why top-line growth is actually the most important metric in the first decade of a VC-funded company. For full context, I encourage you to read Rob’s original post so you can get closer to his model. You can play around with my version of the model here. Here are the assumptions I use in my model:
Our fictitious insurer underwrites $5M GWP in Year 1. It grows at 100% for first five years and 50% for years 6-10. Total GWP reaches $120M by year 6 and exceeds $600M by year 10
It maintains a loss ratio (LR) of 60% throughout
It maintains expense ratio (ER) of 15% throughout. However, note that this is not a true ER figure as we separate out ‘tech costs and overhead’. These costs start at $5M in Y1 and reach $50M by year 10. While the 15% ER figure might seem low, having ‘technology costs’ separated out like this somewhat takes care of this.
The insurer uses 80% quota-share reinsurance so in effect the NWP is ~20%. The reinsurer takes 10% margin in return for the risk.
Our fictitious VC makes an investment of $10M in Year 0 (Series A) for a 25% stake. The insurer does another fundraise of $30M in Year 2 and then another $50M fundraise in year 4 - each in exchange for 25% stakes. As a result, our VC’s net ownership position dilutes to 15% post year 4. There is no further fundraising beyond this point.
There are a few other assumptions too - almost all of them can be debated, however that is not the point here. Rather, I hope to show how LR in early years is way less important than the top-line growth rate. Here’s how our numbers come out in the base-case:
Given that most VC funds have a typical timeline of 5-7 years, a promised multiple of 3.9x by year 8 is not anything to get excited about. It is definitely not the 10x+ outcome that VCs generally try and optimize for.
Now let’s tweak the growth rates and Loss Ratio assumptions. Let’s say our risk-selection was actually poorer and our Loss ratio comes out to 70% (vs. 60% before). We keep it at this level throughout the 10-years. On the other hand, top-line growth is now 200% for years 1-5 and then slows down to 50% for years 6-10. We now exceed $100M in GWP by year 4 and end year 10 with over $3B in GWP. (Remember, this is just a gross figure - NWP is actually much smaller). Anyways, here is how the financials and the VC returns turn out now:
So a 10x return for our Series A investor for any liquidity event beyond year 6. Now that is definitely a lot more exciting and will have VCs likely fighting to write this check. While these numbers are illustrative, they will hopefully convince you as to why growth is generally much more important in early years than net margins. Given that VCs generally take a board seat with their investments, this lesson is generally not lost in most start-ups.
However, many public corporations today have ‘zombie’ businesses in their portfolios. These are businesses that do <$100M in revenue, have <10% growth and are either marginally profitable or unprofitable. While it might be attractive to undertake a cost-cutting exercise to improve the unit economics of these ventures, the fundamental problem in these businesses is the lack of top-line growth. Therefore, finding avenues for growth is the only thing that executives should expend their energy on.
It is also no coincidence that companies that often attract the most ‘ridiculous’ valuations - both public and private - are usually the ones growing at break-neck speeds. Such ‘2x+’ annual growth is (partly) the reason that insurtechs like Lemonade, Wefox, Root and Hippo have been able to raise money at such high valuations. It is also the reason that in early 2019 when Lemonade’s growth appeared to be slowing down, the COO sought to clarify this in a blogpost. Here is what he wrote:
Notice how Shai doesn’t harp on the fact that the LR is still at 99% or that ER might be high but dedicates an entire paragraph to explaining the growth ‘issue’. Ultimately, investors seem to have taken Shai’s explanation as Lemonade was able to raise a new $300M round just a few months later at a $2B+ valuation.
There is an old saying in finance:
Cash is King
However, it should really read:
C̶a̶s̶h̶ Growth is King
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