The Scaling and Profitability Trade off: Venture Capital's Weakest Link!

    It is undeniable technology companies have found their most hospitable setting in the United States and while there are many reasons for the US dominance of technology, easier access to capital for young businesses has been a key ingredient. Venture capital in the US, in its institutional and organized form, can trace its roots back to the 1950s, and over the last few decades, it has generated its share of legendary investors. Vinod Khosla is one of those legends, and it is for that reason that I was surprised to see him tweet the following:

I understand that utterances on social media, often in response to comments by others or made in anger, are often quickly regretted, and I believe (though I am not certain) that Mr. Khosla did not quite mean what he said here, confusing profitability with cash flows, and arguing that every business should put scaling ahead of profitability. That said, his view that scaling should be given priority over profitability is more the norm, than the exception, among many venture capitalists, and while it probably always has been the case, I believe the tilt towards scaling has become pronounced in the last two decades. In this post, I want to zero in on the scaling and profitability trade off, how the emphasis on the former over the latter plays out at start-ups and very young companies, and why we live with the consequences, whether they want to or not.

Scaling versus Business Building

    To put the choices you will face on scaling up versus business building into perspective, let's assume that you are a founder, and that your start-up has a tested product and that you believe there is a market for that product. You can stay with what you have built and build a business to take advantage of the immediate market, focusing on financial health and profitability. The fact that you will stay small, and perhaps unrecognized in markets other than your own, is a minus, but there are pluses. You will have little need for external capital, and you will own much or all of the business, facing little pressure from outside to change the way you do things. Alternatively, you can take a more ambitious route, where you seek out a bigger market, augmenting existing or adding new products, and while that path will deliver larger revenues, you may have to work harder to get it to deliver profits and cash flows, and perhaps have to give up more of your ownership and control of that business.

The Scaling Choice

    Before starting on the determinants of scaling, it make ssense to begin with the metric being scaled. For most businesses, it is revenues that is the chosen metric, with scale capturing how big revenues can become over time. With some earlier-stage businesses, many of which are pre-revenue, the metric can become a variable that these businesses hope to convert to revenues; with tech intermediaries and social media companies, it can be users or subscribers. 

    Focusing on scale, though, there are factors that come into play that allow scaling to have a higher likelihood of success in some businesses than others:

1. Market size: It is easier to scale up a company, if it is small player in a big market, than if if the market is small, and scaling up will quickly give you a dominant market share. That said, the way you describe your business, and then run it, can play a role in how big a market you will have for your products. In my posts on valuing Uber, for instance, I noted that describing it as a logistics company (car service, moving, delivery) rather than just a car service company could triple its potential market. 
2. Market growth: It is also easier to scale up a company if the overall market that it is targeting is also growing, since growth does not require going after competitors' customers. A smartphone company (Apple or Samsung, for instance) in 2010 had a growing market to work with, as customers switched from flip phones and smartphones made inroads into large emerging markets.  In 2026, that advantage had largely dissipated, as the smartphone market has matured.
3. Industry Structure: There is a natural structure to industries, driven by economics and business type, with some industries splintered across many players, and some concentrated in a few big players or even in a winner-take-all. You can scale up more in the latter, but you will have to confront the odds favoring you being one of the winners in the industry.
4. Capital intensity: It is easier to scale up a business that does not require large capital investments to be able to generate more in revenues. Using Uber as an example again, scaling up was made easier in the early years, since it did not own the cars or hire the drivers that comprised its car service, and growth came quickly and with little added investment.
5. Customer inertia: Businesses can grow faster and get bigger if there is less inertia among customers and more willingness to try out new products or services. At the risk of generalizing, this may explain why scaling up can happen more quickly in younger industries (like technology) than in older ones (health care, education).
6. Key person(s): There are some businesses that are built around the specific skill sets of a person (usually a founder or business owner) and these skill sets are not easily transferred or taught to others. A master craftsperson, say a furniture-maker, will have a more difficult time scaling up that business, because without being able to pass his skills on to his or her apprentices (which can take time and require intense oversight), he or she is constrained in how much new business he can take on. If that craftsperson has a recognizable name, it is possible that you could build a scalable franchise model, as has been tried by some master chefs (Wolfgang Puck, Gordon Ramsey etc.)

The graph below captures the scaling choices that companies make as a function of these factors:

As you can see, some businesses can scale up quickly, some take more time to scale up and some never scale up, and the businesses that scale up quickly often scale down just as fast. Thus, the decision of whether to scale and how quickly to do so is as much driven by the nature of the business (capital intensity, industry structure, competition) and the characteristics of the market that it is targeting (size and growth, customer inertia). 

Business Building

    While having access to a big, growing market can allow you to scale up more quickly, your capacity to generate profits and build a business will ultimately come from other forces:

1. Unit economics: Unit economics measures the profitability of the marginal unit sold by a business, and is thus determined by the price charged for that unit and what it costs the business to produce that unit. Businesses like software, where the marginal unit costs very little to produce and can still be priced highly, have superior unit economics and will find it easier to convert growing revenues into profits, since much of the increase in revenue will flow into profits.  Conversely, businesses like electric cars, where each additional car sold costs money to make, will struggle to convert scaled up revenues to profits.
2. Economies of scale: Businesses with large fixed costs, whether they be associated with maintaining platforms and infrastructure, or sales and marketing, face obstacles to profitability. While growing can provide scaling benefits, that works only if the fixed costs don't grow with revenues and if they are not so onerous, that you still have losses after scaling up. 
3. Competition: & Competitive Edges (moats): Large and growing markets provide businesses with opportunities to grow, but for that growth to translate into sustainable profits, these businesses will need pricing power and that power comes from barriers to entry that keeps new entrants out and gives existing players advantages. 

It is true that the operating choices that businesses make play out on both the scaling and profit dimensions, sometimes pitting them against each other. A decision to lower product prices may increase revenues at the expense of unit economic profits, and a decision to spend more on advertising and promotion may expand markets, but the higher marketing costs will impose a drag on profitability.

    One way to illustrate the combination of forces that go into business building is to to go back to basics, and to look at what lies under each one:

As you can see, scaling up is not a mantra that automatically translates in profitability, and the pathway to profits will be determined by variables that are often out of the control of a business. 

Scale & Profitability Mixes

    With the multitude of factors determining both scaling potential and business model viability, it should come as no surprise that the outcomes that we observe can range the spectrum, starting with extraordinary companies that scale up quickly, while delivering huge profits, to companies that never scale up, either by choice or because they could not, and some of which never make money.

1. Lightning in a Bottle: Are scaling and profitability mutually exclusive? Put differently, can a company scale up, while delivering profits and perhaps positive cash flows as it grows? The answer is yes, but it does require a fairly unusual combination of circumstances - a big and growing market, being an early entrant into the market with few competitors, low capital intensity and excellent unit economics.  There are a few companies that meet these conditions, and we will call them "Lightning in a Bottle" firms, partly because they are rare, and partly because success can come from being at the right place at the right time. Google and Facebook, in their early years, were good examples, with revenues growing exponentially and profitability in place.
2. Field of Dreams  (Shoeless Joe Jackson version): As a baseball fan, I have always had a soft spot for the movie, Field of Dreams, where a farmer (Kevin Costner) builds a baseball field in the cornfields, and when asked why, responds with "if you build it, they will come". There are companies that seem to be built around this motto, where scaling up comes first, often accompanied by large losses, but with the promise that "if they build (revenues), they (the profits) will come. During Amazon's first decade and a half of existence, I described their business model as a Field of Dreams model, and gave credit for Jeff Bezos for being steadfast in not only telling this story, but also acting consistently with it, and carrying investors along. (If you are wondering what Shoeless Joe is doing in this story, I am afraid you have to watch the movie all the way to the end.)
3. Field of Nightmares: Amazon was not the first successful Field of Dreams company, but as one of its highest profile winners, it gave rise to a legion of young companies, all labeling themselves the "next Amazon". Needless to say, Amazon's success came from being a disruptor of a huge business (retail), which had atrophied and weakened over time, and many of the Amazon wannabes that tried to imitate it managed to do so on the growth dimension, with immense amounts of capital invested in scaling up, but never turned the corner on profitability, partly because they had neither the unit economics nor the economies of scale to pull it off.
4. Niche Star: Scaling is not always the optimal choice, and there are some companies that recognize this reality early, choosing to stay small and focusing on a portion of the market where they have decided advantages. To that extent that they can convert those advantages into premium pricing and niche market dominance, they can have values that are disproportionately large relative to their operating metrics, i.e., trade at high multiples of revenues and earnings. Ferrari, for instance, sells only a few thousand cars every year, but with an operating profit margin in excess of 20%, it trades at a market capitalization comparable to that of auto companies that sell hundreds of thousands of cars each year.
5. Big and Broken: It is no secret that there are some businesses that start with business models with a fatal flaw, i.e,, a broken business model, and rather than being shut down, they are fed increasing amounts of capital and allowed to scale up. A real-estate based business that leases properties long term, and then sub-leases them short term, has a duration mismatch born in hell, and expanding it geographically and allowing it to lease hundreds of properties, as WeWork did, just makes it a really big, bad business. If you are puzzled as to why investors would supply capital to these businesses, you may want to read on.
6. Small winner & Small losers: If you look at all businesses, private and public, most remain small, some due to business and industry structure and some because of owner constraints on capital and control. These small businesses, though, over time, bifurcate into good small businesses, earning more than their cost of capital and delivering value, and bad ones, earning less than the cost of capital, but still worth more as going concerns, than liquidated.
7. Cut your losses: Finally, there are businesses that start up with dreams aplenty, and over time discover that they can neither scale up, nor make money. In the absence of capital infusions, these businesses fail early, but if capital providers keep funneling resources into these companies, they still fail, but do so later and with a much higher price tag.

In the matrix below, with scaling on one axis and profitability on the other, I plot all eight of my scale/profit combinations:

Any investor or founder who blindly follows the pathway of scaling first and profiting later for every business is using a cookbook approach to business building, and runs the risk of making small failures into big ones. 

The Tradeoff between Scaling and Profitability: Determinants

    As you review the factors that govern the trade off between scaling and profitability, it is clear that the right choice (on how much to scale) will depend on the firm, and that not every small firm is destined to become or be more valuable as a larger firm, and that not all large firms have the same profitability characteristics, once scaled up. That said, is it possible for firms to adopt scaling pathways that look, at least from a business standpoint, to be suboptimal? Of course! There are small firms that have viable pathways to scaling up that choose to stay small, and at the same time, there are small firms that are designed to be small, niche businesses embark on scaling that is value destructive, and the reasons are a mix of human frailties on the part of founders, system constraints (from governments and regulators), access to capital (too little or too much) and exit options (sell, liquidate or go public).

1. Founder Characteristics

    The founder or founders of a business not only play a key role in guiding the business through its early days, when most start-ups fail, but they also make key choices that can determine in its end game. In making these choices, they may be guided by the fundamentals we outlined in the last section, that affect scalability, but they are also a function of their personal make-up, on at least a couple of dimensions:

• Control versus Ambition: There is a natural tension between wanting to control the levers of decision-making in a business and scaling that business, since the latter almost always requires raising capital from providers who will either constrain your choices (if borrowed money is used) or demand a share of ownership rights (if equity). With the latter, founders will find their control diluted over time, and with enough scaling up, it is possible that founders end up with less than controlling stakes. For some founders, that fear of dilution and losing power over their business creations runs deep enough to stop them from embarking on growth plans, even though these plans make economic and financial sense.The flip side of control is ambition, and for some founders, the desire to build big businesses that are not restricted geographically or in product offerings can drive the decision to scale up, even though the fundamentals may not support that expansion. This works only if they can convince investors that their ambitions In fact, this tension between a founder’s need to be in control and that same founder’s desire to build big plays out in what Noam Wasserman called the Founder’s Dilemma, where to make a business bigger, its founder has to step down or at least compromise on control.
• Longevity versus Scale: There is an argument to be made that if your intent as a founder is to build a business that is long-lived, your odds of success improve if you keep your business smaller and more focused on what it does well. While there are many exceptions to this generalized rule, it is worth noting that some of the longest lived firms in the world are family owned small businesses, that serve a niche market, and are passed down generation to generation in the same family. It is also true that firms that see a sudden surge in revenues, usually as the result of an external factors or happenstance, often live to regret their good fortune, as they scale up overnight. In the aftermath of the Covid shutdown, for instance, firms like Moderna and Peloton boomed, but they also overreached, and did long-term damage to their business models.

In summary, the choice between scaling and profitability will play out differently across businesses, depending upon what founders value most, thought it is healthy for an economy to a have a mix of founders, since it creates a mix of businesses.

II. Access to capital

    It is true that businesses need access to capital, to varying degrees, to scale up, and the easier it is to raise that capital, the easier it is to make a business bigger. Capital can come from different sources, ranging from family wealth to venture capital to public equity, with each one carrying its pluses and minuses.

• Family (or friend) wealth:  Every business, through human history, having lived through its early days (when failure risk is high and its products and services are still untested) has faced a choice of whether to stay small, serving a market that it knows and understands, or whether to get bigger, going after a bigger market. For much of that history, though, with businesses funded with family funds and access to capital was limited, most businesses chose the first path and remained small businesses, focusing on building business models that delivered profits, with wide differences in success rates. For a few, owned by wealthier families, access to a much larger pool of capital (from family savings and bankers willing to lend to these families) created family groups that dominated economies, and continue to do so in some parts of the world. 
• Venture capital:  The growth of public equity markets in the late 1800s and much of the last century did little to change the family control dynamic, since investors in those markets were primarily interested in funding larger companies with established business models. Recognizing this gap between capital need and capital access at younger businesses, and the opportunities that the gap presented, allowed for the rise of venture capital in the 1950s, primarily in the United States. These venture capitalists provided seed capital for start-ups, using winners to cover their failures, and got the bulk of their winnings when they exited these investments, either by going public or selling to another entity. Over the last few decades, venture capital has grown, and in the last 12 years, that growth has not let up: 

  

  Source: NCVA 2026 Yearbook

In this century, venture capital has also become more global, growing in Asia and Europe, but it is still true that it is easier for a small business to raise capital to scale up in the United States than it is in much of the rest of the world.

• Public equity: There are some growth businesses that bypass venture capital and go after public equity, a much bigger pool of capital and one that may give founders better terms. In some cases, this access to capital might be enabled by going public, even with unformed business models and little to show in terms of existing operations (revenues or earnings), but in most others, it takes the form of capital invested by larger, more mature public companies in return for a share of ownership. These investments may be labeled as strategic, but the motives for making these investments vary across companies. Some invest to get access to a promising technology or product. some to pre-empt competitors and some for the same reason that venture capitalists do.

The bottom line is that businesses that seek out capital, whether from family, venture capital or public equity, have to accept that the capital providers will demand and usually get a say in business decisions, and the more capital you seek, the more sway they will have.

III. Investor Preferences

    Businesses get their cues on whether to scale up or build business models from the investors who fund them, and much as founders want to map their own path, investor preferences matter, as do their end games. Put simply, a family that invests in a business with no plans for exit will choose a very different path for that business than a VC that invests in the same business with the intent of exiting that investment by selling it to another investor or company, or taking it public.    

    Venture capitalists are often viewed as the sherpas who guided young businesses to success, both operationally and in markets, the mythology about venture capitalists and what they do has also built up. Since that mythology extends to almost every aspect of venture capitalist activity, perhaps the best way to dispel myths and bring in reality checks is to look at what venture capitalists are "assumed" to do in each phase, and contrast it with what they actually do:    

If you are reading this as a critique of venture capitalists, you are misreading it. My intent is not to paint a picture of venture capitalists as lazy and greedy, but to bring home the reality that given how venture capitalists invest, act and are judged, it is unrealistic to expect them to do the heavy lifting of building businesses for the long term and to even make business sense, when they talk about companies.

    There are two parts of the venture capital rulebook that you should focus on, to understand why many VCs prioritize scale over profitability. The first is that they price companies, rather than value them, and in a post from a few years ago, I made the argument in more depth. VC pricing based on what other venture capitalists are paying for similar businesses, often scaled to simplistic metrics, users and subscribers for pre-revenue companies and forward revenues or earnings in what passes for VC valuation:

The second is that VC success is measured based on price at entry and price at exit on an investment, rather than the quality of the business built, and using that metric, the median venture capitalist has not been much better at harvesting alpha than the median mutual fund manager or PE investor:

Source: Cambridge Associates

There are, of course, standouts in each of these categories, fund managers who have delivered well above the market, but in mutual funds and to an increasing extent, hedge funds, that success is fleeting. There are two aspects on delivering returns where venture capital stands out, relative to other active investing classes. 

• The first is that failure, always a concern in investing, is much more a part and parcel of investing in venture capital than in other investing grouping. Put simply, not only are there more VC funds that go out of existence every year, but even the most successful VC funds lose on many or even most of the investments that they make, especially in angel financing deals. 
• The second is that venture capital investing, when it works, can generate outsized returns on winners that (hopefully) cover the cost of failures. 

You can see both of these at play in the graph below, which looks at returns that VCs book when they exit investments:

Source: CF Private Equity, from Pitchbook data

As you can see, across all the time periods, it is the top 10% of VC investments that deliver the bulk of returns to VC investors, and over time, that concentration has increased: in the 2023-2026 period, 80% of all returns to VC investors came from their top 1% of investments. The combination of these two forces (losses on most investments and outsized winners), i.e., the power law in venture capital, has two consequences. The first is that only about a quarter of venture capitalists in each year deliver above-average returns, making the average VC returns in the table above more palatable. The second is that success in venture capital, unlike in other areas of active investing (including mutual funds, hedge funds and even private equity), has been more enduring. The power law characteristic also feeds into VC incentives, leading venture capitalists to direct their capital more into chasing the biggest winners than in building businesses. In fact, the more top-heavy VC returns become, i.e., dependent on big payoffs, the more pressure venture capitalists feel (and pass on to their portfolio companies) to find the next big winner, pushing the ecosystem dangerously close to gambling.

A Changing Game

    With the discussion of the scale versus profitability at the business level leading in, and the assessment of the incentives of capital providers following, I think that we are well positioned to examine how changes in public and private markets have increased business incentives to scale, as opposed to building business models. There are two developments, in particular, that have taken the tilt towards scaling in venture capital and made it even more pronounced - the entry of public equity into the funding of private businesses and the fading of reversal, as an antidote to momentum, in public markets.

The Gray Market Effect

    For much of the last half of the last century, after venture capital established a presence in the United States, it remained the only or primary source of capital for young firms. That has changed especially int the last decade, as public equity investors have increased their investments in young, private businesses, supplementing venture capital in some and even displacing it in others. An early measure of this trend is captured in the charts below:

Kwon, Lowry and Yiming (2020)

While this graph looks at only the number of mutual funds investing in private businesses, and stops in 2016, there was a corresponding surge in capital invested by mutual funds in young, growth companies, with T.Rowe Price and Fidelity investing billions in high profile tech companies like Uber.  They were joined by sovereign funds, who invested heavily in these companies either directly or indirectly, through stakes in entities like Softbank's Vision fund.

    We can debate the reasons for why we saw this surge, with fear over missing out (FOMO) and wanting to partake in tech playing roles, but whatever the reasons, capital access surged for young companies, especially in tech, during the period. In effect, rather than two mostly separated markets - one for young, smaller, private business dominated by VCS and one for larger companies more advanced in the life cycle, where public equity suppled the funds, a gray market was created where VC and public equity fund access allowed private businesses to stay private for longer.

Public Markets: Momentum, Fundamentals and Reversals

    Public equity markets have always been momentum-driven, allowing traders who ride that momentum to prosperity, before bringing them down when the momentum shifts. At the same time, fundamentals act as an anchor, operating as a counter to momentum, leading to reversals and allowing investors to hold their own over time. While the congruence is not always perfect, scaling feeds into momentum and profitability is the most critical fundamental, and in markets with balance, when one gets out of sync, the other restores harmony. 

Over the history of stock markets, value investors have often claimed dominance, and pointed to the returns you could have earned by buying companies that look cheap on a value basis (low price earnings or low price to book) and waiting for price reversals. Traders push back by noting that over the same history, momentum has had a decisive effect on returns, especially over shorter time intervals.  While the momentum effect shows up across the decades, there is evidence that the reversal effect has weakened over time, leaving investors who bet on mean reversion and a return to fundamentals in the lurch:

Source: Ken French's datasets

The reasons given for this shift vary, and are often reflective of the biases of the investors giving the reasons. 

1. The Fed did it: For those who view central banks as all-powerful, and believe that the low interest rates of the last decade were their doing, those low rates have also become the proximate reason for market pricing behavior and reckless risk taking. Their argument is that interest rates that are close to zero induce investors to shift from bonds to stocks, and within stocks, to move from low growth, high earnings stocks to high-growth companies with little or negative earnings.
2. The rise of passive investing: In the battle between active investing and passive investing, with ETFs supplementing index funds, the latter has had a decisive edge in terms of returns over the last two decades, and its share of the market now stands are well above 50%. There are some who argue that the flow of funds to passive investing vehicles has contributed to the increased power of momentum, since more new funds flow to the largest market cap companies than to the smaller ones. In addition, it is argued as the number of active investing declines, there are fewer investors looking at business models and profitability, reducing the pull of fundamentals on price.
3. Public market composition: It is noteworthy that the reversal effect started weakening in the 1990s, a decade when young dot.com companies with unformed business models flooded the market, bypassing the more traditional route of using venture capital to grow. With these companies, where value is almost entirely driven by potential and not by operating metrics today, the catalysts needed for reversal may take longer to manifest.
4. Information sources and access: It is undeniable that investors and traders get information from a wider ranges of sources now than two or three decades ago, with social media and online sources supplying information that used to come from newspapers and financial news channels. In additional to being less curated and controlled, that information is also instantaneously accessible to the public, and price reactions tend to follow. 

While I take issue with parts of each of these arguments, there is some truth to all of them, and they have contributed to making pushing back against momentum a more hazardous exercise for investors.

The Consequences

    With larger amounts of capital being deployed by VCs at young, growth companies, substantial capital infusions from public equity funds into private capital markets, and public equity markets that are more used to and receptive to young company listings, it should not be surprising that it is changing how private companies behave. In the graph below, I look at the characteristics of companies going public in the United States, using the data that is generously made available by Jay Ritter:

Source: Jay Ritter's IPO data

There are three clear changes over time that are visible in this graph:

1. Private businesses are waiting longer before going public: As you can see, the average age of a company going public has risen over time, with the median age rising about 11 years in the last 15 years.

2. Private businesses are scaling up (revenues) more, while waiting: While private businesses wait longer to go public, they are spending that time scaling up more than they used to. The inflation-adjusted revenues at the median IPO have tripled or even quadrupled, relative to IPOs in the 1980s.

3. Private businesses are deferring building business models & profitability: The most striking feature of the data, to me, is that while private businesses are waiting longer and scaling up more before going public, they also seem to be deferring business building for much longer as well. While it was routine for companies going public in the 1980s to be profitable (>80% were), less that a quarter of the companies that have gone public in the last decade have been profitable.

While companies that are going public are bigger (in revenue terms) and less likely to be profitable, markets are attaching large market capitalizations to these newly minted companies, as you can see in this graph which zeros in on tech IPOs:

Source: Jay Ritter's IPO data

You will also notice that companies going public are issuing smaller portions of their shares to the public, at least in the initial offering, suggesting that the need for capital that drove companies to go public has become less pressing over time, perhaps because of more capital access as private businesses. While the median market cap of a company going public in the last six years has exceeded a billion, the largest IPOs command market capitalizations that would have been unimaginable a few decades ago. From Facebook, with a pricing of $104 billion, in 2012 to SpaceX, going public in June 2026 at $1.8 trillion, the trend lines are pointing upwards, especially if Anthropic and OpenAI deliver on their trillion-dollar plus pricing promise. 

Implications

    By itself, the trend towards private companies scaling up more, while public, and going public at eye-popping market capitalizations may be understandable and explainable, but there are implications that we need to consider both from an investing and governance standpoint.

1. Corporate governance: One of the reasons that private companies often delay going public is because governance requirements, from board composition to top management compensation, are more stringent at public than private businesses. While Sarbanes-Oxley, which wrote into law many of the current governance rules for public companies, is often toothless and ineffective, it still forces disclosures about governance (on conflicts of interest and board member relationships) at public companies. In addition, public market investors can pressure public companies to change governance practices or top management, if companies underperform in the market place. One of the perils of letting companies scale up more before these governance questions get raised is that the top management in these companies may have few checks on their actions. It is true that venture capitalists could operate as a disciplinary mechanism, but in an age of founder worship and where VCs can be divided and conquered, you can have companies with market pricing of a billion, hundreds of billions or even trillions run by people who are ill-suited for the task.
2. Delayed business model building: If the first imperative for a private business is to scale up, because scaling pushed up pricing both in private and public markets, the challenge of business building will get deferred to a later stage. The problem with scaling up first, and building a business model later, is that it may be too late, since the choices made to allow for scaling up may impede the pathway to profitability. Again, if your response is that VCs will work on fixing this problem, they have little incentive to do so, since they benefit from scaling up and exiting these businesses, before the business problems become too big to ignore. 
3. Scaling stories: If you believe, as I do, that valuation is a bridge between stories and numbers, and that the balance between the two shifts over the life cycle, with stories dominating early in the life cycle and the numbers taking center stage in the later stages, it is understandable that VCs and founders, when marketing their companies are primarily story tellers. I don't have a problem with that, but as I noted in my last post on AI as a business, the stories that are being told for these companies are often incomplete, and almost entirely focused on the scaling question. Thus, in the Anthropic sales pitch it is the growth in the annualized revenue run rate (ARR) and the size of the AI market (huge, but with no specifics) that comprises the bulk of the story, with little or no mention of business models or profitability.
4. Disruption without replacement: Disruption has been a key component of the stories that underlie many of the largest companies that have gone public in this century. Accepting the premise that a healthy economy needs a shaking up of the status quo, and that disruption can lead to economic growth and better practices, it is still legitimate to look at disruption's debris. One of the perils of supplying capital in almost endless quantities to private businesses that aim to disrupt, without challenging them on business models, is that you may succeed at disrupting the status quo (driving existing players out of business) but your disruptor may not be able to build a business that can be self-sustaining in the long term.

Conclusion

    I am sure that you are already aware of the core message of this post, which is that notwithstanding the current emphasis on scaling up businesses, not all businesses are meant to scale up, and that scaling up comes with challenges that founders may be ill-equipped to meet. That said, ambitious founders will feel the urge to make their businesses bigger, and if they raise capital (from venture capitalists) to make this happen, the incentives to scale up will increase, even if it makes little or no business sense to do so, with all parties hoping to exit by selling to others (public or private) who will price based on scale. While this has always been the case, changes in private and public capital markets have tilted the scale even further in favor of scaling, and it is possible that companies, both public and private, with sky-high pricing have been built on bad business models that are irredeemable.

YouTube Video

Blog posts on Venture Capital and Scaling

1. Blood in the Shark Tank: Pre-money, Post-money and Play-money Valuations (February 2015)
2. Billion-dollar Tech Babies: A Blessing of Unicorns or a Parcel of Hogs (June 2015)
3. Venture Capital: It is a pricing, not a value game! (October 2016)
4. Risk Capital in Markets: A Temporary Retreat or a Long-term Pullback (July 2022)

Data Update 6 for 2026: In Search of Profitability!

     Crass and mercantile though this may sound, the end game for a business is to make money, and a business that fails this simple test cannot survive for long, no matter how noble its social mission, how great its products and how much it is loved by its customers and employees. In this post, I start with a defense of this mercantile objective, and argue that attempts to expand it to incorporate social good leave both businesses and societies worse off.  I look at business profitability, first in absolute terms in 2025, and then relative to revenues, examining why profit margins vary across businesses and sectors. I then raise the ante and argue that making money is too low a standard to hold companies to, since the capital invested in these companies can generate returns elsewhere, opening the door to bringing in the opportunity costs (costs of equity and capital) that I introduced in my last post. 

The Business End Game

    In 1970, Milton Friedman argued in a New York Times article that the social responsibility of a business is to deliver (and increase) profits. That view has come under attack in recent decades, but even in the immediate aftermath of the article’s appearance, there was some push back. Some came from people who argued that Friedman was missing details, with a few noting that it is cashflows, not earnings, that businesses should focus on, and others arguing that it is profits over the long term, not just immediate profits, that should be the focus of a business. My guess is that Professor Friedman would have agreed on both fronts, arguing that he was talking about economic, not accounting, profits, and that there was nothing in his mission statement that foreclosed a focus on long term profits.

    In the decades since, there has been a more fundamental critique of the Friedman business end game, coming from those who believe that his view is far too cramped and narrow a vision for a business, and that businesses have obligations to society and the planet that need to be incorporated into decision-making. Initially, these critics argued for imposing social and environmental constraints on the profitability objective, and while Friedman may have taken issue with some of these constraints, arguing that that is what laws and regulations should be doing, he would (probably) have gone along with most of them, given real world frictions. Later, though, these critics decided to go for the jugular, arguing that the business objective itself be reframed to include these broader responsibilities, with some arguing for stakeholder wealth maximization, where businesses seek to maximize value to their different stakeholders (employees, lenders, customers). That idea gained traction among some academics, many of whom never grappled with putting this objective into practice in real businesses, and among some CEOs, who realized that being accountable to everyone effectively meant being accountable to no one, but I am not a fan.  About two decades ago, stakeholder wealth maximization was supplemented by ESG, an acronym that quickly got buy-in from the establishment. In 2020, when I first looked at ESG, it was at the height of its allure, with investment managers (led by Blackrock), consultants (with McKinsey up front) and academics, all pushing for its adoption. Given the broad buy in, I expected to see clear and conclusive evidence that ESG was not just good for investors and businesses, but also for society, and I was disappointed on every front. The alpha that was attributed to ESG in investing was accidental, coming almost entirely from its overload on tech stocks in its early years, the evidence that ESG helped businesses deliver higher growth and profits was laughably weak, and on almost every societal dimension that ESG was supposed to make the world a better place, it had failed. Even on risk, the one dimension where a rational argument can be mounted for companies following the ESG rulebook, its impact was hazy, with no discernible effects on costs of capital and only anecdotal (and mostly ex-post) evidence for protecting against reputational and catastrophic risks. In the last five years, ESG has fallen out of favor, largely undone by its own internal inconsistencies, but the gravy train that lived off its largesse has moved on, and taken much of what filled the ESG space, repackaged it, and renamed it sustainability. While advocates for sustainability try to create distance between ESG and sustainability, in my (biased) view, much of that discussion is akin to painting lipstick on a pig and then debating what shade of lipstick suits the pig best, rather than attempting to create real change.

    It is with intent, therefor, that I named these three forces - stakeholder wealth maximization, ESG and sustainability - the theocratic trifecta in a post that I wrote three years ago, and argued that they failed for the same reasons.

First, by rooting themselves in virtue rather than in business sense, they rendered a disservice to their own cause. After all, once you decide that you are on the side of goodness, any critics of what you do, no matter how well merited their criticism might be, are quickly consigned to the badness heap, and not just ignored, but also reviled for lacking moral fibre. The problem, of course, is that if an action makes business sense (increases profitability and value), you would not need a virtue brigade to push for that action in the first place. Second, by leaving the definitions of their central ideas (stakeholder wealth, ESG and sustainability) amorphous, they made it easier to sell to investors and companies, but at the expense of consistency and focus. In my 2022 post on ESG, where the Russian invasion of Ukraine had forced its defenders to morph in the face of evidence that that world was more dependent on fossil fuels and defense companies than they had been willing to concede in earlier years, I noted the loss of credibility that comes from shifting definitions of goodness. Third, and most critically, in their zeal to push these concepts to a wider audience and get more people to buy in, they sold a lie, i.e., that you can be good (whatever that definition of good may be) without sacrifice. I have no idea whether ESG and sustainability salespeople meant what they said when they argued that investors could earn higher returns, by adding ESG constraints to their portfolios, and that companies could become more profitable, if they incorporated environmental and social considerations into decision making, but my categorization of people in these spaces as either useful idiots or feckless knaves stems from a refusal to face up to the inherent trade offs.

    After decades of pushback from critics of the Friedman business end game, I, for one, believe that Milton Friedman was right, and that we would all be better off to follow up and ask the question of what can be done, given that businesses are profit-seekers, to advance social good and curb externalities. I don't believe that the disclosure route, which seems to have become the fallback for some seeking better business behavior, will accomplish much, and it may do more harm than good. While laws and regulations can provide a partial fix, they are blunt instruments, and in a setting where businesses can move easily across borders, they may not be effective. Ultimately, we (as consumers and voter) get the businesses we deserve, and if after paying lip service to social causes, we buy products and vote for governments hat undercut those causes, no acronym or word salad will repair the breach.

Profitability in Businesses

    I meant to have a short lead-in on why profitability matters at businesses, but as you can see from the previous section, I did get side tracked, but the underlying message is that making money is central to business success and survival, and that measuring profitability is therefore a necessary part of assessing business success and value. 

Economic versus Accounting Profits

    The Friedman view on the business endgame may have been driven by a vision of economic profits, but in the real world, we are dependent on accounting measures of profits, which are, at best, imperfect substitutes for economic profits. The table below looks at an accounting income statement, highlighting the many measures of profits - gross, operating and net - that you will find in it:

Each profit measure has utility, with gross profits reflecting unit economics, the difference between gross and operating profits capturing economies of scale and the difference between operating and net profits being driven by taxes and choices that businesses make on debt and non-operating assets. In 2025, looking at the aggregate values (in millions of US $) for these line items across sectors, here are the numbers, for both global firms and just the US subset:

In the aggregate, global firms generated $6.2 trillion in net income and $7.7 trillion in operating income on revenues of $72.4 trillion, in 2025; during the same year, US firms generated $2.2 trillion in net income and $2.9 trillion in operating income on revenues of $22.7 trillion in revenues. Across sectors, and looking at revenues, industrials carried the most weight for the global sample, but health care generated the most revenues across the US sub-sample.

Profits scaled to Revenues - Profit Margins

    The problem with dollar profits is that comparisons across companies, industries or sectors are skewed by scale differences, and one simple scalar for earnings is revenues, yielding variants of profit margins. While you are undoubtedly familiar with these margin variants, their real use in analysis is in providing insight into business models

I am not a believer in financial ratio analysis, but I do believe that the income statements for companies, especially examined over time, give us insight into their business models and can help frame valuation narratives. In the table below, I look at differences in margins across sectors in 2025, again looking across global firms, and just US firms:

I have estimated margins, by sector, using the aggregated dollar values for profits and revenues from the previous table, and also reported the cross sectional distribution of company-level margins. Comparing the aggregated margin with the median margin across the sector should give you a sense of how top-heavy the sector is in terms of profitability. In technology, which has the highest weighted operating margin (24.7%) of across sectors, the median operating margin is only 3.41% (-0.30%) across global (US) technology firms; the bigger tech companies are money machines in a sector that still contains a lot of younger and smaller money-losing firms. Note that the margins are not computed for financial service firms, since revenues are often unreported (and mostly meaningless) and gross and operating profits don't have the same measurement value as they do for non-financial service firms.

Industry Margins and the AI Threat

    Breaking down sectors into industries provides more granular detail, and there is a link at the bottom of this post that reports the margin statistics, by industry group. At the risk of stating the obvious, there are large disparities on margins across industries, reflecting differences in unit economics, economies of scale and leverage, as can be seen in this table that lists the industry groupings with the highest and lowest aggregated operating margins among US firms:

At one end of the spectrum, you have industry groups like basic chemicals, which has an aggregated (median) gross margin of 9.31%, making the margin hill much steeper to climb, since operating margins and net margins will be lower. At the other end of the spectrum, in addition to tobacco and railroads (surprised, right?), you have system and application software, delivering an aggregated gross margin of 71.72%, operating margin of 33.21% and net margins of 25.49%, capturing the strong unit economics that characterize the business. 

    While high margins are a desirable feature for a business, these same high margins can make a business vulnerable to disruption, and the AI sell off that we have seen play out in the last few months in software reflects the concerns that investors have of AI putting significant downward pressure on software margins. If your pushback is that the drop off in revenues and margins has not happened yet, and that it is unfair to software firms to mark their market pricing down preemptively, this is exactly what markets are supposed to do, and these software companies benefited earlier in their lives, when market prices were marked up well ahead of the run-up in margins. You live by the sword (expectations of growth and high margins), you die by it (expectations that growth rates will hit a cliff and margins will decline)!

Time Trends in Profits

    I have tracked profit margins for companies for a long time (about three decades) in my datasets, and there is clear evidences that they have trended upwards during the period. In the graph below, I look at the net profit margins for the S&P 500 in the aggregate in this century (from 2000-2025):

As you can see, net profit margins have climbed over the last two decades for US companies, with a number of stories competing for why.  

• The most cynical explanation is that this increase in margins is all sleight-of-hand, where accountants are pushing through changes, aided and abetted by accounting rule-writers, to make companies look more profitable. As someone who has taken issue with the gaming of earnings that you often see at companies, I am disinclined to take this criticism seriously, since many of the changes in accounting rules (such as the expensing of stock-based compensation and R&D) should push earnings down, and accountants have more power to move income across periods than they do to increase the level of income.
• A second explanation is that the macroeconomic environment makes it easier for companies to deliver profits, and this explanation had resonance when interest rates were at historic lows in the last decade. As rates have risen back to more normal levels and the economy limps along, I am skeptical of the reasoning in this explanation.
• A third explanation, and this one has been eagerly adopted by many on the political left, is that that this reflects the increase in bargaining power for capital, relative especially to labor, implying that the increase in profits are coming primarily at the expense of worker wages. While there are certainly pockets of the economy where this is true, the margins for most manufacturing and service businesses, which have the highest employee count and wage costs, have stagnated or decreased over the last 20 years, indicating that neither capital nor labor has benefited at least in these sectors.
• The fourth, and in my view the most salient rationale for margin increases, is that the composition of the market has changed, as technology companies supplant old-economy companies, bringing superior unit economics and economies of scale to play. Put simple, a market that gets the largest portion of its value from tech companies will deliver much higher margins that one that gets much of its value from manufacturing and service businesses.

Should we concerned that margins may compress in the future? Of course, and we always should, but that compression, if it happens, will depend almost entirely on how the economy performs and the effects of disruption, if it is coming, for tech companies. 

Value Creation in Business

    If we define the threshold for business success as generating profits, we are setting the bar too low for a simple reason. Starting a business requires capital, and that capital can earn a return elsewhere on investment of equivalent risk. If those words sounds familiar, it is because I used them in my last post on hurdle rates to describe the costs of equity and capital. Thus, value creation requires a business to generate a return on its equity (capital) that exceeds its cost of equity (capital). That is a simple proposition, and a powerful one, but the measurement challenge we face is in determining the returns that companies generate, and for better or worse, we are dependent on accounting measures of these returns. A good way to see what an accounting return is measuring or at least trying to measure is to look at returns on equity and invested capital in a financial balance sheet:

While accounting returns are widely used in practice, as a gauge of investment quality, they can be skewed not just by accounting inconsistencies but efforts by accountants to do the "right thing" (like writing off bad investments. I have laid out my concerns in exhaustive and incredibly boring detail in this paper on accounting returns, which is dated, but still relevant. I summarize the factors that can cause accounting returns on equity and capital to deviate from reality in the picture below:

    With those concerns about accounting returns in place, I computed the accounting returns on equity and invested capital for all of the companies in my global sample (48.156 firms) and my US sample (5994 firms), and the following table reports the statistics for both groups, by sector:

Again, I report the accounting returns computed based on aggregated values first, and then the distributional statistics (first quartile, median, third quartile) for the company-level accounting returns. As with profit margins, you can see that even in sectors where the aggregated accounting returns are high (such as technology and communication services), the median value reflects the reality that most companies in these sectors struggle to deliver double-digit returns.

    Turning back to our value creation metric, where we compare accounting returns to costs of equity and capital, you have to be consistent, comparing equity returns to equity costs and capital returns to capital costs:

The excess return is a numeric, but as with all numbers in business, it is worth looking behind the number at its drivers, i.e., why do some business deliver returns that consistently outstrip their costs of equity and capital, whereas others struggle? The most powerful explainer of excess returns is not qualitative, since the capacity to generate excess returns comes from barriers to entry and competitive advantages. In the language of value investing, it is the width (strength of competitive advantages) and depth (sustainability of competitive advantage) of moats that determine whether a company can earn more than its cost of equity or capital:

If you are interested in this topic, and it is a fascinating one, Michael Mauboussin brings his erudition and knowledge into play in  this Morgan Stanley thought piece from October 2024.

    Since I have estimates of costs of equity and capital for each of my firms (see my last data update for details), I compute excess returns, by sector, for my global and US samples:

Given what you saw in the last table, with accounting returns, you should not be surprised to learn that only 29% (28%) of global firms earn returns on equity (capital) that exceed their costs of equity (capital). In fact, if you raise the threshold and look at companies that generate 5% or more as excess returns, the numbers drop off to 19% (17%) for equity (capital) excess returns. Most companies have trouble earning their costs of equity and capital, but if you look at the aggregated values, there are multiple sectors in the US (technology, consumer goods and communication services) that earn double digit excess returns, pointing again to larger companies within these sectors being able to set themselves apart from the rest.

    If your concern is that the global statistics are being skewed by regional differences, I compute the excess return statistics broken down by region:

As you can see, there is not a single geography where more than 50% of firms earn more than their required returns, with Japan ranking highest in percentages and Canada and Australia the lowest. Here again, the aggregated values tell a different story, with US companies collectively delivering excess returns of 8.44% on equity and 1.81% on capital, suggesting again that large US companies carry the weight of value creation in the market.

    Given how much time we spend in finance examining investments and developing decision rules (NPV>0, IRR>Hurdle rate) that are supposed to protect businesses from taking "bad" investments, you may be surprised at the prevalence of value destroying investments. Some of the failure at businesses to deliver returns on capital that exceed the cost of capital may reflect imperfections in our accounting return measures, since it is based upon earnings in the most recent year, and that may bias us against young and growing companies building up to scale. In my book on corporate life cycle, I highlight how accounting returns shift as companies go from youth to decline:

To see if this is a factor in our global findings on excess returns, I break companies down by age into deciles and compute excess returns across these groupings:

The table broadly reflects what you should expect to see, with a corporate life cycle, as the percent of companies that beat their cost of capital increase as companies age, but the aggregated excess returns peak in middle age (the middle of the life cycle), more pronounced with US than global firms.

A Profitability Wrap Up

    Looking at the data, and there is a danger here that I am overreaching, it seems to me that over the last four decades, moats have crumbled, partly as a result of global competition and partly because of disruption (which upends businesses, turning good businesses to bad ones), and the business landscape has tilted more decisively to larger firms, as more and more businesses become winner(s)-take-all. It is in this context that I take a more jaundiced view of what AI will do for company profitability and value. I believe that, as a disruptor, it will cause downward pressure on margins at most firms, and increase the advantages that larger firms have in each business. How do I reconcile this view with the happy talk of AI as a tool that will make companies more productive, and that the resulting lower costs will make them more profitable? Unless the AI tools that you are talking about are exclusive to these companies, in the sense that competitors cannot buy the same or equivalent tools, these AI tools will lower costs across the board, and competition will then kick in on the pricing front, lowering profitability. If that sounds like a reach, I would recommend a revisit of the US retail sector over the last three decades, as online retail, initially viewed as a boon by brick-and-mortar retail firms, ended up destroying most of them and reducing the margins for retail collectively. As consumers, we will benefit, but as investors or employees in the disrupted companies, we will pay a price that outweigh the benefits, for a sizable number of us. I do think that the AI disruption will be more akin to a slow-motion car wreck, in terms of its effect on overall profitability, and that the margin slippage will occur over time, but it will damaging. Time will tell!

YouTube Video

Datasets

1. Profit margins, by industry (US and Global)
2. Accounting returns and excess returns, by industry (US and Global)

Paper on Accounting Returns (Long and Boring)

1. Return on Capital, Return on Invested Capital and Return on Equity: Measurement and Implications

Data Update Posts for 2026

1. Data Update 1 for 2026: The Push and Pull of Data
2. Data Update 2 for 2026: Equities get tested and pass again!
3. Data Update 3 for 2026: The Trust Deficit - Bonds, Currencies, Gold and Bitcoin!
4. Data Update 4 for 2026: The Global Perspective
5. Data Update 5 for 2026: Risk and Hurdle Rates
6. Data Update 6 for 2026: In Search of Profitability
7. Data Update 7 for 2026: Debt and Taxes
8. Data Update 8 for 2026: Dividends and Buybacks