I was talking to a friend recently and used the term “ramen profitable”, which she found incredibly amusing. I realized that I had never used the term on the blog or posted about it, even though it’s a very useful perspective on starting a business.
The term was coined by Paul Graham, and he discusses it in the context of technology startups and fundraising (venture capital, not professional begging). It basically refers to a business that makes enough to cover all its costs, plus provide a meager lifestyle for its founders / operators.
When a company is spending more than it makes, the monthly deficit is sometimes known as the burn rate. By dividing the company’s working capital by its monthly burn rate, it can be determined how long until the company will go out of business (unless it can raise more money or something changes). This is clearly a very stressful situation to be in, and investors will be delighted to take unconscionable terms from the founders if they realize the company desperately needs the cash to stay alive.
It’s standard for companies to have their highest burn rate at the beginning. Imagine a professional opening an office (perhaps a lawyer, accountant, dentist or therapist). She has to pay: rent on the office space, liability insurance, salaries (for receptionists or assistants), advertising, furniture, decorations, office supplies and all the other necessary expenses before she earns a dime from a customer. In such a situation, it would be hard to imagine that there WOULDN’T be a high burn rate for the first few months as the company grows towards profitability. The reason why people start businesses that are losing money on the first day is they expect it to grow to the point where it becomes profitable (then hopefully earn them more per hour of labour than they would have made working for someone else).
Some companies intentionally accept a large burn rate in order to dominate their industry. Webvan tried to do this and went out of business when they ran out of money before they became profitable (apparently they were too ambitious and analysts have speculated they might have survived if they’d expanded a little slower). Amazon.com lost money every year from 1995 to 2001. These years of losses were part of their original business plan, a strategy that they have effective executed.
There are a number of benefits, for people starting a company, from focusing on becoming ramen profitable as soon as possible:
- Most founders aren’t pursuing a “billion dollar company or bust” strategy. They’re happy to earn a comfortable living running a successful business and don’t need to take the extra risk necessary for explosive growth.
- It gives a clear and attainable first milestone for the company to reach. By constantly tracking the company burn rate (and working to get it to zero), it keep a young enterprise’s priorities straight: increase revenue while keeping expenses low to become profitable.
- There are all sorts of risks that can kill a business, but becoming ramen profitable decreases the chance of one big one (running out of money, which technically is probably always the official cause of death).
Thicken My Wallet has written a number of excellent posts on entrepreneurship. One of the running themes in his posts is the importance of keeping costs down when starting a company. This is clearly 1/2 the equation of getting to ramen profitability (the other half is getting people to pay you for your product or service).
Ramen profitability isn’t an ends to itself. If someone is working hard for a student lifestyle, they’d be better off going to get a job instead of taking all the risks of running a company. However, reaching this stage gives you breathing room to figure out how to grow your business to a level where it is more lucrative than working a 9-5 job.