Aswath Damodaran disagrees with Vinod Khosla on the scaling vs profitability debate. Here’s why

Valuation expert Aswath Damodaran, in his blog post, disagreed with Indian-American billionaire and venture capitalist Vinod Khosla’s view that putting profitability before scaling up is okay for short-sighted companies and not for those aiming for great growth in the longer term.

Khosla, in a post on X last month, wrote that profitability is an admission by a company that they have no place to invest that is better than giving the money back to shareholders. “You can generate profits or assets for the future. Current situation around data centre investments is the same controversy around building assets for the future or keeping cash on hand,” he wrote, adding that this is okay for shortsighted quarterly Wall Street but not for companies planning great growth 5-10 years out. “Higher risk than keeping cash on hand, but substantially more upside. Pick what you want.”

In a long blog post, Damodaran said it is undeniable that 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. Naming Vinod Khosla a “legend”, Damodaran said he was surprised to see his statement.


“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,” he wrote.

Why scaling differs for different companies

The valuation expert said that the tilt towards scaling has become pronounced in the last two decades. He noted that there are several factors that come into play that allow scaling to have a higher likelihood of success in some businesses than others.

This includes market size, market growth, industry structure, capital intensity, customer inertia and key persons. 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), he explained.

Aswath Damodaran’s rare ‘Lightning in a Bottle’ companies

But can a company scale up while delivering profits and perhaps positive cash flows as it grows? Damodaran said the answer is yes, but it requires a fairly unusual combination of circumstances. These include 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,” he wrote.

There are some other companies that put scaling before profitability, and thus are accompanied by large losses. Damodaran noted that during Amazon's first decade and a half of existence, he described their business model as a Field of Dreams model, and gave credit to Jeff Bezos for being steadfast in not only telling this story, but also acting consistently with it, and carrying investors along.

Following Amazon’s success, a legion of young companies began labelling 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,” Damodaran said.

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 valuation expert said.

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

Moreover, businesses seeking capital—whether from family, venture capital or public equity—must accept that capital providers will demand, and usually get, a say in business decisions. The more capital a business seeks, the greater that influence is likely to be.

“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,” Damodaran wrote.

Why private businesses are waiting longer before going public

The valuation expert believes that for all of these reasons, private businesses are waiting longer before going public, and using this time to scale up while deferring profitability. He concluded by saying that 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,” he added.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)