There’s a bit of a debate in the venture capital community about what matters more to digital health investors in today’s fundraising environment — growth or profitability. Some investors say profitability is king right now, but Cathy Gao, a partner at Sapphire Ventures, thinks the conversation is a lot more nuanced.
“Compared to 2021, when it was really about growth at all costs, there’s definitely a level of renewed focus on profitability,” Gao said Tuesday during an interview at the ViVE conference in Los Angeles. “People are still putting a premium on growth — they would rather have higher growth than higher profitability. Now that being said, the edge cases have all fallen off, meaning if you’re a company that is growing but deeply unprofitable, investors are going to penalize you for that.”
To Gao, the growth versus profitability conversation is “really interesting” in the context of digital health investing for two reasons.
The first is that many digital health companies have a significant service component either on the delivery side or the implementation side. Those service components can hurt margins, especially when a startup is onboarding a lot of new customers during a heavy growth period, Gao noted.
“Because of the heavy services component, profitability or efficiency metrics might actually look worse when a company is growing faster. So that’s something that investors have to really understand and parse through and balance,” she explained.
The other reason Gao thinks the growth versus profitability conversation is compelling is because digital health startups’ growth often looks “really lumpy.” Instead of a smooth growth curve, the line often looks more like stair steps, she pointed out.
This is because it’s not uncommon for a startup to land a huge contract that drives its average annual return (ARR) up and then fall into a static state for a while. Even though sales cycles are compressing, they can still be quite lengthy, Gao remarked.
“There’s been a lot of debate on whether or not traditional healthcare IT companies fit the model for venture capital. Venture capitalists were all trained to look for a J curve — that hockey stick growth that people talk about, which you often see in fast-growing SaaS companies. But digital health is a different ballgame,” she declared.
Gao said that one could argue that selling to a health system is similar to selling to any large enterprise company because it takes a lot of time. But from what she’s observed, the decision-making process at most health systems is incredibly involved, often spanning multiple committees.
Oftentimes, a digital health startup will conduct an initial pilot and then there will be a subsequent launch based on certain milestones — all that kind of muddles what investors can see from just purely looking at the numbers, Gao explained.
“There’s a lot of nuance to healthcare software investing. I think investors saw what happened to some of the companies that went public in 2020 and 2021 in the healthcare world — and these public companies don’t look great right now. A lot of the reason for some of that bad performance is that the unit economics didn’t work and they couldn’t figure it out. I think investors think about that as a cautionary tale,” she stated.
Startups don’t necessarily need to have their profitability metrics completely fleshed out in order to secure venture capital funding, but having no plan for how to reach profitability will stand out as a red flag to investors, Gao declared.
Picture: Feodora Chiosea, Getty Images