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Blog:

Sorry, you’re not right for us, you’re just too…profitable?

07 November 2019

Published by Adam Baron

When I talk to normal people outside the scale up ecosystem about interesting companies, their first question is “How much are they making?!” This is usually followed by a surprised exclamation of “What? They’re not even profitable.” Companies like Uber and WeWork are good examples of this; household names but not profitable.

There is always a healthy tension between profits and growth. To grow faster, businesses need to invest. But the investment may not generate growth for another 6 months to a year. The most obvious way to explain this is with the example of a marketing campaign.

For example, if a company invests s a healthy proportion of its budget on a marketing and lead generation campaign. The campaign is successful in generating lots of leads but there is no immediate increase in revenue. This is because it can take up to six months or more to take a prospect through the sales process and turn them into a paying customer. The company may appear to be less profitable or even loss making that year but the money has been well spent.

Scale ups go through a similar process in many areas, not just in marketing but on a larger scale and with longer lead times. Developing products or breaking into new markets costs more and takes longer but the principle is the same. It is about investing to grow.

Remember back to when you were a child saving for something big you really wanted. All your friends are out spending their pocket money on the next shiny new thing. You know that it will only last them a few weeks but still you feel jealous. You have to sit there watching all your happy friends while you have to save, or “invest”, to get that big thing you really want. That tension between instant gratification and long-term goals is one that every entrepreneur should get used to.

So how important is profitability?

Some entrepreneurs find the prospect of profitability hard to resist. They will raise a first round of funding and successfully use it to gain market traction. As revenue grows, often to around the magic £1m annualised revenues mark, they can see that they are close to breakeven or even profitability. And as this happens, they begin to shift focus from driving growth to managing for profit – after all profit is the ultimate sign of success, isn’t it?

The question you should ask yourself, if you are successful enough to get to that point, is “What is my next step?” Are you looking to potentially sell the company in the next year or two? Do you want this to be a lifestyle business where your ambition is to retain healthy profits and take a nice annual dividend? Or do you envisage eventually raising third party funding and trying to build a faster growing company?

Especially when your sales have grown to around the magical £1m mark, many investors care more about growth than profits. They won’t turn their noses up at a profitable company but they will be wary of profit coming at the expense of growth.

If you raise £3 million and 3 years later you are profitable with increased annualised revenues of £1m million you are unlikely to be in your investor’s good books. This is because the potential valuation that you will now attract, is unlikely to enable the investor to achieve their desired return.

Of course, there are other factors that need to be considered. If you had created huge customer growth without any focus on profitability and therefore at poor margins, that’s a different story. Or if you spent the 3 years perfecting some hugely differentiated technology IP that may also be different. But if you simply went more slowly to show you could earn a profit, you would end up needing to look for alternative funding sources.

All revenue is equal, but some revenue is more equal than others

When investors evaluate companies, they don’t just look at the revenue line at face value. They go through a process of scrutinising it’s make up, “What makes up that revenue?” “Is it one product line or multiple?”

Investors will also place a higher value on recurring or contracted revenue than they will on project or one off revenue due to reliability that they can place on future revenues.  

Quality of Earnings

A key subject is “revenue concentration” or how reliant the business is on the top 3 customers; Do they represent more or less than 80% of the revenue? The more concentrated your revenue the higher the risk that your revenue could decline in the future.

Further questions will also be asked about your revenue and pricing; “How are you pricing your product? How do your competitors price and what are your future pricing expectations?” If you gain fast early growth in a market by undercutting the market to the detriment of margins, that growth is vulnerable when competition gets fierce and prices are forced down due to the competition fighting back.

Revenue is always revenue, except when it’s not

If you take two companies with the same annual revenue, the next thing you consider is the gross margins which is affected by the Cost of Sales (CoS). Companies like to have high numbers in their revenue column but this can be quite misleading. After all, if you sell £5 million of product but it’s though resellers and their commission is £4m your actual revenue is the £1 million margin that the company made.

For example, many eCommerce companies are in fact, middle men. They are booking revenue from customers but then having to pay out a high percentage of the sale to the manufacturer.

Shouldn’t All Companies Want to Be Profitable?

Not necessarily. Let’s consider two hypothetical scale-up software companies, both of which have 66% gross margins.

Both companies raise a seed round of £1m million to fund operations in their first year of operations and both end their first year returning a loss of £1 million. Their sales aren’t yet large enough to cover the costs of their R&D, people, office and marketing costs.

In the second year, Company A doubles its revenue but also its losses whereas Company B only increases its revenue by 20% but breaks even. So which company is better run and which will attract a higher valuation from investors?

The answer is that you have no way of knowing. You could worry that Company A is falling into ‘the valley’ mindset by not worrying about costs. Or you might lament the fact that Company B is “not ambitious enough”.

What if I now tell you that Company A also raised £3m of equity to fund growth. They used the money to hire a bigger tech team so they could roll out their second product line. They hired a marketing team to promote their products more broadly. They hired a sales team to work on deals where their product would complement other existing technologies, increasing customer demand.

By year 5, Company B had reached revenues of £10m with at a 20% net profit margin. Not bad at all. However, the investment Company A made in people led to a higher annual growth rate, returning £30m of revenue at a 30% profit margin by year 5. Both companies looked like good investments at the end of year 1 but I know which one I would have invested in!

There are, of course, some investors that would have a preference for investing in Company B, but that would be reflected in their valuation and expected returns and is generally the mindset of investors in more mature businesses.

Conclusion

Being profitable does allow you degrees of freedom, you don’t have when you rely upon other people’s money and it is a key part of your armoury when you DO need to fund raise.

However, if you do have an opportunity to build an immensely scalable business or you have a genuine head start on the market, then you should absolutely focus on revenue growth. Growing your business faster will create a barrier to entry for your potential competitors, help you grab a market opportunity, create a window for you to launch your technology and secure those vital contracts. The main risk to your business is that others in the market will spot that opportunity or advantage and snatch it from under your nose.

Now think back to that child who is scrimping and saving for a special purchase. There will always be that pull to think of the short term gratification but the benefit of getting though the pain to reach the point of being able to get what you really want, will ultimately give you a lot more satisfaction.