The War Between Driving Growth And Profitability
Last week, Lisa Leiter at Crains Chicago wrote a great article “When Should a Startup Worry About Making Money?” It raised good questions on when a startup should focus on driving growth vs. driving profits. It is an important topic for startup executives to understand the underlying issues, and I am going to drill down deeper with more thoughts on this topic.
This really is not a simple question to answer. There are so many nuances that go into assessing the right answer. What is going on with the economy? How liquid is the fundraising climate? Are you B2B or B2C? Are you the first mover? How defensible is your business, with patents, product complexity or otherwise? What are your competitors doing? How big is the market opportunity? How quickly is it emerging? Are you trying to dominate the world, or build a nice lifestyle business? Are you venture backed, or privately owned? So, in light of all these moving pieces, I will do my best to layout some high level guidance.
Based on the above questions:
- The softer the economy, the more you should protect your cash reserves to weather the storm;
- The better the financing climate, the more comfortable you should feel in accelerating growth with access to investors;
- I think B2C businesses need to think “faster” than B2B businesses, given the nuances of consumer behavior vs. corporate behavior;
- It is always best to be the first mover, and accelerate your lead when you can (or catch up if you are not first);
- The more complex or defensible your business, the less speed becomes an issue;
- The larger the market, the more room there is for multiple companies to thrive, and hence speed becomes less an issue;
- Brand new markets or business concepts are typically dominated by the first mover, so move quickly at the expense of profits; and
- Venture backed businesses trying to dominate the world, need to move quickly to ensure growth and liquidity value for your investors.
Let’s use Groupon as a case study. They were the fastest growing company in the history of business. They went from zero revenues in 2008 to a forecasted $3BN of revenues forecasted for 2013. And, they spent hundreds of millions of dollars in capital and startup losses, to acheive a dominant market position in the revolutionary B2C “daily deals” space. Why was that the right answer and strategy for Groupon? First of all, their product was not all that hard to build, and their early success spawned hundreds of competitors. Secondly, they were the first mover with a highly-lucrative new business model, and they wanted to dominate the global markets before anyone else did. And thirdly, their biggest competitor Living Social was also investing hundreds of millions of dollars in trying to catch up and take the lead in the daily deals space. What was the outcome: a publicly traded Groupon valued at $10BN and forecasted to drive $400MM in net profit in 2013 (its fifth year of business).
Facebook was an equally successful, but different story. There wasn’t a clear e-commerce model to drive revenues with. And, their executives and investors decided the idea was so revolutionary, as a communication platform, that it was critical to get all consumers locked up, even without a clear revenue model. And, that they did, amassing hundreds of millions of users worldwide, on the shoulders of hundreds of millions of dollars of startup capital. And, similar to the premise of the Field of Dreams movie, if you build it, the revenues will come, soon thereafter. Sure enough, Facebook does about $4BN in advertising-based revenues today, and is estimated to go public in 2012 at a valuation of around $100BN. Not a shabby return on their investment!!
Now, let’s look at a third example, this time for a slow mover. Streampix is the new online streaming movie service by Comcast, launched to go head-to-head with Netflix. This was already a very crowded space with YouTube, Hulu, Redbox, Blockbuster, Amazon, iTunes and others trying to dominate online movie streaming. But, why was that a good launch for Comcast? They already had all the studio and network relationships? They already had the cable box hardware in everyone’s homes, so an easy upsell? It was a simple message to consumers to simply stream online movies from Comcast, instead of Netflix, for a lower price already bundled into your cable service. And, Comcast is much better funded, to afford the high content licensing costs with the film studios. Time will tell if Streampix succeeds or not. But, this slow mover has as good a chance as anybody, given the nature of this industry and its current market dynamics.
As I said before, each business has its own considerations. Study your options, and plan accordingly. And, where you can, I am always a fan of moving faster before your competitors do.
Above I asked,WHEN is it better to drive growth vs. profitability. This begs the question:
Is it mathematically impossible to try to maximize growth and profitability at exactly the same time?
The math just doesn’t work. And, for the many companies I meet that are trying to do both, I figured you could benefit from the below reality check.
What specifically drives growth? More salespeople for B2B companies and more marketing budgets for B2C companies. And, both of these typically have a ramp up period before they are driving revenues. For example, if you are selling enterprise software, you most likely will be incurring salaries for your sales team today, well ahead of the sale actually closing a year from now (given the long sales cycle).
Or, as another example, many B2C companies rely on a high lifetime value of their consumers to get a payback on their upfront marketing investment to acquire that consumer. Said another way, they may need to spend $100 in marketing today, which may drive $500 in cumulative gross margin over five years, at $100 per year (with a break even in year one, and profits starting in the second year). What did you see in both examples above? Growth comes with near term costs which eat into the company’s near term profitability.
You Need to Choose Between the Two Roads
I won’t reiterate WHEN you should focus on driving growth vs. profitability, but, understand, you need to pick one route or the other. You are either in a rapid growth phase with near term losses before the revenues show up. Or, you are in maximizing profit phase, which means lifting off the accelerator, and cutting back on your sales and marketing expenses.
As an example, a 40% growth company may be operating at a break even, and a 10% growth company may be operating at a 20% profit margin. If you are committed to driving both, you really only have one option: a medium growth scenario that drives medium profits. Continuing the example above, this could be a 25% growth company driving a 10% profit margin (the midpoints of the above examples). But, to make it clear: using the above examples, it is mathematically impossible to get a 40% growth rate and a 20% profit margin at the same time, so don’t even waste your time trying.
Which Road Do Investors Prefer
Since many of you desire to attract investment capital for your business, it is a fair question to ask which route investors prefer. The answer is: it depends what type of investor you are trying to attract. Most venture capital firms are perfectly fine sacrificing near term profitability in exchange for maximizing growth. Frankly, many venture investors who see a race to lock up market share as a first mover in your space, may want you incurring big losses in the near term to sign up as many customers as possible today, before a competitor does.
On the flip side, most private equity firms need some base level of profitability before they will invest, as they will most likely want to lever up the business with debt, to reduce their equity investment. And, debt service will require cash profitability to pay the interest expense on that debt. So, if you are trying to tee your company up for a sale to a private equity firm, that would be a good time to lift off of the growth accelerator and start driving some profits.
As a marketer, it baffles me when a business leader doesn’t truly understand what drives growth. Growth doesn’t just happen on its own. You need to invest in growth by increasing expenses around your sales and marketing investment. And, the minute you say expenses need to increase, that means profits only have one way to go: down! So, be smart, understand the basic math and pick which route is best for your business. But, to be clear, it is a fork in the road where you will need to decide between the two options. As trying to maximize both at the same time is a fool’s errand.