Whether your company has been around for years or decades or if you’re a start up with revenue, you probably want to grow your business. For many entrepreneurial CEOs, growing their business is first and foremost about increasing revenue, but is growing your top line the only thing you should be concerned with? My answer is a definitive “NO.”
Top line growth is a means to an end, and the end is some combination of greater profits and increased valuation. Let’s look at two scenarios.
In the first, we have a five-year old business that’s got between five and ten million in revenue, is reasonably profitable and wants to double its revenue in the next five years. The ultimate outcome of the goal to double revenue should either be to grow cash flow or increase the value of the company for a sale at the end of that five-year period. If the owner wants to grow the company and retain ownership for the long run, I expect they want to grow the company to make more money. Thus, it’s important to make sure that profits grow significantly over the five-year period and not just the revenue. If they want to exit the business at the end of those five years, will their company be more valuable with higher EBITDA? In most cases, the answer is yes. Even though some businesses are valued based on a multiple of revenue, the buyer’s financial team is also looking at how much cash flow and profits they will be adding to their company when they close on the acquisition. The more profitable the business, the higher multiple of revenue the buyer can justify internally and/or to their investors and lenders.
In the second scenario, we have a two-year old startup with one to two million in revenue that is targeting $10M in revenue within three years. Further, due to the sector they are in, they are seeing other companies sell for a multiple of annual revenue, monthly recurring revenue or number of subscribers. With access to capital from existing and new investors, should they be paying attention to their profitability in addition to just growing their top line? Again, my answer is YES for some of the same and some additional reasons as compared to the first scenario. In addition to the likelihood that greater profitability can drive a higher multiple of revenue or subscribers, the best reason for a startup to focus on profitability is that the more profitable you are (and in some cases that means smaller operating losses,) focusing on higher profitability allows the entrepreneur to conserve cash. The more cash he/she can generate means the less capital they have to raise and the less dilution for founders and early stage investors. Further, higher levels of profit allow for the reinvestment of more cash into producing higher revenues.
In the end, striving for the highest possible gross margins and highest possible operating income will help increase the value of your company and provide more cash for continued growth while limiting the dilution of the founders and early stage investors.
If you or someone you know would benefit from a discussion about how to drive higher profits while growing your topline, please contact me at llevy@CFOoptionsinc.com.