Balancing Growth and Profitability

Much has been written recently about so-called “unicorns” (private startups with $1 billion valuation or more). According to TechCrunch, there were 145 active unicorns in the US last fall. Lyft, Uber and Peloton are some examples of unicorns who have recently gone public. But according to Pitchbook, 64% of the over 100 unicorn companies who completed a VC backed IPO since 2010 were unprofitable. This article explores the balance between growth and profitability and why sometimes an imbalance is created depending on the business model, stage of the company’s life cycle, who the investors are and how the entity is financed.

Just to frame the current environment, Lyft went public last March at $72 a share with over $2 billion in revenue but posted $900 million in losses at a $25 billion valuation. It traded last week at $41.90 at a significant discount to its offering price. 

Uber had an IPO price of $45 in May. Last week it traded around $31.50.  

Peloton went out at $29 but currently is trading around $27; holding its value better than Lyft or Uber.

WeWork was reported in the Wall Street Journal this week about abandoning its IPO for among other reasons, citing cash flow problems but with a hefty $47 billion valuation.

What we are seeing is that there is a big difference between venture capital and public market valuations and many of these high valuation companies generate negative cash flows and thus are unable to sustain their valuations once they go public.

What is the lesson for small business owners?

When it’s someone else’s equity, focus on growth. When it is your money or borrowed money, focus on profitability!

This sounds a little cynical but there is truth to it. Small business owners need to be fanatical about generating cash profits. Forget about Silicon Valley which is an alternative universe! 

Venture Capital firms that invest in early stage companies take a big risk and thus expect big returns. Because startups expect to lose money, there is a tremendous focus on revenue growth and whether the business model is making sense. Thus, so the logic goes, if the company can grow at a fast and high rate, the valuation will increase as a multiple of revenue, often 4-10X revenue. Many startup investors are not concerned with EBITDA except knowing what the amount is so they can manage and finance the burn rate (monthly rate of losses). And since VC’s get in early with a big equity stake and warrants for more equity, the quickest path to a big return is rapid sales growth which will yield a high valuation and ultimately an exit with a substantial gain.

Public markets on the other hand focus more on profitability and if a company is losing money, investors will shy away from a high valuation because they believe a company that loses money will be worth less.

For small businesses, It would be heaven for owners to have vast funds available simply to grow the top line without regard to managing the level of payroll or marketing costs (two of the largest cost drivers in small companies). Owners would just keep spending on growth and lose money until their high growth rate would eventually attract an acquirer. Business is not this simple. 

The “almost opposite” of this scenario is true for small business owners. The reality for small business owners is that: 

Without profitability, there can be no growth! 

And without profitability, there will be no business.

Scale is an important factor. Some startups may have one or two employees in the beginning and no customers so it is easy to understand why in this situation, the enterprise would generate negative cash flow. However, as startup companies scale, costs could rise faster than sales but at some point, the balance needs to shift and sales need to start growing faster than costs. That is when you know you have a scalable business model and a good sign the business will become sustainable.

For small businesses financed with owner money or debt, growth and profitability need to intersect much sooner in the company’s life cycle than a VC funded startup. Many small companies are financed with a credit card or family checking account which does not afford the owner the luxury of time or money to invest in unprofitable growth. Owners need to make money in the first few months by generating sales early and deferring non-essential costs, especially people costs, as long as possible.

My advice to small business owners is as follows:

• Maintain a clear line of sight on your revenue stream and operating costs for 3-6 months out before you invest in new people, services or infrastructure. Be confident in your financial forecast.

• Make sure the sales growth rate stays ahead of headcount and capital spending.

• Closely monitor your expected operating margins and if they are falling short; act now.

• Defer spending that next investment dollar until your infrastructure is practically bursting at the seams. 

• Maintain at least 6 months of net operating cash flow in reserve.

• Do Not chase organic growth with borrowed funds. This is the road to ruin.

In the end, small businesses become bigger businesses when the owners have a tight grip on cash and know exactly how it will be flowing in. The slang term “Cash is King” is still very much relevant to small business owners. It is a pity this is too often ignored in the startup world.

10/28/2019
By Stanley N. Logan