Should you be chasing profit or growth? The ultimate business conundrum
How do you judge whether your business is on track?
For some, it’s all about the year-over-year increase in turnover. For others it’s about the bottom line. Profit. In essence, is success the amount you’re selling, or the amount you’re earning?
The answer is that there isn’t one right answer. Different companies at different stages of their life cycle need different things, often based on how they are capitalized.
Let’s take two examples.
The growth model
‘Rocket’ is a fledgling tech start-up. It has devised a way to deliver health advice on the African sub-continent. It’s based on a simple idea and market penetration is everything. It needs venture capital to push it forward, enabling investment in the product and marketing.
The profit model
‘Submarine’ is a consultancy firm. It offers very specific in-house health advice to corporations in the US and Canada. It relies on a small number of long-term relationships to guarantee its cash flow. Its service is provided by a small number of experts. It is difficult to recruit and train new people in this niche area. It requires no external investment and could continue to function without any sales this year.
Different definitions of success
Rocket is a young growth business with great opportunity for scale. Submarine has a more mature business model and hence is harder to scale.
Rocket has no time to focus on profit. Every dollar (and more) it can get its hands on today is required to push forward tomorrow’s growth. It will measure its success for the next two years on its product development, number of downloads of the app and engagement of its users. This will in turn attract more funding. It’s very possible that the founders will sell-out before they ever generate a profit.
For Submarine, profit is everything. Their growth is organic. Happy clients introduce their contacts, but a good year is relatively uneventful – good people offering good advice for a good fee. Shareholders expect a good dividend and staff are remunerated with a nice bonus.
It’s hard to be both!
Neither of these approaches is right or wrong. Rocket and Submarine are simply different companies providing different offerings, at different stages of their life cycle and looking for different short-term outcomes. Businesses looking for seed and venture capital will always want to grab growth and hence market share. Older, more established business models and hence less easily scalable companies will typically pursue profit.
Some businesses are destined to be growth companies. They are easily scalable and therefore investors are more likely to invest. They tend to look to multiply revenue two to ten times per year (that’s 100% to 1,000% growth in 12 months!).
Others are destined to be profit first companies simply because they are not “investment” credible for traditional Angel and VC investors. They are less scalable and demonstrate steadier, slower growth. They will tend to grow at a steadier rate of 5% to 25% per year.
It is impossible to chase both simultaneously and well – it’s the equivalent of trying to gain qualifications and practice at the same time!
Growth companies shouldn’t completely ignore profit, Mike’s suggestion
However, many growth companies fail because they completely lose sight of profit. This post explains how this mindset can cause friction between founders and investors.
So, once you have defined yours as a growth company, how do you achieve a balance?
An interesting take on this question is offered by Mike Michalowicz in his book Profit First that explains how companies move from Cash-Eating Monsters to Money-Making Machines. He challenges the orthodoxy of the income statement (aka profit and loss), suggesting that accountants have been getting it wrong all these years. The accountants claim that revenue minus costs gives you your profit. However, Mike believes that revenue minus profit gives you your costs.
This is a clever twist. He believes that a company should put a proportion of its income into a separate ‘profit’ account before it commits to spending more. That profit account is sacrosanct. Money in there doesn’t get spent, it is earmarked for profit. The rest stays in your operating account where it can be used to run (and grow) the business.
It is a great idea, and it doesn’t halt any of the ambition behind a growing company’s growth and it demonstrates that it is possible to generate a profit while you are growing (albeit at a more controlled / modest pace). It caps investment without questioning your core purpose.
In the meantime
Ultimately, however, you will either be a Rocket or a Submarine. And that will be determined by your source (and desired future sources) of investment or, if you are an owner manager, your own need to take money from the business to allow yourself to live.
A growth company seeking to take a profit likely won’t grow fast enough to keep the competition at bay and hence grow its market share. A profit-seeking company wishing to rapidly grow will likely find itself conflicted, challenged with cash flow and being unable to satisfy its investors’ need for shorter-term performance.
At some point businesses shift their focus from one to the other. Facebook, for example, was once a fast growing tech start-up. It offered investment in potential. It has recently begun to offer dividends and a very different set of investor benefits.
Timing is everything. Specifically, an understanding of when that shift will take place. A clear plan, alongside clear communication, will best manage board, shareholder and customer expectations. And knowing the right moment to switch focus from pushing revenue to creating a more streamlined, efficient business is crucial.
And, of course, there are exceptions to the rule. Some businesses just find a happy medium. I was lucky enough to meet an elderly gentleman at a cocktail party. After getting to know him, he showed me a piece of paper covered in faded colored lines. He had plotted its turnover every year since the early 60’s. No year demonstrated growth of less than 5%. Nor did any year generate growth of more than 30%. Compounded annually that business is now making over $150M annually and with no external investors telling him what to do. You do the math!
Lorne Asks: Have you read Profit First by Mike Michalowicz? Spot on!
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