A very useful article both for investors who evaluate young companies for financing, and for entrepreneurs who want to attract venture capital and turn company into a large corporation.
It amazes me when a journalist writes an article about a promising startup (for example, preparing for a public offering of shares), and scornfully says: "They don't even make a profit!"
I cite journalists as an example, because it is they who support the myth that profitability is ALWAYS a priority, and I hear many entrepreneurs, even the most adequate, repeat the same mantra.
There is a normal relationship between profit and growth. To ensure faster growth, it is now necessary to find resources for investments that will begin to bring results only in six months or a year. This is most easily explained by the example of sales managers.
If you hire 6 sales managers with a salary of $120,000 a year, then your monthly expenses will increase by $60,000, although these sales managers may not generate any revenue for another 4-6 months. And in the first quarter, you'll have a profit of $180,000 less than if you didn't hire them. I understand that this is all kind of understandable, but even very intelligent people forget this simple arithmetic when calculating profitability.
It's not always right to hire more employees.
You need to understand whether they will make a profit over the next year, or whether you have access to relatively cheap capital (what is this concept?) To cover losses until your investments begin to bear fruit.
Most companies (more than 98%) in the world (even tech startups) should concentrate on profit. Profitability gives the level of freedom that is unattainable when using other people's money.
- You will have an advantage in attracting investments (many investors are not looking for opportunities to build a huge corporation and appreciate your ability to conduct a profitable business)
- Profitability gives investors more options to return investments. While Google and Facebook can afford to buy the company for the sake of its employees (at least according to data by December 2011), many organizations do not even allow the idea of buying a non-profitable company. When they evaluate your company, their thoughts are about: "How long will it take before I return the money that I spent on acquiring the company?" If the company does not make a profit, then you are only an item of expenses for them.
- Profitability undoubtedly makes the company more resilient in hard times.
Features of an entrepreneur who should not concentrate on profit:
- he has, or thinks he has the ability to build an extremely scalable business over the Internet;
- he has access to investors who are ready to help build an Internet project.
And how I like to repeat:
"If your idea is really brilliant, then in the market they will notice it, and there will be those who want to compete with you. If you lead the market, then attracting capital and investments in advance will help when competitors appear. If you don't, someone else will. "
In more detail
I often discussed this issue with many aspiring entrepreneurs. They have already raised $2-3 million, created a product that has some leads in the market, reached the income mark of $1 million. At this point, the founder feels that he is already a step away from making a profit, and promises to reduce costs in the coming year and try to make the first profit. He doesn't want to depend on investors anymore.
To this I answer the question: "What purpose are you pursuing? Are you looking to sell the company next year or in a year? Do you plan to maintain a small business, but which generates a stable income? Do you see the possibility of raising venture capital in the future to accelerate the development of the company? "
In the circles in which I rotate, there are many people who want to build a large corporation - and at a certain stage you will need to attract venture capital. And for this you will need borrowed funds. I often point out that at the same time, investors are much more concerned about the growth of the company, rather than profit, so you need to be very careful not to cut down the bitch you are sitting on. Of course, I understand the desire to control everything, which in essence requires profit. But you should not sacrifice investments in the growth of the company in pursuit of profitability.
Venture fund representatives will only grin to learn that you have achieved a profitability of 1.5 million with the help of investments of 3 million dollars in three years. The hard truth of life. If in three years you significantly increase the number of clients, not focusing your attention on profitability, then it is another matter. If you spent three years improving super-innovation technology, it would also be more impressive. But if you have merely slowed the pace of development to make a profit, you will need to look elsewhere for the means to grow further.
When I study the company's income reports (also called the "income statement"), I first look at the line of income. When evaluating the company, it is worth considering whether the company's income level is rising.
I always say this to journalists, who ask me about stock market events. If you take two companies, each with $100 million in profits, they may have very different prospects for the future. One can increase income by 50% each year, the other by only 5%.
Even if both companies have the same profitability ratio (profit/income), the first company will do much better by the end of the year. And while the easiest way to estimate a company's share-to-profit ratio is to estimate the share-price ratio, one should also not forget the price/profit/growth ratio. (Of course, there are a lot of complex financial instruments, but with this ratio, many can draw preliminary conclusions.)
Investors appreciate growth
The value of the company is the expected profit from future cash flows that will be earned on today's investments (as you know, the dollar next year will be worth less than today) and the company that is growing faster will earn more in the future.
And for starters, when evaluating a company, estimate its growth rate. Assessing only the profits of companies will not give a clear understanding of which of them has more rosy prospects.
And when new companies are evaluated (and venture capital funds often look at newcomers), it is necessary to evaluate customer growth, and not profit growth.
It is important what the profit of your company is
When I evaluate profitable companies, it is important for me to understand exactly how it receives income. Does a single product or product line make a profit? 80% of revenue is provided by 20% of customers or the 3 largest customers generate 80% of revenue?
This is a "profit concentration," and the more profit is concentrated, the higher the risk of a decrease in profit in the future.
I am also trying to figure out how the price of a product is formed, how competitors determine the price of product, what are the prospects for pricing in the future? Rapid growth in the market comes to naught with tougher competition and a corresponding drop in prices.
Income discord
But not everything is so simple and it is not enough to estimate the number of dollars in the line "income." For example, look at two companies. Although both companies have the same annual income, company 1 has much higher profitability, because the cost of sale is much lower.
Cost of sale is the value of each sales transaction for a company. For example, if you sell product through third parties who take 30% of each sale, then the cost of sale is 30% of the income (if there are no other sales-related expenses).
The above schedule is not an exception to the rules. The first company is a regular software company that sells product directly (through sales managers or online). Many software development companies have a profitability of 85-90%, which is why they are a historically attractive business sector.
Company 2 may represent an intermediary company that is paid by advertising networks for posting ads on publishers' websites, and for this the company gives 85% of the profit received to the publisher. It is normal for the intermediary to take from 15% to 30% of the sale value.
It may also be a tourist site that receives a percentage for selling air tickets. Companies like to look at big numbers in the income column, but this is often misleading. Even if you sold $500 million United Airline tickets, the amount received does not amount to your income. Your income will be $75 million, which you received in the form of interest on the reservation.
It may be an online commerce site, or a flash sale, that earns from clothing sales, but must pay a high percentage to clothing manufacturers. Many such sites are essentially intermediaries. Their profitability varies between 15-40%.
Surely you are now shaking your head and thinking: "Well, yes!," But honestly, even the most experienced of my acquaintances confuse "gross income" and "net income." I myself watched how people were amazed at the extraordinary revenues of flash sales sites:
"Company X is already making $100 million. An amazing leap! "
Mm, no.
The company receives $100 million in gross profit and the profitability is 12%, i.e. most of the money is in goods. Many companies at first did not even physically hold these goods. That is their profit is 12 million.
This is also a very good achievement. But that's not like 100 million in two years.
Shouldn't all companies be profitable?
Not necessarily. Let's look at the following software companies, each with a 66% return on investment.
The performance of both companies is the same after one year. Both raised US $1.5m (business angel or sowing fund capital) for their first-year running expenses. Both companies spent a million dollars in the first year.
66% profitability is normal (companies sell their product through a middleman who takes 33% of the profit), but the volume of sales does not cover the costs of the development team, management, marketing, office expenses, etc. In most Internet projects, 80% of the costs are for staff.
So, which company is better?
There is no answer to this question. A naive journalist may complain that Company A is not lucrative, or that it is a typical online startup that doesn't care about expenses. Because they doubled their current spending, even though they didn't make a profit.
What really happened? They raised $5 million in venture capital to expand their business. This money was used to pay the salaries of new technicians so that the company could launch a second line of production. Hire a marketing team to promote the product everywhere. A team of business development specialists has been invited to work on making deals to include their product in other products to increase demand. A larger office was rented for a more convenient placement of employees, to increase the attractiveness of yourself as an employer.
If their product proves to be in demand on the market, this investment will pay off.
Look at the following years of development of the company:
Although Company B has shown greater prudence in spending, it has turned out that the investments of Company A in the staff have brought them more than a year's income. At the end of the fifth year, Company A had already earned 14 million on the total calculations (profit for the investment period), while Company B had earned 5 million dollars.
At the moment, Company A's revenue is $47 million a year, and Company B-$12 million, so the next period - from the sixth to the tenth years of its existence - for Company A, too, was more successful.
I know which company I would invest in. The growth rate is very important.
Let us consider an even more aggressive scenario. Take the Internet company with "super fast growth". Of those that no-one's known experts quickly call useless, because they are not profitable.
The company would need to raise at least 35 million dollars to finance its expenses. And most likely, it attracted 50 million or more. Note that they. most likely attracted investments in several rounds, not at the same time.
Crazy? Stupid? Shouldn't it be worth cutting your current spending to become "profitable"?
Again, not everything is so clear. If growth is so lightning, as shown here, and if they have access to cheap capital, then it would be insane not to attract venture investment and remain unprofitable.
Ratio between profit and growth
You can increase profits without investing today's dollars in tomorrow's growth.
When another journalist comes to blame Amazon for its lack of profitability, he would like to understand the following. Amazon continues to grow at such a frenzied pace that, of course, part of its current profits, it reinvests in its own development.
If a company does not grow fast enough, then they must allocate their profits differently, for example, by returning money to shareholders.
The final argument about profitability and positive cash flow
Another elementary thing, but based on my experience, and it could be useful. Many investors worry more about the cash flow than about the company's profits.
It is worth noting - for those who do not yet know what the difference between income and cash flow is - that profitability and a positive cash flow are not the same.
You can be a lucrative company and lose money.
What do you think? Did you think "lucrative" means you make money?
Income reports are prepared in accordance with accounting standards that "compare income and expenditure for a given period."
For example:
- An advertising agency (intermediary) can sell ads worth 500,000 $. May enter into an agreement with the publisher who makes these announcements, according to which he pays for his services after 14 days. The advertiser, who bought the advertisements, will pay for them in 2 months. So I can show that my company is profitable based on these figures in the earnings report, but in fact I spent $500,000 that I have not yet received (negative cash flow).
- I could have awarded contracts totaling $1.2 million in 2 years. And so I get $50,000 a month in revenue per month, according to the income report. But the customer can pay bills by the end of the quarter. And for the first two months of the quarter, I'll be down.
- The same happens with expenses. I can buy $450,000 worth of equipment, and I will distribute this amount for the next three years, during which, according to my calculations, the equipment will be used. And every year I'll have $150,000 in expenses I've already spent.