Tuesday, September 27, 2016

Lesson #245: You Cannot Cut Your Way to Growth

Posted By: George Deeb - 9/27/2016

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I recently wrote about the war between driving growth and profitability, and that you cannot successfully maximize both at the same time.  The key point here was driving growth requires additional investment in your business, in the form of new sales and marketing activities, the expenses of which put negative pressure on your bottom line.  But, what happens when that additional investment takes your business into a short term loss position?

You would be surprised how most entrepreneurs would answer that question, especially in family-run businesses where every business expense is perceived as taking monies away from their personal expense needs.  There seems to be a general aversion to losses and taking on debt to cover those losses.  So, instead of raising the required capital needed to fund the full need, they try to cut expenses in other areas of their business to make room in the budget for the sales and marketing need. Or, they simply lower their growth objectives to a more affordable level within their current budgets. All, reactions of entrepreneurs that typically don’t know what is required for long term success.

Why You Should Fund the Full Amount Needed for the Plan

At the end of the day, your long-term goal, should remain your long-term goal.  If your management has collectively been hired to help you grow a $10MM business into a $100MM business over the coming five years, you are going to ruffle a lot of internal feathers if you suddenly switch directions to building a $20MM business.  Those executives signed on to help be part of an exciting 10x growth story, not a 2x growth story, and you most likely will lose them with that move.  Especially, if they were recruited with an equity stake in the business, and they suddenly realize it is only worth 20% of what they thought it was going to be worth.  So, think through the ripple effects of your actions.

Why it is Perfectly Acceptable to Incur Debt

Where in the Business 101 handbook did it ever say debt was bad and should be avoided at all cost. That certainly could be the situation for companies with no reasonable way of paying the debt back, forcing them into bankruptcy if they miss their payments.  But, for most healthy companies that are producing long term cash flow, debt is a perfectly acceptable vehicle with which to fund your short term needs.  It is certainly a lot more affordable than diluting your equity ownership with a new equity financing.  So, debt is not a bad word, it is a perfectly acceptable way to capitalize your business for up to 50% of its needs, provided you have a credible plan to pay it back.  How do you think private equity firms make all their super-sized returns on their portfolio investments—it is not by investing 100% equity for those companies.  Debt helps them leverage their equity resources, to stretch their equity farther and drive a higher return on their equity investment.

Why it is Perfectly Acceptable to Take on Losses

If you look at the growth curve of any startup, almost all of them start by incurring losses in their formative months or years, as the revenues are simply not there yet to cover their startup expenses.  It is absolutely no different for later stage companies: think of your increase in growth investment as like another startup-like event that is perfectly normal and expected.  It is not a bad thing to incur losses if there is a logical reason for the expenses, like needed investment to help jump start long-term revenue growth.  That $1MM loss today, could be the difference between $50MM and $100MM in revenues five years from now.  So, don’t focus on the short-term impact of the loss, focus on the opportunity cost of what you are leaving on the table by not incurring the loss.

Why You Don’t Cut Monies from Other Departments

And, taking money from other departments is not the answer either.  Let’s say you need $1MM of new investment in sales and marketing.  But, your technology department also needs $1MM for new product development needs.  And, you only have $1MM of free cash flow to work with.  Sure, you could give each $500K, but that only helps the business accomplish half of its desired goals.  But, if you tell the technology department to delay your investment in new products for a year, it is not long before your engineers quit or your customers are not seeing innovation and move to your competitors.  And, then you will have an even bigger financial mess to deal with.

Concluding Thoughts

The only time you should take out the hatchet and start cutting expenses, is when your business is broken and your economic model is flawed.  Or, if there is an economic slump you are trying to navigate through.  But, if you have a healthy business and you are trying to accelerate your growth, you really shouldn’t take the hatchet to any part of your business in order to better afford the additional expenses.  Instead, you should finance the full need of the plan, either with debt or equity, whatever is more appropriate for your specific situation.  And, if you are simply trying to avoid diluting your ownership stake, I ask you one question:  would you rather own 100% of a $20MM company or 80% of $100MM company?

For future posts, please follow me on Twitter at: @georgedeeb.


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