Profit vs. growth

Eight to 10 years ago, I got a call from a client of our firm who wanted my help setting up an actual board of directors (BOD) for their privately held, multi-owner business. It was a well-established company in a mature industry. One of my associates had appraised their firm, valued at something on the order of $17 million plus. The CEO wanted me to see him and spend a day with him to determine what the BOD would do and how directors should be named.

Before my scheduled visit, I asked the CEO to send me any information he thought would help bring me up to speed with his company. Besides our appraisal report, he sent me their financials and a copy of their business plan. The first page of the business plan stated that they “would rather be a $50 million annual revenue company making a $10 million profit than a $100 million company making a $10 million profit.

I asked him why that was the case. He told me they thought being smaller but more profitable than the industry norm meant they would be leaner and more efficient. I told him I understood that. However, he would leave $30 million to $35 million on the table. He asked me how that was the case. I told him that at that time, the average firm in his business was worth around 65% to 70% of revenue. I did not say a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization), as most financial jockeys will tell you for several reasons. One, it’s projected EBITDA that matters, and that is significantly impacted by growth. And two, my experience is that buyers won’t pay the premium they should for a highly profitable company because they don’t think it will be sustainable, especially after they buy it. So, a percentage of revenue is a more reliable indicator of value than a multiple of EBITDA.

So back to my story. That percentage (65% to 70%) of an additional $50 million in revenue would be worth between $30 million and $35 million in value. Not to mention a larger company could pay everyone better. If they pursued a growth strategy vs. a profit maximization strategy, their future valuations would be an even higher percentage of revenue if they could grow.

He immediately understood me and shifted their strategy to growth vs. profit maximization.

We sold part of their company to a multibillion-dollar private equity firm for low nine figures a couple of years ago. This year, their revenue is running at a $330 million annual rate. They are highly profitable — even more percentage-wise than they were as a $27 million revenue company trying to maximize their profitability. All of their owners fared quite well over these past years. The CEO is transitioning to chairman and has named his successor.

That is just one example of how shifting your focus from profitability to growth can pay off enormously. I have plenty of other stories I could share if I had to.

My point is this: most small business owners are more worried about their profitability than their top-line revenue growth. I’m not saying it isn’t essential to make a profit — it is. Without doing so will put you out of business. But trying to maximize profitability probably means you will be compromising investments in your business — investments for inventory, new product development, marketing, facilities and people. Those things will kill your growth. And that will hurt your value.

You may be better off thinking long-term about the proverbial pot of gold at the end of the rainbow vs. how much you can take out this year at the end of the year.

Think about it.

Mark Zweig is the founder of two Fayetteville-based Inc. 500/5000 companies. He is also entrepreneur-in-residence in the Sam M. Walton College of Business at the University of Arkansas and author of the award-winning book, “Confessions of an Entrepreneur.” The opinions expressed are those of the author.