Why Software Businesses Must Solve The Profit Equation Or Get Ready To Take A Serious Haircut In Val
Updated: Apr 15, 2020
The success of a software business (or any business for that matter) depends on its ability to generate profits. Profit is especially important to any software business that needs to secure bank financing, attract and retain investors or fund growth initiatives. Unless you’re the federal government, you have to make a profit long term to stay in business. And, more importantly, if you ever plan to sell your business, profitability is the golden ticket.
Unfortunately, the headlines are littered with companies that are monumentally unprofitable yet have the ability to raise capital and even go public. These headlines spur the belief that you don’t have to be profitable to stay in business. A recent article about a data analytics startup caught my attention.
"Domo, a $2 billion Utah startup, filed for an IPO - and warned that it will need to 'significantly reduce operating expenses’ if it doesn’t raise money by August”
So - here is a company that is filing for an IPO - AND simultaneously announcing to the world that it still has not solved the profit equation. In fact, the headline sort of threatened that if they didn’t raise money, they were going to have to figure out how to be profitable. Seriously? Duh! (In the interest of full disclosure - Domo actually did complete their IPO in early July - more on that later.) This type of a headline has become all too common. Domo is far from alone - in fact they are in great company with this type of headline - Amazon (who actually solved the profit equation since going public), Square (who is inching closer to profitability), MoviePass (here’s a fun example!) - the list goes on.
You might think that I’m writing this article to pick on Domo. To be honest, you can slug any number of company names into this article and the story would read the same. But unless you’re Domo, or Amazon, or Square - or have some “disruptive” technology or business model, you’ll need to be profitable to raise capital, hire talent and grow your business.
Investors are willing to invest in ideas that, over the term of their investment, can generate a return on the capital invested. Typically, that return is dependent on profitability - unless, of course, you’re talking about a unicorn (a company that rapidly reaches a $1 billion valuation in the startup phase). That was the assumed case of Domo. When they came out of “stealth mode” with a $2 billion dollar valuation, they were a unicorn. And, as is the case with many other companies, the valuation turned out to be inflated. The valuation of a private company is always suspect. Although you can apply any one of dozens of valuations methods, the only way to truly arrive at a valuation of a private company is to have a willing buyer and and willing seller who agree on price. In that regard, the Domo valuation was certainly valid, because it was able to raise capital based on an inflated valuation. Unfortunately for investors, that was not the end of the story. Because Domo went public in early July, we now have a way to determine the valuation (or market cap) of the company. As of the end of July, that Market Cap was about $420 million - a far cry from the over $2 billion valuation the company was able to secure from earlier investors. Domo raised about $200 million for the company’s balance sheet with the public offering. Their cash burn for the last two years averaged just under $180 million per year or about a $15M loss per month. At that cash burn rate, they raised enough capital to carry them for the next 13 or 14 months - which does not give them much of a runway to solve the profit equation. They need to work quickly. OK - enough about them.
So what can software companies learn from this message?
We see these stories played out all the time in the media. Big idea, fast growth, company raises millions, etc. etc. Unfortunately, the stories that don’t make the headlines on a daily basis are the good businesses that have a sustainable business model or that sell for a reasonable price because the owners focused, at least partly, on profitability.
Business Condition Quotient (BCQ or Rule of 40)
As a benchmark - mature, best in class, software companies should have a combined annual growth rate plus EBITDA (earnings before interest, taxes, depreciation, and amortization) of 40. Using Microsoft as an example, in 2017 had a BCQ of 40.9 (5.4% Growth + 35.5% EBITDA = 40.9).
GROWTH + EARNINGS = BCQ
Businesses that strive to be best in class with a sustainable business model can use this as a benchmark to make incremental improvements in their business - and ultimately improve it’s value. If your anticipated growth rate is 20%, then the target for EBITDA should also be 20%. If the growth rate is higher, say 40%, then it’s OK to break even, based on the assumption that high growth companies use their profitability to fuel that growth. On the other hand, very slow growth companies should be more profitable. In those rare instances of ultra high growth, in many cases, the company operates “upside down” - or loses money - to fund the growth initiatives. This is the assumption that many high growth startups use to justify their lack of profitability. It’s not unusual for startups to experience ultra high growth in the early years, and for investors to expect to lose money until the company reaches profitability. However, it is so important to solve the profit equation early so you can work toward that profitability. All too often, companies are determined to grow at any cost, without regard to profit, and soon find themselves in a tailspin because they have run out of capital before they learn how to make money.
No “magical event” happens once you reach a BCQ of 40. In fact, many operators I talk with operate above 40 - which is just a benchmark to give you a target. And, you should be striving for incremental improvements. If your BCQ is 5, then you should shoot for 10 next year. If it was 15 last year, shoot for 20 this year. If you hope to sell your business in 3 years, it should be your goal to reach a 40 BCQ by the time you put the company on the market. Understand that it’s OK to sacrifice profitability for growth so long as you have a plan and can articulate a path to profitability. But if you’re not growing or worse yet, have negative growth, you should place a high priority on profitability, although most buyers will pay more for growth PLUS profit.
Easy to say, right? Where do you look and how do you start? A $5M business that cuts 50K in expenses adds 1% to the bottom line. And if you’re running a $5M software company and can’t figure out how to cut 50K in expenses, you’re not looking very hard. Too many entrepreneurs think of their company as a “job” and source of income, not an asset that has real value. In other words, the company becomes and enables their lifestyle.
While profitability is not the only key performance metric you should measure, it’s arguably the most important one. Without profitability, you aren’t generating additional capital (cash) to invest in your business, it’s difficult to get financing, and if (when) you sell your business, you’ll take a serious haircut on the valuation.
This article first appeared in Software Executive Magazine in October 2018.