The brutal truth if to grow profitable
I rent office space at a tech incubator down-town Stockholm. Being a small business entrepreneur this has been a great solution that add pulse, colleagues and daily inspiration. Surprisingly however, many of my colleagues, including some of the angels and venture capitalists that hangs around our office seems to have a somewhat naïve tune to growing companies. At least if one would like to do it long-term.
Do not misunderstand me. We all have different strengths. Be it the visionary pundit, the marketing virtuous, the enthusiastic sales guy or the coding geek. Mine is growth and recently I have met some interesting likeminded people.People who know how to grow businesses and know what to focus on. Let me share a few basic things to consider when scaling businesses, and give you some food for thought why most business ventures don’t scale:
The math behind the definition of size:
Most people would agree that turnover is a proxy for size. Other measures like number of customers, profit or even number of employees can be an indication. But eventually, once the capital is being consumed and the second last investor has cashed-in and you need to fund continued growth on the company’s own merits, it all boils down to how much revenue you make to pay for staff, production, marketing and so forth.
For the sake of argument let’s aim to build a €40 million turnover company. It is far from a large player but it is a mid-sized business large enough to run relatively stable long-term and with resources to continue develop its business.
My first point for discussion is the sheer sales volume needed to invoice €40 million a year. If we engineer and manufacture an industrial product selling those for €40k each, we need to sell a 1.000 units a year. If the sales price is €10k each, we need to sell 4.000 units a year. That’s a lot of contracts. With a hit ratio, or conversation rate, of roughly 20% on any sales lead we need 5.000 and 20.000 serious sales prospects respectively in any given year, in these two examples. How to build resources and efficiently manage that large volume of sales prospects successfully with own sales staff and/or partnering with other sales companies is one of the first strategic decision to consider and start executing on. Partnering with other companies and sales channels means less control, less interaction with the end-customers and a margin deterioration, but for many businesses that will be the only way to reach volumes necessary to run a long-term stable business.
Finding and hiring employees, not least the sales staff, will be critical to reach scale. Also if you are a software online based business with scalable ambitions, you need physical live-being sales staff. I have met online based entrepreneurs that indeed believe sales will flood to them just because they have a great offering, competitive prices, an up-to-date user-friendly online sites and one or two initial break-through customers. I will argue that also these companies need sales staff that constantly feed the machine with users and customers. That can be call centers for outbound sales calls. That can be social media content marketing staffs. That can be advertising staffs. That can be senior staffs running endless rows of online and live events and workshops. And that can be the normal BtB sales executives. Some people still don’t know that one of the world’s most successful online businesses, Salesforce, has 19.000 employees of which a considerable majority work with sales. That is up from 14.000 employees the year before.
Amongst the FinTech companies I work with, crowd funding has been a popular business proposition. However, with 2-4% fee you need a staggering €1-2 billion in crowd funding volumes a year to make the crowd funding company a €40 million turnover business. Which many valuations of crowd funding businesses imply they are about to become while still being far from those volumes of businesses. That equals 4.000 transactions a year, or 80 transactions a week, with an average transaction size at approximately €0.5 million. Again, that’s a lot. Few domestic markets will generate these (quality) volumes and necessary angel investor appetites to back it up. Cross-border scalability, semi-automatic co-operation with a private equity or venture capital firm that can sweeten each deal or other channels to gain deals and funding will be necessary to reach such volumes.
Back to the engineering and manufacturing business. You need at least 250 employees to sell and manufacture for €40 million per year. Probably a bit more but let’s settle with that for the sake of argument. Assume 20% being white-collar sales, engineering and administration staff and 80% being your blue-collar assembly, welding and/or machinery staff. These people will set you off with €13 million in annual staff cost assuming €4k in monthly white-collar salary and €3k in monthly blue-collar salary, plus social charges.
Inventories, being office furniture, computers and phones for white-collar staff, as well as benches, racks, tools and some heavy machinery for blue collars will set you off with €200k per year in depreciations with 3-10 year’s depreciation periods.
Rent is highly dependent upon place of residence. Assuming 25 sq.m. per white collar and 40 sq.m. per blue-collar in a rural non-city center area would cost you roughly €400k per year.
With above fixed cost and a sale of €40 million a year you need at least 35% gross margin on sales to make it to a zero result. A 35% gross margin on your €40 million sales means you have €14 million in net revenue having deducted the 65% of material and handling. These $14 million shall pay for above €13.6 million in your fixed costs.
You also need to pay for interest and taxes. In manufacturing you typically have a working capital need at any given time equaling roughly one-third of your annual sales in order to finance manufacturing until you get fully paid by your customers. Negotiating advance payments would give a positive effect on liquidity and reduce necessary working capital needs. Assuming a 3,5-5% interest on receivable financing or other working capital facilities will set you back with circa €500k in annual interest expenses while your pre-tax profit will land around zero in this example. Hence the importance to work your margins, manage the cost and to try negotiate favorable advance payment terms when possible.
If you manage to charge 40% gross margin, your net margin will be 4% with €1.5 million in net profit on your €40 million in sales. If you can make it a 45% gross margin, your net margin will be 7.5% with a €3 million in net profit. The lesson learned is that your sales margins will be extremely important going forward (mind your cost all the time, optimize your stock and materials handling and develop your pipeline, sales, pricing and negotiation skills).
So what if we are not really at the €40 million mark yet but so far have reached €5-10 million in annual turnover? Well, the same mathematics but with two important differences:
- Your net margin after tax will likely be somewhat thinner since you have less sales volume but have started to accumulate overhead costs, not yet gaining scalable advantages (general manager, accounting costs, purchasing and similar).
- With a smaller company comes a smaller net profit in absolute terms. The €1.5 million in net profit in above €40 million turnover company with 40% gross margins will only be in the order of €0.2-0.3 million if your sales are €10 million (and has some relative overhead dis-synergies from a smaller business than the €40 million comany). That is not much funds to set aside for future investments in product development, market development and dividends. Hence, again, size is important for long-term sustainability and a certain buffer against unforeseen customer, supplier or market changes.
Can we improve the business case by outsourcing production?
Production is relatively capital intense, regardless if being manufacturing or IT-operations, and hence many companies outsource production to others to limit investments necessary. This allows to work more with a flexible cost base as opposed to fixed costs from own premises and blue-collar staff. It also allows a focus on the important sales, product development and staff hiring, although some full time resources will actually be needed to oversee and work with your outsourcing partner.
To outsource production might even improve the net margin calculation somewhat should you find a supplier with established volumes and hence lower production costs than you yourself can manage. Remember, your cost savings in own premises and staff will be exchanged for expenses to your outsourcing partner that will do the work for you. Outsourcing the production is not for free, and hiring a professional purchaser and quality engineer will become important quite early on to allow spending time on your supplier relationship. Presence, i.e. frequent visits to your supplier will be necessary to work on the quality and to show that you are an important customer and needs to gain priority for delivery when things get sour at your supplier-end (which will happen from time to time). Consequential costs and loss of customer reputation will be huge should your supplier run into problems or delays.
So, why shall you ever start production of your own with all the capital needed, new premises, new competences, increased number of employees and hence the fixed costs?
- Knowhow; product development, engineering and operations will learn a lot from production to create cost-effective solutions (manufacturing or IT respectively). At certain point you will have to start working your net margins as much as possible and being close to production will be one of the most important way to achieve margin improvements in your design, engineering, processes, material handling, manufacturing, operations and logistics.
- Security of supply; the longer your relationships gets with your supplier/-s and the larger the volumes gets the more dependent you become upon your supplier/-s, which is not necessarily a good thing.
- Relevance and license to operate; when your business grow, new and larger customers will like to see you as a serious long-term supplier with deep inhouse capabilities. I.e. it has an importance in itself to have your own optimized material handling and production capability, not only sales and design.
- Prototyping; will likely be faster and more cost effective with own production capabilities.
- Intellectual properties; you will be in full control of your design and engineering skills with own production facilities. A typical trade-off for smaller firms but increasingly important when your business grow in success.
In conclusion, you can probably improve the business case by outsourcing production but it will likely not be the long-term solution should you aim to make substantial growth with your company.
The soft things of growing the business – HR:
Almost without exception, small and mid-sized companies seem to be dependent upon 2-4 key individuals. Often the founder and a minor few of the other colleagues do 70-80% of customer sales and sits on core key design and engineering competence. That is really bad if aiming to scale the business. Both with regards to resources, leverage and with regards to dependency on key individuals not becoming ill, getting demotivated or leaving the company.
We are all different. I am the coaching growth guy supporting others while I don’t mind getting my own hands dirty in hands-on customer meetings, engineering discussions or digging into and solving financial challenges. But I am not the typical visionary think-tank guy, others do that much better. Other business people are either the typical sales person or the engineering genius. The key growing a business however is to delegate and make more people accountable to do similar but more work as the 1-4 founding super-stars. That is what leverage is all about, and it’s a huge challenge to many entrepreneurs that are used to be in control, to make all the calls and always having the last say. In particularly when many entrepreneurs seem to be the stereotype ADHD- or ADD-individuals with massive capacity to focus on their particular business, which the average employee usually does not share.
There are several ways to skin a cat (sorry for poor saying). The business will not grow if you cannot step back, employ and coach more people to do the job for you. More people will mean more job done. It might not turn out exactly the way you would have done it yourself, and not with the same speed, but it will be done and gradually more often then you alone can make it happen. If you cannot delegate and coach others to grow; get a coach yourself that help you achieve this, or simply step back, focus on what you are good at while hiring another general manager that knows leadership and how to delegate, coach and empower others in your team. It is as simple as that if you really would like to grow your business.
The second HR growth issue beyond coaching for leverage is to dare to actually hire more people. Yes, it cost and yes it consumes your valuable time but almost all sales-growth is equivalent to the number of sales staff and sales support staff working for you. Someone can only do that much. The key however is to find the right people and this is where you really need to spend your time as the leader of the company – finding more and the right people that fit the company as the company grow. Not spending time on every little piece of the puzzle in you company. That will only get you stuck and growth will be for others, not for you.
Usually one would like to have a mix with a few senior and really well connected sales executives, as well as some younger up and coming account managers to help on daily contacts, contract administration and add on sales. Once the company grow, you need more of that. A never ending task.
Another well-debated issue when hiring and managing sales staff is if all sales guys can do all parts of the sales process? The jury is still out there but personally I believe some people are the typical door-openers while other are not. Very out-going, social, curious and not afraid to travel and call new prospects guys shall be your key door-opening sales staff. Others are more of the administrative type doing indoor after-sales, contract administration and accounts management. My advice is to find a good mixture and to spend a lot of the management time and dimes to find as many of the senior, well-connected and established door-openers as possible, and then coach them. Those are the ones that will drive your growth.
On the sales side, there is not much cost to save to improve your business case. On the contrary a really good sales staff that are well connected in the industry and that are seasoned enough to negotiate enough gross margins and stand-firm by charging the change-orders will make a really positive impact on growing the company.
The need for working capital:
Liquidity is the blood that keeps the company running. Don’t mix revenues or profit for cash flow and liquidity.
You have fixed expenses in terms of staff and rents and you have variable expenses in terms of travelling, materials and supplies. Some firms also have large IT-costs depending on the type of business.
Your terms of payment will be an important denominator on how much liquidity you need, and when. Assuming you do sell of course, otherwise your liquidity will just equal your capital less your burn-rate.
Far from all businesses are blessed with upfront payments from customers. Often you purchase gods, materials and/or services and only get paid once you have delivered to your customer. Working your chain of production to shorten your lead times as much as possible is not only an advantage in sales argumentation but also important to limit outstanding spending, i.e. limit your working capital need and the constant strain on your liquidity buffer.
Keeping detailed track on your stock and inventory turn-over and work as much as possible with just-in-time deliveries and material handling is another important area to reduce your tied up capital, and hence the working capital need. You have paid for the stock but you have not yet sold and got paid for it.
If your business is software related, trying to improve your license agreements and to constantly review your traffic and data for optimization can reduce expenses and hence working capital.
Keeping weekly track on liquidity, cash at bank less expenses plus income is important in any business but more so if you grow the business since your working capital needs will rapidly grow as well.
To many early-stage small and mid-size growth companies receivable financing is a perfect method for financing. The interest rate might be higher than on a credit facility or working capital facility with your bank but the main benefit is being a hazel-free solution. A bank facility needs a relatively stable business, it often needs an income track-record and not least it needs shareholder guarantees.
Eventually however, your business will be mature enough and your working capital need will be large enough that spending time on raising a bank facility will be worth the investment. Most important however, keep track on your liquidity needs and make as accurate rolling liquidity forecasts as possible for at least a few months ahead, preferably 18-24 if possible and if growing at speed.
Scaling businesses is fascinating, energizing and rewarding. Based on my experiences and all available facts it is challenging. Most companies don’t make it. Hopefully I have managed to contribute with some basic food for thoughts on scale, the need for leadership and the importance of working capital. The list of other considerations is still long but this can be a good start.
Thank you for reading and good luck with growing your business. Please feel free to like, comment, share, tweet, email, etc. Hopefully the Pareto principle, also known as the 80-20 rule, will apply. I.e. 80% agree and 20% will give a constructive challenge.