The essence of a successful business lies in its ability to create value. The mechanics begin with establishing profitable business activities, and then growing these activities to multiply value. This increasing value is the reward for all stakeholders for the risks they have undertaken.
Dichotomy of growth and profitability
In my years of navigating the financial service and internet world, I've seen a recurring theme: the challenging balance between growth and profitability. This topic isn't just a one-time business debate; rebalancing between growth and profitability is an ongoing interplay and these decisions define the company’s trajectory.
In this article, I intend to offer not just an analysis but a guide to growing companies on how to balance between growth and profitability to create sustainable value, blending my personal experiences with broader market trends and time-tested strategies.
2021 to 2024: From growth to profitability
Remember the halcyon days of 2021, when growth was the star of the business show? Startups and conglomerates alike chased expansion with an almost unbridled enthusiasm, fuelled by a seemingly inexhaustible pool of venture capital. The narrative has shifted dramatically in the latter half of 2023.
The economic landscape transformed with venture capitalists being more selective about where they want to invest. This compelled a renewed focus on profitability. While seemingly sudden, the shift in focus was not superficial and as we enter 2024, the focus on profitability looks here to stay.
Understanding the fundamentals
To understand the trade-off between growth and profitability, let’s start with the bedrock principle of business: value creation. This concept is not just a buzzword; it's the central objective of creating and sustaining a company.
Value creation, in its simplest form, is the process of generating benefits for stakeholders that exceed the costs of the inputs used. It's about making something more valuable than the sum of its parts. In a business context, this means creating products or services that customers value more than their alternatives.
Why is value creation central to businesses? It's because it provides rewards for the risks undertaken by founders, employees, and investors. Each of these stakeholders contributes valuable resources - be it capital, time, or skills - to the company. They take these risks in the hope of reaping rewards. Value creation is the mechanism that justifies these risks, providing returns that are commensurate with or exceed the resources invested, that is, generating profits.
Mechanics of value creation
How exactly is value created? The answer lies in the company's ability to effectively and efficiently utilize capital. Let's break this down:
Profitability is the foundation: The first step in creating value is establishing a profitable business activity. This means that the business must be able to produce goods or services at a cost lower than the price at which they are sold. Profitability ensures that each unit sold contributes positively to the company’s bottom line. This – Unit Economic Profitability – is the primary indicator that the company is adding value.
Growth is a multiplier: Once a company has established profitable business activities, growth can act as a multiplier of value. Growth, in this context, refers to expanding the reach of these profitable activities, whether through increasing sales, entering new markets, or scaling operations. Growth in profitable areas enhances the company's ability to generate returns on invested capital.
Unprofitable growth necessitates caution: It's crucial to understand that growth in itself is not inherently value-creating. Growth in areas where the business activity is not profitable can actually be value-destructive. Essentially, if a company is growing in areas where each unit of product or service is sold at a loss, then the more it grows, the more value it destroys.
Thus, a key principle emerges: Focus on growth after establishing unit economic profitability. This principle acts as a safeguard, ensuring that each unit of product or service sold contributes positively to the bottom line, safeguarding against the perils of unchecked expansion. But let's not forget the exceptions. In industries where early market capture is crucial or where economies of scale play a significant role, front-loading investments can be a strategic move, albeit a risky one.
The Balancing Act: Navigating growth and profitability
This is where the real challenge lies. Striking a balance between growth and profitability is akin to walking a tightrope.
Startups often focus on growth – securing market share, establishing brand presence, and building customer bases – and then shift to profitability. This cannot be a static decision but has to be a dynamic, evolving strategy that requires constant reassessment and adaptation.
Also, what applies to one industry, may not apply to another as is. For instance, venture capitalists observed a simplifying “Rule of 40” for software companies. This rule states that, for a software company to create value, the sum of its revenue growth and its profit margin should exceed 40. While such a rule may hold for the asset-light scalable software businesses, the realities of fintech, such as the need for a balance sheet, the important role of fixed costs, certain dis-economies of scale, money as a raw material rather than a lubricant -- make it very difficult to prescribe such a universal rule.
A practical playbook for walking the tightrope
Drawing from the success stories and pitfalls I've witnessed, my practical playbook for navigating this complex landscape would be:
Master your unit economics: Understanding the profitability of each product or service is crucial. Dive deep into the numbers. Analyze the cost of acquiring customers versus the long-term value they bring. This will help you identify the most profitable segments of your business and where you should be focusing your growth efforts.
Play to market dynamics: Your strategy must be aligned with industry dynamics and market stages. Be vigilant about market trends and shifts in consumer behaviour. This awareness will allow you to anticipate changes and adapt your growth strategy accordingly, ensuring that you are not left behind as the market evolves.
Adapt to new information: The ability to glide between growth and profitability as circumstances change is vital. Stay agile in your approach, and don't be afraid to reassess and realign your strategy. This might mean pulling back on certain initiatives or doubling down on others based on their performance.
Be transparent: Keep your investors and stakeholders aligned with your strategy. Regularly communicate your vision, the rationale behind your strategic decisions, and your progress. Transparency builds trust by ensuring that everyone is on the same page.
Stay true to your North Star: Ensure that your short-term decisions feed into your broader business objectives. Every step taken should be a building block towards your ultimate goal. This alignment ensures that you are not just growing for the sake of growth or turning profitable because it is vogue, but are building a sustainable, profitable business.
At QED Investors, these principles are at the heart of the advice we give to our portfolio companies. For us, unit economics is a principal filter to identify companies for further deep dive during our investment process.
Embrace the challenge with optimism
The journey of balancing growth and profitability is challenging but rewarding. It's about building a business that's not just successful today but is primed for success in the future. Embrace this challenge with an optimistic mindset.
With the right approach, this balancing act can become a strategic advantage, propelling your business towards resilience and sustainable success. Remember, the most successful businesses are those that learn to dance gracefully on the tightrope between growth and profitability, leveraging each phase for maximum impact.
Sandeep C Patil is Partner and Head of Asia Investments for QED Investors, a US-based venture capital firm specialising in fintech.
