While it is obvious that growth adds value, it often seems less obvious to many companies just how valuable additional growth can be – and how best to think about certain trade offs when it comes to value creation.
We find that a surprising number of entrepreneurs tend to revert too easily to a simple mantra for their business – something akin to more is better when it comes to revenues and less is better when it comes to expenses. While this mantra is true enough on its face, it does little to inform the best way to think about the trade offs that inevitably need to be made when pursuing value creating growth.
As an example, we frequently encounter the margin objection. It goes something like this – “Our gross margin is only 20% and we simply cannot afford to pay a capital cost that is 10% – must less 15% or 20%.” From a shareholder value point of view this line of reasoning is simply not true by itself. It is certainly true if there is not incremental growth – it may be true if incremental growth is low – but it is also certainly not true if growth is high. While the contributing variables are many and somewhat involved, the growth threshold for wealth creation for a 20% growth margin business is typically in the 5-7% range when the capital costs are commensurate with those available from commercial finance providers. Said another way, when commercial finance is the capital source, all gross margin contribution above 5-7% revenue growth typically contributes 100% to an increase in shareholder wealth.
On an intuitive level this makes sense: Let’s say a company sells at a 20% gross margin – gets paid in 60 days – and pays 1.5% per month for its commercial finance capital. In this example, the company earns 20% profits for the incremental sales, pays capital costs of 3% (1.5% per month times two months) and is left with a gross margin after capital costs of 17% – all of which contributes to shareholder wealth.
The chart below illustrates this reality well:
In this example, the Incremental Revenues are shown on the x-axis (horizontal) and the Gross Margin Contribution on the y-axis (vertical). The BLUE lines demonstrate the Y- Gross Margin Contribution for each X – Incremental Revenues unit – for a 20% gross margin business that gets paid in 30 and 60 days (DSO = Day Sales Outstanding) assuming the commercial finance capital costs are 1.5% per month.
In all cases, the contribution is positive on a marginal basis.
We’ve also shown the same for a 15% gross margin business getting paid in 60 days – the lower GRAY line – and a 25% gross margin business getting paid in 30 days – the upper GRAY line.
This said, we don’t dispute the mantra that lower is better when it comes to expenses – including capital cost expenses. What we do suggest is that the analysis does have some level of nuance and that if growth can be realized with additional capital being made available, then it is certainly quite likely that shareholder wealth will be increased despite the higher costs for that capital.
We recently ran across a newer company with ~$3.5 million in sales – selling an ~20% gross margin product – with a reported opportunity (and production capacity) to more than double sales in a year with access to more working capital. Even if the capital costs were 1.5% per month – or 3% total assuming 60 DSO, the shareholder wealth question is a simple one:
Assuming the same fixed costs, would you rather own a business with $3.5 million in revenues and a 20% gross margin or a business with $7 million in revenues and a 17% gross margin (net of the capital costs)?
The answer is also simple – the $7 million business.