How Should a Start-up Think About the Trade-off Between Growth and Margin

There’s a tug-of-war between growth and profit margins. It is difficult to choose one over the other, and we call this situation a ‘trade-off’. While firms can face this dilemma at any stage, start-ups have to look at it from an analytical perspective.

To weigh growth and profit margins, we take a look at it through an investor’s eyes.

1. Understanding Revenue and Performance

Let us understand what revenue is. In the simplest terms, revenue is the cost of goods sold (or gross margin) minus the operating costs. Investors assess the performance of a company by looking at the revenue lines.

Suppose, there are two firms A and B. In a year, both of them gained a revenue (profits) of 1 crore. However, in terms of revenue growth, firm A had a growth of 50%, and firm B had a growth of 5%. In this case, firm A clearly has better growth performance. Investors are more interested in this performance rather than the amount of revenue.

2. Evaluating Revenue Growth

Typically, investors look at the growth of revenue and not merely earnings. However, the evaluation is a calculation of future cash flows (the expected value) which are discounted for current value (it takes inflation into account). Obviously, a rapidly growing company has a better chance of yielding more profits in the future. But for start-ups, consumer revenue is the decision-making factor for investors.

Let us take the example of a software company that has rolled out a new app. In the first year, the adoption rate of the app is 120%. In the next year, the rate falls slightly. Over the next five years, the adoption rate remains more or less stable. Here, the investors would certainly consider the bloating rate of adoption over revenue growth.

3. Analyzing the Revenue Concentration

Think of this as juxtaposing your consumer base against the revenue. To start with, you need to analyze the ratio of consumers to revenue. It can be illustrated like this – 90% of your revenue is generated from 35% of the consumers.

The rule of thumb goes that if your top five customers account for 25% of the revenue, you have a high consumer concentration. Higher consumer concentration translates into a greater risk of plummeting profits in the coming future. Investors would think twice before leaping such a scenario. This is why start-ups should focus more on building and bolstering a consumer base instead of relying on existing customers.

Other than this, profitability across product lines is considered, that is if the revenues stem from one product line or multiple lines. Pricing is another notable aspect. Often, a start-up garners good revenue initially. But later, as the prices are forced down due to competition, the revenue takes a plummet.

What Keeps Start-ups Away from Chasing Value?

Despite the lauded importance of generating value, companies are still inclined towards cutting costs. Let us take a look at some reasons that make firms choose margin over growth.

  1. Lack of Good Ideas

A single good idea or an innovative product can transform a company and keep it abreast for decades. Imagine Apple without iPhone. Unfortunately, firms take a different approach and try to squeeze profits by cutting costs. Some others simply refuse to try new ventures or take risks. Due to this attitude, good ideas never see the light of experimentation.

This can be tackled by encouraging new ideas and rewarding experiments. Take risks on the ideas that seem promising.

  1. Smart Ideas, Outdated Investment Approach

Not all companies refuse to innovate or take risks. Some start-ups come up with promising ideas. Unfortunately, they devise outdated, traditional investment ways to achieve their ultra-modern goals. Several ideas don’t make it to the end of the screening process. A flood of ideas is reduced to a few drops by the time it comes out of the funnel.

With that being said, not all the ideas are credible. But we live in a capital abundant era, there is a lot of scope to invest in multiple promising ventures at once. The right approach would be to negate the losers but double down on the promising ideas. The key is to open all the doors before deciding which one to walk through.

  1. Dearth of Productivity

Your company has come up with the right idea, you have impressed the investors, and now it’s time to execute the ideas. At this stage, a lack of talented human resources and productivity can mar your project. Human productivity is directly affected by work culture. Excess bureaucracy, no promise of growth, and skepticism towards creativity are the biggest turn-offs for productivity.

The best way to overcome this is delegating responsibilities, giving enough autonomy to employees to try out new ideas, encouraging creativity are just some of the ways to boost employee morale.

Finally, it all boils down to the fact that generating value and attaining meaningful growth rather than chasing and squeezing profits. Innovation and growth can potentially propel your company decades ahead of your competitors.