Too many companies grow their revenue without knowing if they're actually earning a reasonable margin. Most literature will tell you that a growing top line is critical to a higher valuation. However, if you are growing your revenue line by offering your services at a discounted price, are you really creating value? In my previous article, "Intrinsic Value per Share and the Roadmap to Measurable Value Creation," I singled out clean revenue as one of seven drivers of a higher multiple. In this article, I get into this concept in a bit more detail.
Revenue can be improved by increasing price, improving utilization or productivity, and/or increasing volume. However, companies get in trouble when they start increasing volume by discounting their prices or taking on subprime clients to secure market share. This is a slippery slope.
When buyers look at businesses, they assess the quality in the numbers more than the quantity in them. A company that generates $10 million of EBITDA on $50 million of revenue (a 20% EBITDA margin) is more valuable than one that does the same $10 million of EBITDA, but on $80 million of revenue (a 12.5% EBITDA margin). The more profitable company often has a much lower working capital investment, lower equipment requirements, and lower labor intensity than the lower profitable one. Both deliver the same EBITDA, but the more profitable one does it with less effort.
Therefore, it is not just about being the biggest and chasing any revenue. It is about chasing "good" revenue and walking away from revenue that does not meet your company’s margin threshold. In fact, even before chasing new work, good companies audit their revenue lines first to determine how valuable this revenue is. Here’s how they do it:
They Understand Their Value Proposition
Why do clients pick one company's product or service over its competitors? Why would they pay a premium? Good, valuable companies know this answer cold. They know their value proposition. Therefore, the first thing to ask yourself is whether your company offers a commodity or not. If it doesn't, then what differentiates your product of the following:
- Is it the service around it?
- Is it the warranty?
- Is it the fact that it is supplied, installed and delivered always on time, on budget and safely?
The fundamental step is to put yourself in the shoes of the clients, and figure out what they expect and regard as valuable. Then, of course, you provide it to them, but you also understand it so well that you can appropriately price this value that your service/product provides. Lastly, you deploy every single dollar of your marketing budget and tap into every available sales and engagement channel (direct, social media, traditional media) to tell the market about your value proposition.
They Understand Their Cost Structure
A customer asks for a 15% discount. Should a company just give the discount to keep the work? How does the company even know if the work is worth keeping? Good companies have excellent cost accounting for each service or product line. It is imperative to understand the variable and fixed costs of goods or services sold, but also (and perhaps more importantly), the allocation of fixed overhead, depreciation and financing costs to the product/service. Too many companies price based on a "contribution margin" basis. Just earn enough to cover the variable costs to contribute against fixed overheads because "this money is already sunk." It is impossible to create value without a pricing structure that covers all costs plus a markup that earns a return on capital
that is commensurate with the risk of being in business.
They Eliminate Non Core Product Lines
Once a company knows what it actually costs to provide its products or services, it can rank them all based on profitability. When companies conduct this exercise, they often see a very distinct 80/20 rule - 80% of the profit being generated by 20% of the services or products they offer. This is because most companies offer too many products, which end up consuming resources and requiring more overhead to maintain. They get away from their core services/products, which are often the most profitable, at the expense of service line growth.
They Audit Their Clients
Which companies ever "let go" clients? Valuable ones do. The same 80/20 rule applies to clients as it does to products - 80% of the profit is delivered by 20% of the clients. However, most companies dedicate the same or more time, effort and cost to the marginal 80% of the client base. It takes courage to "let go" clients that are not profitable, but valuable companies do it regularly since they understand that their resources are better deployed servicing and chasing after clients that deliver an adequate return.
They "Productize" Their Services
A lot of companies sell services by the hour. The challenge with this business model is how tough it is to make it scalable
. A scalable business does not limit its revenue line by the time available. It eliminates time from the equation. For example, a financial consulting practice where the consultants charge by the hour can grow its revenue and be very profitable, but it is ultimately limited by the number of consultants in the firm and the time they put in. What if, rather than sell the consulting services, the firm packaged the service into an easy-to-follow, downloadable checklist or how-to book? The product sales would no longer be dependent on the consultants’ time.
So Grow, But Grow the Clean Revenue....
Smart buyers always review revenue to ensure the work is high quality. How repeatable is the work? Are the clients class A, B or C? How much of the growing revenue is consuming the most resources or generating low margins. Understandably, business owners may chase after any revenue in an effort to grow the company. However, it is OK to say "no" if you are not generating the right margin for your efforts or if the product simply utilizes more resources than it deserves in terms of its profitability. Valuable companies continuously review and tweak their service and product lines in a continuous drive to grow the bottom line rather than the top line.