Growth vs. profitability: the secret to stable partnerships in unstable times

  • Posted by: Jim Reinhart, Chief Financial Officer

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"Maybe 'growth at all costs' doesn’t make sense."

 

I remember reading Geoffrey Moore’s Crossing the Chasm early in my career in the technology industry and thinking that it was the gospel of building a successful technology company. Find a beachhead, build on small successes, continue to grow profitably, and then cross the chasm (while still remaining profitable). An entire class of companies went public in the early 1990s on this formula, including Powersoft, where I spent a couple of great years before departing for business school.  

When Amazon.com went public in 1997, it was one of the most notable companies to go public without profits; and its IPO heralded a new era that continues today – the primacy of growth over profitability. The simple idea is to not worry about profits in the early years of existence – simply grow as fast as you can to gain market share. This makes sense for some industries, and not so much for others.

 

Growth vs. profitability

For industries with large network effects, it can make sense. In short, “network effect” means the more market share you gain, the more valuable you become to your current and future customers, users, or clients. Social networking is a great example of large network effects (hence its name). For most enterprise software companies, the network effects are relatively low – not non-existent, but much lower than social networking. Therefore, for enterprise software companies, it is not clear that growth at all costs makes sense.

We have seen the pendulum swing sharply between focus on growth and profitability several times since Amazon’s IPO. Certainly, we saw a sharp focus on profitability following the dot com bust and then again in the wake of the Global Financial Crisis. However, over the past 23 years, we have spent more time on the growth side than the probability side of the equation.

Look no further than the ego-driven rush to achieve Unicorn status (i.e., a private company valued at more than $1 billion). Yes, companies must have success with products and customers to achieve the sky-high valuations they seek, but only as a means to the end goal of becoming a Unicorn. Moreover, institutional investors (namely private equity and venture capital firms) fueled this growth-at-all-costs, Unicorn-status mentality. Why not? If these investment firms can say they are investing in more and more valuable companies, that helps them raise more money from pension funds and other limited partners. What’s lost in all this mania is the customer’s needs and priorities.  

 

"Even prior to COVID-19, the tide started to turn against unprofitable companies…"

 

The turning tide

Until now. Even prior to COVID-19, the tide started to turn against unprofitable companies with the pendulum swinging to the profitability side. As companies like We (DBA WeWork) discovered in a particularly unforgiving manner, their unprofitable business model was unsustainable. As a result, they were forced to lay off thousands of employees and significantly cut back on expenses. Was this good for their clients, tenants, or employees? Not likely. Casper, Uber, and Lyft are other examples of companies facing more scrutiny regarding their lack of profits.

Now, with COVID-19, the situation for companies of all types – profitable or not – is tenuous at best, and dire for many. Venture capital firms and private equity firms have advised their portfolio companies to cut costs and prepare for a nuclear winter. Many of these companies have continued to operate without profits, and because they are not profitable, they are not in control of their destiny. The long-term interests of their clients are trumped by the near-term interests and whims of their investors. This is inevitable when companies take outside capital.

Misaligned incentives affect unprofitable public companies, not just private companies with outside investors. However, public companies face an additional challenge in that much of their employee compensation is in the form of stock. As a public company faces more scrutiny regarding its business model, its stock price often takes a direct and very visible hit, which in turn, affects employee compensation (and morale).

 

"As credit unions and community banks look to establish a five- to seven-year partnership with a digital banking provider, we think financial prudence and stability matters."

 

What really matters?

Why does all this matter to financial institutions? As credit unions and community banks look to establish a five- to seven-year partnership with a digital banking provider, we think financial prudence and stability matters. In fact, we think it should be one of the most important considerations when evaluating options. Access Softek has been in business for 34 years. We have operated profitably for many, many years. Continuous financial prudence is in our DNA, not something we need to adjust to. We have seen competitors face and fail challenges far less than the one we are all facing today. Many of these companies simply disappeared. Many were gobbled up by much larger companies, only to see whatever innovation they once had fade away.  

Is this a self-serving examination? Yes, but that’s exactly the point. We serve our clients – not shareholders, not investors, not debtors. We exist to offer our clients the best innovation, product, and services that we can offer. Our revenue that we earn from client fees fuels the innovation and product delivery that we perform on their behalf. We pour the lion’s share of our revenue back into the company to develop new products, update existing products, support our clients, and employ outstanding people. For the benefit of our clients, we need to grow with both existing clients and new clients. Hence, we do invest in sales and marketing, but we do so prudently. Most importantly, our long-term strategy and long-term success is aligned with our clients rather than with outside investors. 

As you consider your digital banking partners for the next seven years or more, look closely at their finances, their expenses, their culture – their DNA. We think stability plus innovation provides the best of both worlds.

Jim Reinhart, Chief Financial Officer
Author: Jim Reinhart, Chief Financial Officer
Jim Reinhart joined Access Softek with over 20 years of corporate finance, M&A, and strategic finance experience. He previously worked for Goldman Sachs, Deutsche Bank, J.P. Morgan, and Ernst & Young.