Revenue growth drives value…but it does not top the list.
Grow or die. It is the entrepreneur’s mantra, a cornerstone of capitalism, at the core of owner decision-making in businesses of all sizes, and across the economy. The American emphasis on growth is reflected in judgments about the strength of our markets and how valuable businesses are. If growing companies are successful and worth more, then flat or decreasing sales must mean trouble.
A singular focus on building topline revenue is understandable. When growth supports and is enabled by a thoughtful and data-driven strategy, rigorously executed, the benefits are clearly greater than the risks. The most obvious outcome of strategic and intentional growth is greater economies of scale. When a business reaches that key inflection point where margins begin to increase exponentially due to growth, returns on assets and investment emerge that cannot be achieved through any other operational efficiencies.
Owners know from experience that growth can be fleeting and unpredictable, especially in a “VUCA” environment (volatile, uncertain, complex, ambiguous). Today, VUCA has taken on new meaning as we attempt to navigate the unknowns, and ravages, of COVID-19.
But there are other, even more powerful, value creating fundamentals that reduce the myriad challenges of a VUCA universe. When considering how to best position a business to accelerate in a post-COVID marketplace, it’s wise to consider how to fully leverage value drivers.
So what are the top three value drivers, and why do they matter so much?
John Warrilow, author of the excellent book Built to Sell, identifies six kinds of recurring revenue, listed here from highest to lowest impact on value. I’m going to spend some time on this type of revenue because it matters so much.
This is the most valuable type of recurring revenue because your cash flows are easy to project, production and supply chain needs are stable, and contracts may be financeable depending on their structure and terms. Of course, the duration of the contract matters – the longer the better – and cancellation clauses also play a part in determining how valuable they really are. There are some downsides. Sometimes you have to compromise payment collection terms or discount pricing in return for a better contract – and there are many reasons to be vigilant about what the company can bear at any given time. Big concessions when the balance sheet is weak may not be a good idea. At the end of the day, having contract for goods or services is a major value driver.
If you use any software-as-a-service (SaaS) with a monthly or annual subscription (like Dropbox), you are probably neck deep in auto-renewing subscriptions. Auto-renew is often the default, although you can opt out or change it in the future. It may even be a requirement to qualify for a discount. Many subscribers agree then fail (or forget) to turn it off – making these types of subscriptions very “sticky” and worth a lot. If you can create loyalty among your auto-subscribers, you’ve hit gold. Most of the time, users are loathe to switch software because of the pain of transitioning to a new service.
Sunk money subscriptions
One great example of a sunk money subscription is a home alarm. The technology itself creates a sticky investment – it’s the sizzle. The subscription fee on top of the system is the steak and where the real money is. Once my system is installed, the monthly monitoring subscription is solid – I’m very unlikely to switch services because it would mean installing new equipment (a significant additional cost). In this model, customer revenue is maximized through equipment, service and subscription fees.
Magazines are valuable when their readers are dependable, even more so when they cross over into raving fans. Relatively predictable cash flows make a huge difference in planning and keeping your bank happy. I have a subscription to The New Yorker. I love it. When I get the renewal notice – typically about six months prior to expiration – I check the box and send the check (early). I don’t want any interruptions and the subscription price is very low compared to buying it off the stand. I essentially give the publisher a free loan and they know I’m unlikely to cancel later. Hey, I got the free tote bag so…
Sunk money consumables
Warrilow calls this an investment in a “platform” and gives a great example: razor blades. Blades are really expensive. I buy mine at Sam’s Warehouse 24 at a time. The shaving handle is “free” of course. The whole kit – shaver and blades – are a platform. Blades are not necessarily interchangeable with other handles – so I’m in. The durable part of the platform—the handle—and cost-effective bulk buy option for blades, locked the door against platform competitors for a long time. Remember recurring revenue models create higher barriers to entry against competitors. It helps you win the customer for longer periods – and you can use the time to turn customers into a community of raving fans, all the while building the financial value of your base.
Think toothpaste. I use Sensodyne even though the price tag is higher. I’m still cost conscious so I buy it at Sam’s Warehouse (again) because I can get a better per tube price if I buy bulk. I just bought about four months of toothpaste! Even if I decided to change brands, which I won’t, the manufacturer just won the race with its competitors for at least four months. The important metric here is repurchase rates. I essentially repurchased three times in one transaction. Brilliant! There’s a reason why manufacturers want to be in Sam’s or Costco. Getting customers to purchase in bulk creates a barrier to entry for other manufacturers. That advantage allows retailers to drive discounts from their suppliers and achieve higher margins. Everybody wins – including the customer. I get to buy things I like for less money and go to the store less often. Perfect.
Regardless of your industry or type of business, it is possible to incorporate recurring revenue commitments into your model if you get creative and are willing to go the extra mile with your most loyal customers.
Commanding a Niche in a Growing Market
Steve Jobs defined niches as “white spaces” where competitors are either absent or weak and innovation would have an outsized impact. Finding viable niches and developing plans to “own” them is strategy of the highest order. Companies that do it well establish competitive advantages and barriers to entry acting as long-term value protectors.
A good example of effective “niching” is an architecture firm that builds expertise and reputation for producing excellent construction documentation that bridges creative design, engineering and compliance (permitting, etc.). Without accurate and timely documentation, projects don’t get built, causing unnecessary pain, delays, and financial losses. Planning and permitting documentation isn’t sexy and it’s behind-the-scenes trench work a typical architect hates to do. Outsourcing to a knowledgeable value-added niche partner who does it well every time makes sense.
Because this “meat and potatoes” work is necessary for every project, the niche firm can leverage expertise across the entire architecture, project development, and construction market. Being the best in their niche leads to a commanding competitive advantage in a large sector of the US economy.
The most valuable businesses don’t depend on any one individual for success.
Often, owners of smaller businesses play a crucial role in daily operations and hold mission-critical knowledge and key relationships. Sometimes owners are in three or four boxes on the org chart. This might reduce payroll, but an owner should be able to take a three-week vacation and not worry about the company’s performance. At least that’s the dream.
Doubling or tripling up key roles also misrepresents the true cost structure of the company. The owner may fulfill many roles – but doesn’t get paid at market to do so. If those positions were filled by others with salaries and benefits, the true costs of producing the product or service, and delivering it to customers with the service they deserve, would be revealed. Making a profit without recognizing all the costs can play tricks on businesses when it comes to pricing their products and services. If your prices are too low, when you have to cover those costs (which you will as you grow) you may find yourself in the unenviable position of a discount seller with nowhere to go but down. It’s a very difficult place to build a company from.
Here’s a 10-point scorecard to determine whether the owner is truly independent. Score 1-10 on each statement, with 10 indicating the highest possible independence (i.e. if the answer to “did you miss me?” is “we didn’t notice you had left,” you’re on the right track). These statements are written from the owner’s perspective.
- Only “do-or-die” matters make it to my desk. All other important decisions can be made without my input.
- I spend at least 80% of my work time “on” rather than “in” the business.
- I work no more than 40 hours a week.
- I can take a one week or longer vacation without my cell phone or laptop.
- Employees don’t have to ask me to get a good answer to an important question.
- A key customer is just as comfortable talking with a trusted employee as they are with me. The customer’s relationship is with the company, not me alone.
- If there is a service or quality problem, even very serious issues can be resolved successfully without my involvement.
- I add the most value in strategic—not operational—conversations.
- I’m not copied on operational emails (and am perfectly comfortable with it).
- If something happens to me, the business will continue to operate well without any significant interruptions.
Any score below five is a red flag and deserves attention. Although 100 is probably unattainable, a score of 80 or above is fantastic. It means the business has reached a key milestone in the journey from a lifestyle business to one with sustainable enterprise value.
For smaller lifestyle businesses, the idea that the owner isn’t the “heart, soul and face” of the place is difficult to imagine. But too much reliance on the owner is actually an impediment to growth. Every business has a “first dollar.” The decision to build a larger business that lives beyond the owner is important and it must be intentional to be sustainable.
Let’s go back to growth as a primary value driver – there’s no question it is but we don’t put it in the top three because it’s actually pretty complicated and can go wrong quickly. Growth should be strategic and intentional, as much as possible. You can find more information about strategic growth on RFN Advisory Group smart ideas page.
Recurring revenue, commanding a niche in a growing market and owner independence are the three top value drivers in a business. The flip side of the value coin are the killers. The follow-up article focuses on the top three values killers is now available.
About the Author
Sean Hutchinson is a Gellert Family Business Fellow. Annually, Fellows are selected by the Gellert Center because of their expertise working with family-owned firms and their recognized positions as leaders in family enterprise theory and practice over many years.
Sean is a third-generation heir to his family’s business, has founded half a dozen companies and has worked directly with entrepreneurs for the past three decades. Sean specializes in working with entrepreneurs and business owners to help them define and achieve their ideal business outcomes.
As one of the founders of RFN Advisory Group (previously SVA Value Accelerators), Sean’s primary focus is strategy and growth. He helps owners and their leadership teams imagine what being a ‘company of the future’ looks like for them, and then helps them achieve it.
Sean has invested heavily in education over the years – both in expanding his knowledge and sharing his experiences with other professionals. Sean sees his work as transformational, not just transactional, and it all comes down to getting business owners ready for next.