Sunday, April 22, 2012

Chasing Growth while Neglecting Profitability is Recipe for Disaster

From the link:

Chasing growth while neglecting profitability is ultimately a recipe for disaster. Yes, there are situations and proven cases where this strategy works (Facebook being the obvious standout), but for the most part businesses need to focus on building a profit-generating business model before investing in rapid growth outside of their core zone of comfort. Too often profitability is thought to be a function of size (growth). The opposite is more accurate.

Clayton Christensen, a Harvard Business Professor and famed writer epitomizes this view with his theory that managers need to be impatient for profit but patient for growth. A recent HBR blog by Rob Wheeler details Christensen’s rationale via three components:

(1) When businesses are impatient for profit, entrepreneurs are forced to validate their assumptions and demonstrate that customers are fundamentally willing to pay an acceptable price for the company’s offering

(2) Expecting a business to be profitable quickly forces it to keep its fixed costs low; b/c a business’s cost structure determines which customers it finds profitable, keeping these fixed costs low preserves strategic options for the company when it is choosing which customers to target

(3) reaching profitability quickly ensures that when outside financing dries up, the venture can succeed on its own

Too often I hear of start-up’s throwing out that clich├ęd phrase of “we will be profitable once we reach critical mass.” If you can’t prove your business model has profit potential at a smaller scale, what proof is there that you can manage the model to profitability at a larger scale? Wheeler points out that Groupon’s business model does not benefit from significant network effects like Facebook and that the company’s product is not more valuable to users as more people adopt the platform. This is an astute observation and should make any potential investors think twice about diving into this highly overvalued IPO.

I’d like to conclude with the following: Investing blindly in growth is dangerous. Investment capital is better utilized shoring up the profitability of your business, testing alternative revenue streams, and eventually selecting a foundational model that can return free cash flow and profits back to the owners of that capital. Yes, Facebook succeeded in targeting growth and has become highly profitable. For every Facebook, there are 1000+ Webvans.

(Webvan was an online grocer during the dotcom boom that in 18 months raised $375MM in an IPO expanded from San Fran to 8 U.S cities and built a giant infrastructure with a 26-city expansion plan including $1 billion spent on warehouses. The founders seemingly forgot that the grocery business has incredibly thin margins and were never able to attract enough customers to reach break-even cash flow).

- Article by "Ryan Lambert. MBA"

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