Losing Money, but Making it up on Volume
BY Ed Powers
Does your company need just a bit more capital to scale and make it to profitability? Or is it just a money pit? How to tell.
Your business seems like it is growing well enough, but your cash flow isn’t what you want it to be. You have customers, perhaps not as many as you would like, but your product is definitely selling. Your company’s ability to make or lose money seems to depend more on when your profits (or losses) are measured than anything else.
One month is good, but then the whole quarter isn’t. As for year-over-year, you think your top line will grow, but the bottom line doesn’t feel very good. You have small shocks periodically—expenses increase because the cost of materials suddenly jumps as a result of some global commodity change. You don’t dare tackle a price increase. So, that increased cost eats your profits. You start to wonder if the seasonal downturn in your business is more than the normal dip. You can’t get more financing and your stress level is high, because you need working capital. You have a sinking feeling that your investment in your own company is the piece of the capital structure taking the beating. You think, “if I just had a little more capital, I could get over this hump and really get going!”
Small businesses channel the tone of the overall economy, there’s no doubt about that. As a group, they have become more integrated into global supply chains. So, a change at the purchasing end reverberates throughout all the links.
Commodity price changes also rattle companies. Trying to manage those input costs is incredibly difficult. (Note to a business owner—if hedging a commodity is too expensive for your business, it means no other market participant thinks they can profitably take on the risk of that commodity price either.)
Seeking capital in this environment is no picnic. Your financial statements usually conflate two things that can have opposite meanings to capital providers—one is that your business actually might not make money and the other is that your business might need more scale.
The first case (not making money) is denied by most business owners until it is too late. The symptoms mentioned above mean for certain businesses that they actually can’t pull cash all the way through to the bottom line. There are other lower-cost competitors and the shocks that hit the business aren’t really shocks—they are long-term secular changes in the industry that can’t be controlled. Technological changes or other factors are driving customers to another product or solution. And relentless expense control in some businesses can only do so much, because the fixed expenses of the business are just too high.
The second case (needing more scale) can be more interesting to an equity capital provider. Particularly in certain industries (software is a classic example), the product needs to be developed well enough, which requires a lot of capital, but then as customer adoption increases, that scale drives profits repeatedly to the bottom line. Investors look at these companies with an eye toward the gross margin on an eventual sale, thinking “if I can get this company to this level of sales, I will more than make up for the capital we pumped into developing the product.” It’s a simple breakeven analysis, calculating how much product needs to be sold profitably to cover what has been invested to date. It also requires lots of cost accounting, some of which feels like more art than science.
Investors are much more likely to believe the second case about newer technologies and newer companies, figuring that companies that aren’t making money that have been in operation over a medium to long term may be inefficient or suffering from a more than cyclical downturn in their industry. They also think the potential upside to older companies is less, as they think these industries won’t suddenly create more profits than they have historically.
So, what’s a business owner to do?
Figure out what the true fixed costs are versus variable costs. Shrinking your fixed costs lowers your breakeven point. Many small businesses transform the fixed cost of owning your own real estate to leasing space to lower their fixed cost hurdle.
Measure the Gross Margin. If your customer isn’t willing to pay much more than your cost of producing a product, you are in a tough industry. You need to know if you are making money at that level.
Consider the price. Many businesses are in industries with highly competitive pricing. Conversely, business owners are often reticent to touch prices, but are in industries where price changes can be absorbed by the customer. Think through how important your product is to your customer—they often need you more than you know―and you need to be paid for that.
Take a clear-eyed look at your business to figure out if capital should be coming in to fund growth that will get you over that hurdle―or as painful as it may be, reassess if capital is being destroyed because the business just isn’t profitable. You will quickly be able to see whether you’re dealing with a capital gap or a money pit.
Based in New York, ED POWERS is a managing director and head of the Capital Access Funds team at Bank of America Merrill Lynch. Capital Access Funds is an experienced, returns-driven private equity fund-of-funds.