The power of margins
Saturday, August 28, 2010/
There’s one certainty in a growth business – it’s going to consume all the cash you can get your hands on!
The obvious solution is to have a source of finance available to meet the increasing demand for funding. But banks tend to shy away from high growth enterprises, as they typically don’t have the bricks and mortar to secure the debt. That leaves equity funding as the only practical external source of funds.
However, new equity dilutes existing shareholdings. If the business is privately held, then the funds will have to come from the private equity sector and the money will come with conditions, not least of all that the investors will require a liquidity event such as an IPO or trade sale within a few years.
The only practical path out of this trap is to generate higher levels of cash organically. You do this by increasing margins – reducing expenses or increasing prices. While this may seem a bit impractical, in fact, the high growth business is well positioned to do exactly that. While some progress may be made by reducing expenses, the major source of extra cash will need to come from increasing prices.
High growth businesses are in a unique position. They achieve high growth because they have a number of key product/market characteristics. Typically they satisfy a compelling need, have a sustainable competitive advantage and target a well defined niche market.
Generally, they work in emerging markets where demand exceeds supply. This unusual situation actually allows them to push up their prices as, at least at the margin, the market is not sensitive to small increments in price. A lift in prices increases their margins and generates additional free cash.
Apart from fuelling growth, higher margins allow the business to take greater risks, recover from mistakes and fight off competition. It is like having a war chest which you can use at your discretion to use in the best interest of the business. It could, for example, be used to increase the rate of R&D and thus improve your long-term competitive position or it could be used to undertake an acquisition to overcome a market or growth constraint.
We should never take our sales prices as a given. By changing product positioning, target customers, problems addressed and distribution channels, we can often find ways of increasing the price and therefore the margins. Any sustainable increase in margins will greatly improve the resilience, growth prospects and profitability of the business.
If all you had to do was fund work in progress, you just might be able to cope, but there are very large costs associated with growth which need to be funded well in advance of sales. Staff need to be recruited and trained, accommodation needs to be in place, inventory needs to be purchased and stored, computer software and hardware systems need to be implemented and so on. Infrastructure and support costs are lumpy and often need to be in place well before they are needed. Without access to a ready source of cash, growth businesses stall and lose their momentum.
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