Grow fast or
die slow: The role of profitability in sustainable growth
How can
software and online-services companies determine the right balance between
growth and profitability?
It is clear to most in
the software and technology community that the days of growth at any cost are
behind us, at least for now. Of course, growth is still important—it remains
one of the most important factors in valuation, access to capital, and
shareholder return, as well as the ability to attract top talent. Although some
companies, investors, and shareholders are still focused solely on rapid
growth, many in the start-up ecosystem are increasingly pushing for sustainable
growth, which balances high growth rates with evidence of a path to profitability.
These investors and operators view sustainable growth as the leading indicator
of a software company’s overall health and potential.
While this increased focus on sustainable growth is well
founded, a one-size-fits-all approach can leave value on the table. This is
particularly true for software businesses, in which benefits tend to accrue
disproportionately to players with scale. Context also matters when considering
the optimal trade-off between growth and margin, including a company’s stage in
the growth cycle, the macroeconomic environment, availability of capital,
market dynamics, competition, and the chosen strategy for driving adoption and
achieving scale.
To understand these nuances, we examined McKinsey’s
database of publicly traded software companies, which contains information on
about 3,000 players from around the world. The data spans the years from 1980
through 2013, making it possible to identify long-term patterns. While our
previous research focused on revenue growth, our current investigation also
looks at the role of profit margins.
We uncovered several important insights about the
trade-off between growth and margins. Software businesses that have achieved
$100 million in revenue, and are beginning to see the benefits of scale,
generally place less emphasis on profitability than companies that have reached
$1 billion in sales. We also found that while this strategy may benefit
companies seeking to surpass the $100 million threshold in the short term, they
must eventually increase their focus on profitability to achieve sustainable
growth (as evidenced by the increased focus on profitability among those that
have reached $1 billion). These insights relate to another major finding: most
software businesses fall into five specific categories based on their growth
and profitability profile, and the strategies for value creation differ for
each category.
Scale influences
strategy
We began by dividing the companies in our analysis into
two groups based on annual revenue thresholds—those that had reached $100
million annually and those that had
reached $1 billion—since a company’s size has an important impact on
outcomes. Their divergent paths become most clear when we contrast their
earnings before interest, taxes, depreciation, and amortization (EBITDA)
margins. First, consider the two most prominent trends seen with $100 million
players:
·
Slight annual declines. Since
1980, public software companies that
crossed the $100 million revenue threshold have, in aggregate, seen EBITDA
margins decline slightly over the past three decades. There were a couple
periods when there was a sharp spike in the number of companies in the $100
million revenue category with negative EBITDA margins, such as the dot-com era
and the years immediately preceding the financial crisis.
·
Greater spread. In
the 1980s, most software companies that passed the $100 million threshold had
margins of between 10 and 20 percent. The spread in the last decade has been
more than five times that amount.
The slight annual declines, combined with the greater
spread, could be occurring because most software companies followed a
perpetual-license model prior to the early 2000s. That meant they generated
most of their customer lifetime value at the initial purchase, resulting in
higher profit margins from the start. However, many software companies are now
following a software-as-a-service (SaaS) model, where they typically have
negative margins early on as they invest in customer acquisition, success, and
retention.
Now consider the companies that made it all the way to
the $1 billion revenue threshold. Like the companies that crossed $100 million
in revenue, they experienced greater spread over time, particularly around the
dot-com era. But the EBITDA margins of these companies—measured at the time
they crossed the $1 billion revenue threshold—have consistently increased over
the years.
These EBITDA trends—the drop for companies that crossed
$100 million in revenue and the increase for those with more than $1 billion in
revenue—suggest that profitability increases in importance as a company
matures. There are several possible “cause and effect” explanations for this
dynamic. On one hand, scale effects may make it easier for companies with $1
billion in revenue to achieve a higher EBITDA margin. On the other hand, it is
also possible that these companies place more emphasis on profitability as
their growth opportunities become more
limited.
Growth rates
influence profitability
To understand the trade-offs made between growth and
profitability, we divided the companies in our database in a different way. We
separated them into three groups based on the growth profile that they demonstrated
when they crossed the $100 million threshold: “supergrowers,” with greater than
50 percent compound annual growth rate (CAGR); “growers” (10 to 50 percent
CAGR); and “stallers” (less than 10 percent CAGR). This is the same
categorization used in our original 2014 analysis of
companies in the Grow fast or die slow database. We then determined the average
EBITDA margins and total returns to shareholders (TRS) of each profile at both
the $100 million and $1 billion revenue milestones.
Our analysis identified some themes in the strategies
that companies in each growth category are pursuing, as well as the underlying
market dynamics at play.
Supergrowers
Supergrowers report an annual CAGR of greater than 50
percent. Companies with $100 million in revenue have an average EBITDA margin
of 5 percent, compared with 24 percent for companies that have passed the $1
billion threshold. This group includes some of the most well-known software
businesses today, including Facebook, Google, and Microsoft.
Supergrowers at the $100 million revenue level are
primarily rewarded for their high growth rates. Investors typically focus on
how much market share these companies capture in pursuit of becoming “the
winner” in their space, often at the cost of profitability. If these companies
do indeed win their category, they will eventually resemble the supergrowers
with $1 billion in revenue, having both high margins and fast growth rates.
Growers
Companies in this group have an annual CAGR of 10 to 50
percent. Growers with $100 million in revenue have an average EBITDA margin of
11 percent, compared with 18 percent for companies that have passed the $1
billion threshold. Companies such as Monster, Sage, and Symantec were
classified as growers when they passed the $100 million revenue threshold in
the late 1980s and early 1990s.
As their name implies, growers are still achieving
healthy revenue growth. However, they may not be able to achieve the even
higher CAGRs seen with supergrowers. As these companies perceive that their
growth is reaching its limits, they begin to focus more on profitability. Since
the grower category has the highest average EBITDA margins of all groups for
companies at the $100 million revenue threshold, it is possible that these
companies are limiting their growth for the sake of showing profitability
earlier.
Growers that reach the $1 billion threshold have solid
margins, but they are still lower than those of supergrowers in the same
revenue category. Two external forces often limit their profitability:
·
These companies operate in markets where the
winner-takes-all dynamic is relatively weaker.
·
The upper limit of the total available market (TAM) is
relatively low for growers compared with supergrowers. As such, new entrants
and competition erode their margins to a greater extent.
External forces are not the only factors to affect
margin, however. Some growers might limit growth simply for the sake of showing
higher profitability. While this strategy may produce short-term benefits, the
few companies that reach the $1 billion revenue threshold risk losing the high
margins enjoyed by the highest-growth players that reach the $1 billion revenue
threshold.
Stallers
Stallers—those companies with revenue CAGRs under 10
percent—are in a difficult position. At the $100 million inflection point, they
are experiencing slow growth and have an average EBITDA margin of −5 percent.
Operating in the red, stallers do not have the option of trading profitability
for growth, and most of these software businesses never make it to the $1
billion threshold. Instead, they go out of business, get acquired, or linger in
the $100 million to $500 million revenue range.
The few stallers that do reach the $1 billion revenue
threshold have some competitive advantage that allows them to achieve
profitability while still growing slowly. However, these companies have an
average EBITDA margin of 14 percent, lower than that achieved by the growers or
supergrowers that reach the $1 billion revenue threshold.
Companies fall into
five categories based on growth and profitability
Our original 2014 analysis segmented companies into the
three categories described previously based on revenue growth rates:
supergrower, grower, and staller. After incorporating profitability as a new
dimension, we found that most software companies fall into one of five
categories based on their growth and profit profiles when they passed the $100
million revenue threshold.
Each category has several distinct characteristics with
respect to CAGR, EBITDA, and TRS. Not all profiles are created equal—some are
more desirable than others and lead to better TRS.
Sustainable
supergrowers
Companies with this profile are in the most enviable
position, combining supergrower status (more than 50 percent CAGR) with
healthy, sustainable margins of 3 percent or more—quite often much higher.
Unsurprisingly, the average TRS is the highest in this category (22 percent).
Many of today’s largest consumer Internet companies were classified as
supergrowers when they crossed the $100 million revenue threshold, including
Alibaba and Google.
Sustainable supergrowers are likely in a very stable
position but still not immune to outside competitive threats. They should focus
on solidifying their competitive advantage by increasing scale and reinforcing
network effects. For instance, they might be able to increase customer
retention through differentiating features that increase switching costs and
discourage multihoming (connecting to more than one network).
Supergrowers
at any cost
Companies in this category combine supergrower status
with bottom-quartile EBITDA margins (less than 3 percent and often negative).
They include players such as Digitas and eBay, both of which fit this profile
when they crossed the $100 million revenue threshold in the late 1990s.
This category can be a good place to be for a time,
despite the low profits. Consider, for instance, insurgent companies or new
players that want to compete in a white space where innovative products or
services are just emerging. Such players often want to capture as much market
share as possible to win the category. Many SaaS businesses have pursued this
route during their early days and growth stages, using venture financing to
fuel negative margins and high burn rates.
Companies that are supergrowers at any cost should
realize that this strategy works only for a finite time and may lead to lower
near-term shareholder returns. (The average TRS is −2 percent for this
category.) Once the growth rate slows and the companies have captured as much
TAM as possible, investors will want to see increasing margins. To prepare,
companies in this category should create a clear plan for shifting from growth
to profitability and be ready to execute it.
Sustainable
growers
As with supergrowers at any cost, this category can also
be a good place for a company to reside for a short time. While growth rates
are more tempered (10 to 50 percent CAGR), companies in this category have
sustainable margins (3 percent or more) and a healthy average TRS (9 percent).
Many of the original software businesses founded in the 1980s were classified
as sustainable growers when they crossed the $100 million threshold, including
Adobe, Autodesk, and Symantec.
Grow fast or die
slow
Software and online-services companies
can quickly become billion-dollar giants, but the recipe for sustained growth
remains elusive.
The healthy margins in this category can be a two-edged
sword, since they satisfy investors but also attract competitors. As
competition increases, sustainable growers will need to develop new strategies.
Some may invest in new areas for
growth, such as additional geographies, customer segments, or
adjacent markets—a strategy that could turn them into sustainable supergrowers.
Other companies might prefer playing a defensive game by protecting their
margins from insurgents. That strategy will slow their growth and turn them
into cash generators, which is our next category.
Cash
generators
Most companies do not begin as cash generators. Instead,
they fall into this category after making stops at one or more of the
supergrower or sustainable-grower categories just described. Companies that fit
this profile when they crossed the $100 million revenue threshold include
Activision, which merged with Vivendi Games to become Activision Blizzard;
Macromedia, which was acquired by Adobe; and Reynolds and Reynolds, which
provides vertical software for car dealerships.
For cash generators, growth has stalled, giving them a
CAGR under 10 percent. They have little white-space opportunity left, but their
margins remain very high because their business has achieved scale and has a
sustainable competitive advantage. Since the market has historically valued
growth above all for software companies over the past few decades, cash
generators have the lowest average TRS of any category (−6 percent).
Typically, cash generators are most likely to thrive if
they reinvest cash into the business to find new areas for growth, especially
if they take action while margins remain high. If these companies follow
inorganic strategies, using their cash for mergers and acquisitions,
they can gain access to new customers that can help fuel growth. They will also
see faster results from this strategy than from organic attempts to capture
additional market share.
Strugglers
Companies that have stalled growth and low margins are
fighting an uphill battle—and their average TRS of −4 percent reflects this. A
business can land in this category at any point, including relatively early in
its life cycle or after many successful years in the market. Strugglers often
succumb to unfavorable macroeconomic trends, increasingly competitive market
dynamics, or myriad other issues. Their best option for optimizing value
creation typically involves looking for a strategic buyer to provide them with
an exit option. If that is not possible, strugglers should create a clear and
focused strategy that will help them move into another category, provided that
they have the necessary execution capabilities.
Tips for jumping
categories
In the end, a company’s category depends on both
external factors, such as network effects and market dynamics, and internal
factors, such as product quality and ability to execute. But the category a
company resides in does not necessarily dictate its fate. Once leaders
understand where their business fits, they can develop strategies to improve
their position within a given category or to make a leap to a more desirable
one. Both approaches often involve focusing on a few critical operational levers
and making some calculated bets. Consider the approach to customer retention, for example. A
company that is a supergrower at any cost might choose to deemphasize churn
mitigation, at least temporarily, preferring to allocate more resources to
new-customer acquisition. A cash generator, by contrast, might decide to
dedicate more resources to customer success, with the goal of protecting the
existing base and exploring new cross-selling and upselling opportunities. Of
course, companies must reassess their selected approach if they shift from one
category to another.
With the rise of SaaS over the past decade, the “growth-at-all-cost”
strategy is often appropriate early in a company’s life cycle, especially in a
winner-takes-all market where a clear path to profitability involves capturing
share. But companies that pursue this strategy must eventually shift their
focus to profitability, since growth alone will get them only so far. The
secret to success is determining how and when they should make this trade-off.
By
Chandra Gnanasambandam, Allen Miller, and Kara Sprague 1017
https://www.mckinsey.com/industries/high-tech/our-insights/grow-fast-or-die-slow-the-role-of-profitability-in-sustainable-growth?cid=other-eml-alt-mip-mck-oth-1710
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