Managing growth and profitability in uncertain times

It’s no longer news that the global economy is facing persistent inflation, macroeconomic uncertainty, and looming concerns about a recession. Across all industries, we are hearing from CEOs, bankers, venture capital, and private equity clients that large and small enterprise customers are reducing costs to manage through the current environment. 

For technology and tech-enabled businesses and their financial sponsors (venture capitalists, growth-originated private equity, and lenders), growth rates are expected to decline, gross margins are under pressure and the path to profitability is shortening for most companies and investors.

At the same time, high growth-private and public companies which had a ‘growth premium’ prior to and through the pandemic have seen valuations fall to pre-pandemic levels. While there were a record number of IPOs and SPACs over the last 24 months, many experts expect to see a record-low number of public offerings over the next couple of years. 

One silver lining in the current environment is there was also a record amount of new capital, or ‘dry power’ raised by VCs and PEs through the pandemic and that capital will be deployed in new investments and follow-on financings in the next 12 to 24 months, albeit at much lower valuations. 

Another positive trend that appears to continue despite geopolitical, macroeconomic, and sector-specific valuation challenges is digital transformation and disruption. While the pandemic drove many surface-level shifts to ‘digital’, most of the large enterprise and SMB businesses are still early in their digital transition journey and disruptive technologies such as artificial intelligence and automation are far from mainstream.

Given these competing forces, how should CEOs, Founders, and their investors think about balancing investment in R&D, product, and sales and marketing to achieve a high growth rate with shorter paths to profitability? What will the new metrics be for creating equity value at exit and over what horizons?

Re-cast your growth thesis

Many tech companies, VCs and growth-oriented PE firms have been disproportionately focused on growth at all costs over the past several years and came to expect a ‘growth premium’ to be placed on their business, regardless of profitability. Our advice to clients and what we are hearing from investors is to revisit your growth forecast and prepare for longer sales cycles as customers reduce spending and defer non-discretionary projects.

Evaluate your cost structure

During high growth periods, tech companies are busy managing growth and delivering revenue with less focus on costs and profitability. With slowing growth, now is the time to optimize your cost structure and become more diligent in evaluating investment initiatives that have an unclear ROI.

Customer retention and attrition

When new sales and bookings are high, companies tend to explain gross attrition rates with positive net attrition results. Customer onboarding, engagement and customer success tend to suffer when the company is smashing new booking targets. Protecting the recurring revenue of existing customers should be the focus of the company and new bookings and sales should be managed against the ability to service existing customers. This is the downside risk protection the company and its investors will need to manage to ensure profitability growth.

Create a culture of profitable growth

It’s not usually easy for leaders to reset the culture during a transition to focus on profitable growth. This transition can be the most difficult for companies that added dozens or even hundreds of employees, managers, and executives during rapid growth. The rules, assumptions, decision making and even the MBOs (management by objectives) may need to be reset to drive fundamentally different behaviour. Not all team members can make this shift, especially if their careers have only seen high growth and high spending environments that always led to an ‘up round’ in valuation. 

Improve your competitive positioning and value proposition

When the market you are in is growing at double digits and all your competitors are in high growth mode, everyone is winning their fair share. Fighting for tighter budgets, proving your solution is mission-critical, and managing through longer sales cycles can kill growth forecasts and throw off profitability targets. Digging into your customer data, deepening your competitive insights, and improving the effectiveness of your sales and marketing efforts are critical when you are trying to secure reduced budgets from your customers. 

Managing your cost of capital, structure, and liquidity

The cost of capital has increased with higher interest rates that are likely to last through the next 12 to 18 months. Equity is also much more expensive as valuations have fallen. You may need to consider divesting a non-core product or line of business to reduce debt or free up cash for other investments. The shareholder base that had a high growth thesis may want liquidity and the company may want to recapitalize with a growth-oriented private equity firm to provide liquidity to existing shareholders and find a new growth partner to help execute on a path to profitable growth. Despite the current environment, exiting to a strategic buyer who can help the company achieve revenue and cost synergies may be the best alternative for the company. 

What you should know

Considering all these factors, we know a couple of things to be true in the Canadian technology industry: We know that some of the best companies and the highest equity value have been created in the most difficult economic cycles. We also know we have a culture of incredible entrepreneurs and investors with a track record of being capital-efficient and prospering through the most challenging situations. My bet is the next stage of growth in our industry is going to be equally as exciting as the last few cycles.