Gear up your business (at the right time)

[Two posts in one day.  When it rains, it pours.  If you are bored, check out today's earlier post here]

One thing we as venture investors focus on, both at a theoretical level when we are making new investments and at at practical level when we as board members are helping our (particularly later stage) companies think through growth and investment strategies, is the concept of operating leverage.  Operating leverage, or as it is sometimes called, marginal profitability or gearing, is, at a simple level, the percent of incremental revenue dollars that flow to the bottom line.  This is important because most investors, especially public equity investors, and acquirers value companies based on earnings growth and a company with higher operating leverage will over time be more highly valued than a company with similar top line growth but lower operating leverage.

At a theoretical level, operating leverage is a sign of the health of your business model.  To the extent you make expensive widgets with limited ability to premium price, less will fall to the bottom line.  If you can sell the same high value, low cost product over and over again, more will flow.  If you have real network effects at work in terms of customer acquisition, sales and marketing costs as a percent of revenue will decrease.  If your R&D team can stay the same size, while revenues increase significantly, you will have high operating leverage.  Most venture investors are attracted to models with high leverage as it allows company to grow profitably very quickly, thus decreasing capital intensity (unless there are high capital expenses or financing costs, which i have ignored for purposes of simplicity).  As a result, as an entrepreneur thinking through your long term business model and the points of leverage becomes an important strategic planning exercise.

To bring this to life with some examples, I looked at Apple – the current gold standard among tech stocks -  and compared the P&L for Q1 2011 to Q1 2010.  In this time period, revenues grew 83%, or $11.2B, while operating earnings grew 98%, or $3.9B (taxes and below the line items have also been excluded for simplicity and comparison across companies).  This means that for every incremental dollar of revenue, 35% fell to the bottom line [$3.9/$11.2].  Pretty impressive.  I also looked at results for some recent IPOs and found that Zillow had operating leverage of 38%, Financial Engines 31%, Zynga 17% and Linkedin 9%.  The all time high I found in a quick scan through public filings was Microsoft, which in 1997 dropped an astounding 67% of their revenue growth to the bottom line.  Not surprisingly, other high fliers with fabulous business models have seen significant operating leverage in their business such as Google, which in 2006 dropped 47% of each revenue dollar to the bottom line, and eBay which had marginal profitability of 56% in 2002.

Apart from working to improve the fundamental attractiveness of your company's business model, as you grow one of the tradeoffs that a CEO (and their Board) of a high growth company faces is how to balance the trade off between investing for growth and showing leverage.  Some the examples above show the these trade-offs.  Linkedin, which actually showed 27% marginal profitability in 2010 versus 2009, is obviously now investing pretty significantly for growth.  Microsoft, on the other hand, may have under invested in 1997 when many competitors were emerging around them.  Conversely, if Linked in continues to invest heavily forever and only drop 9% of each incremental revenue dollar to the bottom line, and if they were to trade at Google's current 14x EBITDA multiple, they would need to grow their revenues a staggering 32 times to $7.7B from the 2010 level of $243M to merely meet their current value of $9.6B.   Zillow, on the other hand, at the same multiples, would only need to grow 6 times from their 2010 revenues to justify their current valuation given they have vastly higher marginal profitability.

So as your business moves out of survival mode and into significant growth mode, managing these tradeoffs should be a regular part of the conversations you have with your team and Board.


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