Many entrepreneurs place much more emphasis on grow than on profitability. That is unfair.

Growth is the holy grail for many entrepreneurs in technology companies. Logically. Growth is important to stay ahead of the competition, to build market share and most importantly to increase sales. Good growth figures and, above all, clear growth prospects also encourage a high valuation of a company. Growth leads to more income, and more income means more money for a potential buyer to quickly pay back the investment.

At least… when a profit is made! A buyer finances a business takeover with debt or equity, or a combination of both. Turnover alone is not enough to recoup the invested capital. The turnover must be profitable – because it is with the profit that the investment is ultimately paid back.

The center of the negotiations

At a sales process the degree of profitability is at the top of both buyer's and seller's notes. In fact, profitability is right at the center of negotiations – because a company's asking price is generally expressed as a multiple – multiple – of the profit. 

Jan wants twenty times the profit for his company, you hear you say. Profit usually refers to the so-called EBITDA: earnings before interest, tax, depreciation and amortization. It concerns the 'pure' profit, not taking into account interest, taxes and one-off items. Incidentally, there are also negotiations in which other multiples (for example x times the turnover) are central – but I will omit them here.

Different win percentages

What kind of win rate is a buyer usually looking for? Or in other words also, how high should the profit be for a top appreciation at a sale? That is different. PC hardware manufacturing companies usually have wafer-thin margins – but high volumes. Cost control is essential there. 

What you see more often (certainly in the Netherlands) are IT service companies and software companies, nowadays mostly software as a service (SaaS) providers. Benchmark in the M&A for such companies is an EBITDA margin of 20 percent or higher. 

If the margin is lower, then something is not right, or a lower or even negative margin has been deliberately chosen. The mirror image applies to a potential buyer: for him there are acceptable and less acceptable reasons for a low margin.

High fixed costs

First the negative version. Bad signal to a potential buyer is if a low margin is caused by high fixed costs. If a company has thirty employees and five of them are not productive, this is reflected in a structurally low profitability. It is better to give those five a one-off high severance payment than to drag them along with the company for a long time. 

Other common culprits are a too spacious and expensive office, or too expensive applications. If you are comfortable with an off-the-shelf accounting package, you should not opt for an expensive and complex SAP integration. As an entrepreneur, always take a critical look at your ability to be profitable. And if you're not, wonder why, No Monkey Business uses as a rule.

Temporary costs

Then the other side of the coin. The profit can also be (temporarily) lower because you are spending a lot of money to bring in customers. Marketing and sales costs put an acceptable pressure on profits, provided, of course, there are clear revenue streams. 

Suppose your company sells software subscriptions. You spend 600,000 euros in a year on marketing and sales, or 50,000 euros per month. A subscription to your product costs 12,000 euros per year, or 2,000 euros per month. Then you have to sell a lot of subscriptions in a B2B environment to be able to bear the monthly marketing costs. 

But that's not the way to look at it. If your customers stay with you for many years (in jargon if you have a low churn have), for example of 10 percent, then a contract will run for seven to eight years. That 12,000 euros is actually worth 84,000 to 96,000 euros. Seven or eight subscriptions would be enough to recoup the marketing costs! 

Growth always important

The moment (many) SaaS companies stop marketing and sales activities, you see that profitability increases enormously. Please note: that does not mean that it is a good idea to focus on marketing and sales with a sales transaction in mind on hold to put. The buyer also prefers to see a lot of growth. It is better to clarify why profitability is low in the growth phase. In jargon, you normalize that low profitability in the future projections.

For example, it can happen that a too high ebitda actually leads to your company growing too slowly – while with a low EBITDA you still manage to receive a very high valuation for your company. And also: if turnover does not grow and you also have high costs and low profitability, then a high valuation is almost unthinkable.

Tip: click on this infographic and print it out.

Attractive valuation

Finally, how do you achieve an attractive valuation for your company based on profitability?

Step one: take the accounting for the past three years, and calculate the average EBITDA margin. A potential buyer wants these numbers anyway, even if growth prospects are more important.

Step two: determine the options for increasing the EBITDA margin without the measures hampering growth. This is partly a out of the box process, although there are fixed elements. 

  • For example, do you still need such a large office, now that hybrid working is here to stay for many companies?
  • What are the general and administrative costs (G&A or general and administrative, in slang)? Is it necessary to have three people on administration and several secretaries? Is it logical for the accountant to visit a team several times a year?
  • What software do you use – and how much does it cost?
  • How productive are all teams – and what is the billable rate of your people. If that's 40 percent, that's too little. At many companies you see that substantive employees do everything to keep customers happy (rightly so), but that many extra hours are not passed on. That is unfair.

Step three is to make a thorough analysis of the tackling points and work out solutions. 

Step four is implementation. If the previous steps have been taken professionally, not only will the costs be reduced, but additional sales will also reduce the cost revenue have risen. Both contribute to higher EBITDA margin.

No Monkey Business presents a series of 16: the NMB Value increase Top-16.