Economic Model Part 7: Everyone Loves an Economic Engine
This is the seventh in a series of posts that I am writing aimed at helping entrepreneurs maximize their economic performance. You can find a summary of the economic model series here. My last post described the characteristics of attractive economic models. This post describes how everyone loves a great economic engine, but how it is difficult for many people to clearly understand the economic engines in growth companies.
Everyone Loves an Economic Engine…
Everyone loves seeing an economic engine in a business. An economic engine allows companies to:
- Grow quickly while not consuming much capital and, as they scale and mature,
- Throw off a lot of cash and grow that cash flow over time and
- Withstand the effects of market shifts and economic downturns.
Investors love a great economic engine because they have the confidence that they will get a solid return on their investment. Managers love a great economic engine because they can pay themselves well, invest in growth initiatives, and they don’t need to spend time raising capital or convincing investors that the business is worthwhile. Employees love great economic engines because it makes them feel like their job is safe and that they are part of a good company.
There are two operating points for economic engines that create the highest perceived value for a business: the high growth economic engine and the high cash flow economic engine. The high growth engine has high growth and high gross margins, but may not have a good bottom line. Everyone looks past the bottom line and loves the growth. Accelerating growth is even better! (accelerating growth is revenue growth rates that are higher this quarter than they were last quarter) The high cash flow economic engine produces great free cash flow. As long as there is a minimal stable growth rate, everyone loves seeing the cash flow. Every once in a while, a company has high growth and high cash flow. These companies have the best perceived value, particularly when they have a perceived competitive advantage.
Build an economic engine and everyone will love your business and also love you for building it!
…But Many Economic Engines are Difficult to See…
There may be a problem, however, if investors, managers, employees and customers can’t see a company’s economic engine.
The Simplest Economic Engines to See
Almost anyone can see a great economic engine as a company matures and the growth slows down to a point where the economic engine is expressed as net income and cash flow. What they see is a cash flow statement that has free cash flow that increases over time. Cash flow growth is relatively easy to see in financial statements and because most investors can see it, there are many investors that consider purchasing stock in the company. Because more potential employees can see it, more people want to work at the company. Because more potential customers and partners can see it, more customers and partners will want to work with the company.
More Difficult Economic Engines to See
Economic engines of expansion stage companies are more difficult to see and it takes a more specialized investor to see them. These investors look for high-revenue growth with very little capital consumption relative to the revenue growth and they also look for solid gross margins (revenue less the costs to serve customers). They love high-growth companies with high gross margins with the idea that as the company’s growth slows the company will create positive and growing cash flows. While not everyone can appreciate these economic engines, expansion stage investors (like our firm OpenView Venture Partners), growth-oriented employees, and more innovative potential customers spend the time to really understand the economic engines of these growth companies and they love the companies that have great growth and great gross margins that don’t consume much capital.
The Most Difficult Economic Engines to See
There are some growth stage companies that have some specific issues that make it much more difficult to see the economic engine and create risks to the ultimate value of the economic engine. Fewer people can understand these models without some assistance. For example:
- Many growth companies spend so much time growing their companies that they have not tuned their economic engines. Once they tune their companies for economic results, their economic engines will be better.
- Some companies perform a lot of people-intensive work for their customers that results in lower gross margins. Their plan might be to streamline and/or automate (a.k.a., productize) the manual work over time or to shift their customer mix over time to customers that are less demanding of people-intensive work, thereby increasing their gross margins over time.
- Some companies will have gross margin expansion over time due to economies of scale (for example, they have more purchasing power if they buy in larger quantities).
- Some companies anticipate their target market demand shifting, becoming more dominant in their target market, and/or having more great customer references that will make future customer acquisition less costly and capital consumption relative to growth more favorable.
- Larger companies have multiple economic engines that contribute to the company’s economic results. When these results are blended in a financial statement, it is difficult to understand the power of any individual economic engine.
- Many public companies purposefully disguise their economic engines in their financial results because they don’t want the information to become public for one reason or another (for example, so that their competitors can’t see their great economic engine for a particular business unit or geography or so that their investors can’t see how poor their economic engine really is).
You Can Help People See Your Economic Engine
Assuming that you are not a public company that wants to disguise your economic engine, you can help investors, managers, and employees see your economic engine by separating out its components so that everyone has complete clarity about how your engine works, what parts of the engine you are working on, what you anticipate your results will be, and why you have a reasonable probability of achieving those results.
You should also describe how you are aiming for the high growth economic engine or the high cash flow economic engine. It will help to get people enthusiastic about what you are building and also help them to focus on the work necessary to achieve the results that you are anticipating.
Everyone loves an economic engine, but you may need to help them see yours!
My next post is on the “Who Makes a Great Spreadsheet Model”
If you want to learn more about economic models, keep reading. I would also appreciate any comments or suggestions that you have, as I plan on turning this series into an e-book and I want to make sure that it is as clear and complete as possible.