Strategic Crossroads: Balancing Profitability and Accelerated Growth
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This article explores two growth scenarios for a new venture, analyzing their strategic and financial implications. The first scenario favors self-financed growth with quick profitability, while the second opts for accelerated growth at the expense of later profitability. A detailed financial model sheds light on their respective outcomes. The choice between these two scenarios depends on your goals, risk tolerance, as well as considerations regarding funding, dilution, and the envisaged exit timeline. Ultimately, this essay encourages reflection on the pace and modalities of your company’s development.
E. Krieger
If you want to develop your business through pure self-financing, profitability is almost a necessity from the first year of activity.
However, if your goal is to maximize the financial value of your company and your own shares, the pursuit of quick profitability is not essential. It may even prove counterproductive. The challenge will be to grow rapidly to become an acquisition target for a large group. The latter will then leverage technical and/or commercial synergies or try to prevent your startup from becoming even more dangerous by falling under the control of a competitor.
To illustrate these two scenarios of growth and profitability, nothing beats an arboricultural metaphor and a bit of financial modeling against the backdrop of a DCF model based on a company’s discounted cash flows.
The chosen example corresponds to an SME (« Quercus » scenario, the oak tree genre, with slow growth) or a startup (« Populus » scenario, the poplar tree genre, with faster growth) at a crossroads, having reached a turnover of €700k, which is the median revenue from which startups are able to raise seed funding. According to the investment bank Avolta (2022 data), these fundraising rounds occur 3 years after the creation of a startup, which has successfully exceeded €50k in monthly billings from the third year onwards.
Scenario #1 « Quercus »: self-financed growth
In a self-financed growth scenario, with an annual sales growth of +20% and an EBITDA rate of +20%, our SME would achieve €4.3 million in turnover and €0.8 million in operating profit ten years later.
Assuming investments (Capex) amounting to 4% of turnover, amortized over 3 years, and an effective corporate tax rate of 25%, we can calculate the operating profit and annual taxes. By estimating the working capital requirement (WCR) at 15% of turnover, we can calculate the available cash flows each year, these flows being both reduced by taxes and the variation in WCR. By discounting these flows at a rate of 25%, in line with the expectations of many venture capital investors, we can calculate the present value of the various cash flows available over a period of ten years. This discount rate is also called the weighted average cost of capital (WACC), which has the effect of shrinking future cash flows, especially when this rate is high and when the free cash flows are distant.
Finally, assuming an « infinite » growth rate of 2.1% per year, we can add to the present value of the cash flows from the first ten years a « discounted terminal value, » resulting in a company valuation of €700k, assuming the company has neither cash nor debt at the time of the evaluation.
This valuation exactly corresponds to the current turnover of our company: the SME « Quercus » would thus be valued at 1 year of turnover at time « t ». This is highly favorable compared to most SMEs but not truly in line with the « startup logic, » which assumes much faster growth for a planned exit in shorter timeframes than for a company developing more moderately and purely through self-financing.
Scenario #2 « Populus »: hyper-growth objective
In an accelerated growth scenario, let’s now assume an annual sales growth of +60% for the first 5 years with a negative gross operating surplus (EBITDA) rate of -20% due to significant commercial investments. From the 6th year onwards, our company would, however, become highly profitable, with an EBITDA of +40% and an annual sales growth still sustained but now at +30%. Ten years later, the startup « Populus » would achieve €27.3 million in turnover and a very comfortable operating profit of €10.3 million.
Maintaining the same assumptions for investments (Capex), corporate tax, WCR, discount rate, and infinite growth rate, we now arrive at a company valuation of €3.8 million. The valuation resulting from this scenario is more than 5 times the current turnover of our company, which is much higher than the previous scenario.
With a discount rate of 15%, the valuation difference would even be a factor of 10 between the two scenarios…
From creation to exit: years apart depending on the chosen strategy
These two archetypal scenarios shed light on the financial specificities of each development mode.
Referring to the median revenue threshold of €9.3 million from which startups are sold (source Avolta 2022, mentioning a median sale of €38 million based on a median multiple of revenue of 4.1), our « Quercus » SME would only reach this revenue level in 14 years with €9 million in revenue. This timeframe is reduced to 6 years in the second scenario, with €9.5 million in revenue for the « Populus » startup. Remembering that each of the companies is already 3 years old in our model calibrated to the revenue level and the median time required to raise seed funding, our « Populus » startup would be 9 years old at the exit… and 17 years for our « Quercus » SME. Almost twice as long!
These 9 years precisely correspond to the median exit time for startups analyzed by the Avolta barometer (2023 data) when funded by venture capital. And « bootstrapped » companies, not having sought venture capital, are only sold when they are a median of 15 years old, which is close to the 17 years in our model and, in any case, much longer than when a company welcomes investors whose business model is essentially based on achieving capital gains as « quickly » as possible.
Implications in terms of financing and founders’ shares
In terms of cash production or consumption, the differences between the two scenarios are also enlightening:
- Our « Quercus » SME is profitable from day one and generates €0.6 million in positive cash flows over the first 5 years, which would even allow it to distribute dividends during this period.
- Our « Populus » startup, on the other hand, consumes €5.2 million in cash over the same period, which must necessarily be offset by financial flows. These flows will primarily be equity injected by investors, although our startup may also resort to non-dilutive financing such as repayable advances or tax credits related to research or innovation operations.
In the first case, the founders of our « Quercus » SME will not need to appeal to external investors. In the second case, the founders of the « Populus » startup will likely seek two rounds of seed and venture capital financing, or even a « Series B » if faster acceleration is needed.
If we align with Avolta 2022 data, the cumulative fundraising for seed and Series A rounds amounts to €4.2 million for a median dilution of 29%, then 28%, bringing the founders’ share to 100% x 0.71 x 0.72, resulting in 51% at the end of these two funding rounds where investors will hold 49% of the startup.
Recall that according to the Avolta 2022 study, the median resale value of a venture capital-funded startup is €38 million, based on a revenue multiple of 4.1. In the absence of specific « preferential liquidation » clauses, the founders of our « Populus » startup would pocket 51% of revenue of €9.5 million multiplied by 4.1, i.e., €20 million.
When a company is not funded by venture capital, the median sale amount is €21.6 million, based on a revenue multiple of 1.7 corresponding to less recurrent and less valued revenues than for a startup. The founders of our « Quercus » SME would then pocket 100% of revenue of €9 million multiplied by 1.7, i.e., €15.3 million. This capital gain is not only lower than what the founders of our startup would receive but will be cashed in significantly later than for the shareholders of the startup dedicated to hyper-growth.
In the case of venture capital funding, the pressure from investors will clearly be greater than that which the founders of our « Quercus » SME will put on themselves to move forward. Governance and managerial pressure considerations are also to be taken into account because everything must move faster in startup mode compared to a traditional SME.
Which scenario to choose?
The choice between the two scenarios depends on your personal equation, beyond what a tool like Excel can model.
It also depends on your ability to break free from median values to develop at a faster pace and create even higher financial value, with or without venture capital. In this case, exit gains can be much higher than the amounts indicated, but it is important not to forget that these median data correspond to the archetype of successful companies. 50% of new businesses do not survive beyond 5 years, and this failure rate is even higher for startups, where less than 10% reach the stage of Series B (source Avolta), a figure to be compared with the 90% failure rate generally observed in the startup ecosystem.
Rather than an arboricultural metaphor, we could have used the image of a bobsleigh for startups, where the winners take the prize largely thanks to the highest possible initial speed and a lot of skill in negotiating the numerous turns. Our SME, on the other hand, might have taken a detour through ancient Greece to be compared to Ulysses, whose odyssey lasted 20 years.
From the bobsleigh championship to Penelope’s perseverance awaiting Ulysses’ return: it’s up to you to choose the story in which you will be the hero. Regardless of their code names, these two scenarios aim to make you reflect on the pace and modalities of your company’s development.
Etienne Krieger
PS: For tree and garden enthusiasts, here are some details to justify our arboricultural metaphor:
- Oaks, trees of the Quercus genus, can take several years or even decades to reach a significant size. Their annual growth is estimated at about 30 to 60 centimeters under optimal conditions, and many subjects surpass 200 years.
- Poplars, trees of the Populus genus, can grow about 1.5 to 3 meters per year, five to ten times faster than oaks… but their longevity is generally shorter, around 50 years. Rapid growth can have disadvantages, such as increased fragility, shorter lifespan, or even problematic environmental consequences. Before planting fast-growing trees, it is better to consider all factors and choose species adapted to your region and needs. In short, everything is needed to make a remarkable forest or garden. Consulting a landscape architect will allow you to create the plant universe that suits you. In the same spirit, a financial expert and/or members of your strategic committee will help you make the right development choices for your company.
