Do you really know how your business should be performing?

Setting the stage for the Building Back to the 'Rule of 40' CEO Working Breakfast on 2nd July

Talking to CEOs of companies in the Megabuyte universe, I am often struck by how few have a really clear idea of what good looks like when it comes to financial performance. By that I mean they obviously know that more growth and profit is better, but they don’t have a clear target for their own business. And even for those that do have a target – with the ‘Rule of 40’ being an exemplar in this regard; the notion that organic growth and operating margins should sum to at least 40 - many do not have a detailed plan about how to achieve it.

In my view it is critical for any business to have a target business model and for boards to have a crystal-clear view on what good looks like for their financial performance.  I also have a clear view on how I think they can go about developing that model. And I make a clear distinction here between understanding what is going on in your business with good data – which most well-run businesses are likely to have – and knowing what it should look like.

We will be examining the ‘should’ element at the second event in our new Megabuyte CEO Working Breakfast series on 2nd July. Informed by three companies who are consistently delivering to the ‘Rule of 40’, Wireless Logic Ltd , Matrix and Bridewell , and Megabuyte analysis, we will aim to deliver genuinely actionable insights for CEOs on key questions including how to go about developing a target business model, how financial performance correlates with valuation, and the optimal balance between growth and margin.

Tech companies that are Megabuyte subscribers have access to this event as part of their subscription. We will also have a number of limited spaces for by-invitation CEO guests so if you are interested in joining us please drop me a line.

The importance of a target business model

So, why is it so important for boards to work to a target business model? I think there are two key reasons.

The first is that it provides essential context to key decisions in the business. For example, if your business is not growing as fast as the market then this could be because of some issue with your product or service, your pricing, or you go-to-market execution. But unless you know what the market growth rate is, and therefore that you are not growing as fast as the market, then how can you know there is a problem?

The second reason is that we unequivocally know from our extensive research over the years that there is a clear correlation between Rule of 40 performance and valuation. While investors favour growth over margins, or vice versa at different points in the cycle, they almost always apply a higher valuation to those that achieve the best Rule of 40 score.

Balancing the target business model equation

The question then is to ask how to develop a target business model. When you think about it, the Rule of 40 itself only gives us one side of the equation - namely what does good look like for financial performance? The other side of the equation is how to achieve it. To my mind, there are two key questions that go hand-in-hand with a conversation about Rule of 40. The first is, ‘What is a sustainable growth rate for your business?’ and the second is. ‘What level of investment do you need to deliver that growth rate?’.

For me, a board has to answer these questions sequentially.

The art of the achievable…

On the question of what level of sustainable growth is achievable, I think there are a couple of ways of looking at this:

If your company operates in a fairly-definable and stable market, you should be able to develop an informed view of market growth and then some assumptions about your company’s growth relative to that. Questions on the latter point might include, ‘Do you have a particular competitive advantage that should give you a reasonable expectation of growing faster than the market?’

The alternative, if you are not operating in such a definable market (but assuming that you have already established product-market-fit), is to take the bottom-up approach based on your progression in the target addressable market. In this scenario, you will still need an informed view of the addressable market and then there will be some test and adjust on go-to-market investments to generate a given level of growth.

…and what it might (or should) cost

Having understood your achievable growth, the next step is to understand what cost levels you require in each part of the business in order to achieve this level of growth. I’m assuming here that you already have your internal data in the right shape to answer these questions; it’s amazing how many companies simply add the numbers up in the way they always have!

Then the next job is to assign target percentages against each element of the cost base with the greatest level of granularity you can, but stopping short of spurious accuracy. Your source of data for this should be a relevant peer group of companies. Not necessarily competitors, but companies of a similar size and business model. In some ways, this is the trickiest aspect of the process because getting accurate peer group data at a decent level of granularity can be difficult. You can lean on third party organisations such as Megabuyte, ask your private equity investor (if you have one) to aggregate any data they have from current and past portfolio companies or use your network to ask other CEOs what works for them.

To be clear, I’m not saying that this process will provide you with an entirely empirical view of what good looks like that you can rely on in perpetuity. Running a scale-up business myself, I understand that this kind of analysis always comes with some pretty heroic assumptions. That is the nature of these things. But that shouldn’t stop you doing it and then adjusting it as your business grows and market information changes.

I am confident that having an agreed target will help you to drive a stronger financial performance from your business and, in turn, unlock greater shareholder value not only from stronger financial returns, but also from a higher valuation.

If you are searching for granular, reliable data that can support you in refining your business model, we can help. As at today, the Megabuyte team is meticulously tracking the financial performance of some 1,800 UK-headquartered Software and ICT Services companies that publish full accounts.  How do we do that?  We curate publicly available data from Companies House and supplement it with direct board insights, to build a detailed, proprietary view of individual companies’ financial health. If you would like to evaluate our data quality against your own, please get in touch.

Email lauren.robinson-stanley@megabuyte.com to register your interest in attending Megabuyte's CEO Working Breakfast Building Back to the 'Rule of 40' on 2 July 2024 at Charlotte Street Hotel, W1T 1RJ