At Marlin & Associates, we focus on advising CEOs, boards and owners looking to buy, sell, or raise capital for exciting mid-market companies that provide software, data and related services. We’ve been at it for more than 14 years now and we particularly enjoy working with business owners who have built sustainable companies that offer differentiated solutions, to large markets, and have a track record of growth.
Over the past few years, we’ve observed many companies that profess a “grow at any cost” mentality. This approach has been successful for a number of category killers that dominated their respective markets and, in fact, managed to sustain huge annual growth rates. It has led to some tremendous exit values via IPO or m&a (and plenty of tremendous paper valuations).
We tell companies that are growing their top lines at huge rates and have equally large market opportunities hit the gas pedal hard. If they don’t have backers to fund huge growth, we’ll help them find investors who will. At the same time, we’ve recently been telling more modestly growing companies that they are free to keep investing everything they generate back into the business for growth, provided they have backers willing to fund them in perpetuity. But, if these companies are contemplating an exit anytime soon, or have any fear of losing that backing in an economic downturn, we suggest that they start paying close attention to a metric we call “incremental margin”. It’s all about how much of their incremental revenue they are actually bringing down to the bottom line and to cash flow.
It surprises some clients that we are now focusing as much on incremental margin as we are on top-line growth. To be clear, we’re not against growth. High revenue growth rates drive higher valuations. But we’re increasingly seeing that, except in cases of companies with massive top line growth, most acquirers and investors are also looking hard at sustainability. And for many of them – measuring incremental margin is a key sustainability metric.
Some of this thinking may be driven by recognition that the current bull market began in 2009 and is now 7 years old (the average bull market lasts 5 to 6 years). We’re not calling for an economic downturn anytime soon – there have been several bull markets lasting close to 10 years – and this market has plenty signs of strength. But, while we’re not economists, most of us know that no market stays strong forever. Most buyers and investors also remember what happened with the last downturn: revenue flattened (or declined); credit markets tightened and lenders became risk averse; and PE & VC firms only funded only their strongest portfolio companies. Many CEOs belatedly realized that their business models were not sustainable without outside capital – and that became tough to find.
The current economic cycle is still strong – interest rates are low, consumer confidence is high, and financial investors and corporations are flush with cash. We’ve been busy advising companies with differentiated solutions, large market potential, solid top line growth, and strong incremental margins. Nevertheless, beginning in the second half of 2015, we began to notice waning interest in outsized valuations for companies that were burning lots of cash without a clear path to near-term positive cash flow. There seems to be a renewed focus on sustainability. We believe this a good thing.
Cash flow is again king.