A New Imperative for Tech Companies: Balance Growth with Profitability

The software industry has been very successful in the past decade. The industry benefited from secular demand, but there was also plenty of easy money flooding the market and investors looked for high-growth companies. Profitability? That could wait. Companies that didn’t show a profit could still obtain high valuations and attract investor dollars. Rising markets and soaring share prices kept investors, founders and company management happy. Now the era of focusing only on revenue and growth is over for tech companies. High growth can no longer be used as a mask for zero or low profitability.

Fortunately, the positive demand drivers in the software market from the past 20 years still exist today. Demand isn’t the obstacle to showing profitability. But the easy-money era is gone, which is creating a shift in the market. A growth-now, profitability-later mindset won’t work anymore. To be successful, tech companies need to take a more balanced approach to both growth and profitability. 

The Main Drivers Fueling the Growth-oriented Tech Market

The changes forcing technology companies to shift away from prioritizing growth at the expense of profitability aren’t because of a soft market. Secular demand, driven by increasing digitization for technology products and services, persists despite today’s lack of easy money.

From the beginning of the digital era, the demand for technology-fueled advantages and convenience has been a driving feature for businesses and personal consumers, and tech intensity and spending are expanding for both as well.

Innovations around cloud computing sparked a new technology paradigm. Cloud-based services spurred even broader demand by democratizing access to the most advanced technologies. Like pioneers racing to stake their claim in a land grab, tech companies raced to gain prominent market share positions in the world of cloud computing, prioritizing growth over profitability. Furthermore, money supply has been abundant to fund tech companies, which fueled high valuation and incentivized businesses to focus on growth.

COVID-19 continues to impact the tech market. Even though the crisis phase of the pandemic has passed, people still spend more time at home for work and their personal lives. This new reality creates an ongoing need for more and better online services for both business and consumers who require a growing infrastructure that can keep up with the demand. 

Demand Remains, but the Easy Money is Gone

The money supply is tightening as rising inflation leads to higher interest rates, which affects valuation. The negative impact of higher interest rates disproportionately affects the value of growth-focused businesses, compared with those that can show current profit. The value of growth businesses depends on future growth and profit prospects, which are now discounted at a higher rate.

Consequently, growth companies are having a harder time attracting investment. In an email to employees, Uber CEO Dara Khosrowshahi wrote that the “hurdle rate for our investments has gotten higher” and that the company’s “investors look for safety. They recognize that we are the scaled leader in our categories, but they don’t know how much that’s worth.” In other words, Uber’s investors want to see cash profit. In the email, Khosrowshahi clearly stated the company was shifting its priority to profitable growth.

Although the secular demand for technology products and services persists, tech companies should brace for near-term tightening. Higher interest rates and recession concerns might hurt short-term demand. Technology buyers may start postponing spending on discretionary technology; however, spending on essential technology products may not suffer the same impact. 

Tech Companies Must Balance Growth with Profitability

Companies can no longer be successful with a growth-only or growth-first mindset. They need to show profitability, even at the expense of some growth. Investors and shareholders are changing their preference from growth to growth with profitability, putting the pressure on companies to make changes to improve their profit margin.

With outside investments harder to come by, companies will be forced to increase and conserve the cash they have on hand. Furthermore, as tech valuations melt down, stock-based compensation might become less attractive to employees. Coupled with wage inflation, companies will be under significant pressure to increase cash compensation. Businesses need to focus on profitability to meet the expectations of shareholders and withstand the potential upward pressure on expenses. 

Best Practices to Drive Growth and Profitability

Historically, there is a trade-off between growth and profitability. The foundation to achieve that balance is to offer a high-quality product with a clear competitive advantage that translates into strong returns. This is not always easy. To achieve the right balance between profitability and growth, companies must focus on:

• Pricing discipline. Discounts, bundles and freebies place too much emphasis on growth and ignore profitability. It is more prudent for companies to develop pricing discipline to balance growth with profitability.
• Market priorities. Businesses may need to prioritize offerings for markets with size and potential or markets where the company has significant differentiation. Chasing small niche markets with undifferentiated products is not always economical. Instead, businesses should concentrate on markets that either have customers with high lifetime value (LTV) or show potential for higher LTV through increased retention and upsell opportunities.
• Efficient research and development (R&D). It is important for management to focus on developing products and markets that can deliver scale, efficiency and profitability. Now is not the time for moonshots. Instead of expanding product portfolios and features to appeal to the broadest market, companies need to develop their core products and focus their product road map on features and new products showing high likelihood of becoming profitable quickly. In this new world, a deep moat may serve the business better than a wide one.
• Organizational efficiency. Throughout the entire organization, it is essential for management to seek economies and operational efficiency that control costs and direct spending where it can generate the highest return.

The bottom line: Rationalization of the product offerings, sales organization and R&D can drive more effective solutions and more efficient organizations, resulting in better margins. 

Impact of Personnel Costs on Achieving Profitability

Labor is the highest cost line item for any tech company. The cash cost for employees may expand as stock-based compensation becomes a less attractive form of employee compensation. In addition, higher inflation already started a wage inflation spiral in the tech sector, especially as some IT salaries haven’t kept pace with inflation and the labor market remains tight. Companies must plan for growing labor budgets.

Achieving sales efficiency is one area where tech companies can find opportunities to reduce their labor costs. The growth-first approach leads to a sales-at-all-cost approach. Trying to capture every possible dollar in revenue without considering the acquisition costs may lead to disproportionately large sales teams and long-term inefficiencies in the business. Companies deciding to dial back the growth imperative to show current profit should instead look to build an efficient sales model – one that factors costs and potential returns of sales staffing or initiatives in the decision-making process.

Within sales and throughout the entire organization, it is important for tech companies to create a cost-efficient workforce and align staff with efforts that can show a favorable impact on the company. 

Finding the Path to Profitability

Reducing costs overnight is difficult. Getting rid of too many (or the wrong) people risks slowing company growth to a degree that inhibits profitability. However, the software industry may need to change its business model from one focused on driving revenue growth to one that achieves a balance between growth and profitability.

Tech companies unable to find a demonstrable path to profitability will find themselves trapped in an unsustainable growth-only model. The solution for tech companies not yet showing a stable stream of current and ongoing profits is simple, but not easy. Growth-first companies need to make fundamental changes in how they operate.