When Profit Is the Enemy of Value

Becoming profitable is a huge achievement for any business, so I know what I'm about to write is going to sound like a contradiction in terms: Sometimes what makes your company more profitable also makes it less valuable.

Don't believe me? Let me tell you a quick story.

Every week, I used to have my controller prepare a set of financial reports for my consulting firm. I had a particular order in which they were to be presented. The first report I wanted was the cash flow forecast, which I always scanned quickly to ensure we had plenty of money in the bank to pay our bills into the future. The second was the profit and loss (P&L) statement, which I would spend a lot more -- maybe too much, as it turns out -- time on.

For one, I took our P&L as an indicator of how much revenue and profit we were making and therefore how we were tracking against our annual growth targets. I would also indulge in thinking about the year end and the bonus I could extract from my company based on how its profits were shaping up.

Finally I'd use the P&L to do a quick valuation for our business. I had seen industry reports that consulting firms were selling for 8 to 10 times pre-tax profit, so I would multiply our profit by eight and smile at the thought of the nest egg I was creating.

As it turns out, I was putting too much stock in my P&L and not enough in another document: the valuation statement. In fact, as I started to learn about valuation, I found that what made my business more profitable actually made it less valuable.

For example, a large portion of the revenue in my consulting company came from one bank. The more the bank bought, the more profitable we became. As our relationship deepened, it became easier and easier to sell to it -- to the point where the bank often represented as much as 25 percent of our revenue.

I made a point of conducting all of our meetings face to face, which allowed me to "run into" the colleagues of my current client, who inevitably would ask for my company's help on a new project. I would enter the bank to discuss an exiting project and leave with three new opportunities.

The more the bank spent, the fatter our profit margin got. The bank stopped second-guessing my proposals, which meant my prices started to creep up unchecked. As the owner of the firm, I was the bank's main point of contact, which allowed me to service its account without hiring a salesperson or an account manager, making their projects even more profitable.

When I decided to have my business valued, the professionals I spoke with discounted it substantially, arguing that a single customer representing a quarter of all revenue created an unacceptable risk.

I had a choice to make: If my goal was to be as profitable as possible, I would need to focus even more of my energy on my bank customer. If my goal was to be as valuable as possible, I would need to diversify my business by finding less profitable customers.

We all make this trade-off -- often unconsciously -- between profit and value every day:

• If you want your business to be more profitable, do more of the selling. If you want it to be more valuable, hire salespeople.
• If you're focused on profits and your staff members know what they are doing, don't waste time documenting your processes. However, documenting these procedures will make your company more valuable in the long run.
• It's more profitable to keep selling old products and more valuable to innovate new ones.

If your goal is to sell your company for a premium to a third party, there may be times when you have to prioritize what makes your company more valuable over what makes it more profitable.

Since my ultimate goal was to sell my business, I decided to diversify. Our profit margin slipped, and my annual bonus dropped, but our value increased substantially since no one customer represented more than 5 percent of our revenue by the time I finally sold the business.

Are you focused on building a more profitable company or a more valuable one? What trade-off decisions have you been faced with where profitability is the enemy of value?

Read more:

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• Building a Business: 4 Milestones Worth Celebrating
• Should You Share Equity With Your Employees?
• 3 Signs Your Business Is in Trouble