Financial Guidance from Private Equity Expert Glenn Hopper
One measure of financial performance that all investor-backed companies are deeply familiar with is EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
This key financial metric is not a measure of cashflow or net income. Rather, it is a number used by investors to evaluate a company’s operating cashflow. This number is used by investors because it tries to standardize operating return on companies regardless of sector, industry or company size. It does not factor in how the company handles financing or capital expenses, as it is meant to show an approximation of how effective a company’s operations are at generating profit. EBITDA does not include treasury deductions for payments of interest and taxes or other non-operating expenses.
EBITDA can seem a mysterious number for companies not used to dealing with private equity or venture capital investors. In order to clarify some of the confusion around this number, we spoke with technology and finance-focused author Glenn Hopper, who has worked as a Chief Financial Officer and consultant for investor-backed startup companies for almost a quarter of a century. Hopper is a private equity specialist who works with businesses to help them boost EBITDA and increase value. Hopper examines the function of private equity in corporate finance and how it can be applied to promote growth in his book Deep Finance: Corporate Finance in the Information Age.
“Investors are looking for companies where they can see a clear path to an exit – whether that’s a sale to a strategic buyer, another investment company or a public offering,” Hopper says. “They typically invest across a wide spectrum of businesses and industries, and they want to use a common metric that shows their companies’ operating profitability when compared to other firms in their portfolio.”
Hopper continues, “With EBITDA, they can look across all of their portfolio companies and see this common number regardless of non-operating expenses like interest and taxes or capital spend. It doesn’t tell you everything a potential investor would delve into in a due diligence process, but it’s kind of the gold standard for first blush.”
EBITDA is important, Hopper says, but you’ll most commonly hear investors talk about EBITDA margin, which is the company’s EBITDA in relation to Revenue. “Investors want to back growth companies that they believe will have a higher value in the future than they do today. So a company’s EBITDA today may be low, but if they see there is opportunity for EBITDA margin improvement at scale or with some operational changes, they are likely to invest,” Hopper says. “Remember,” he adds, “Investors aren’t putting money in based on what the company’s value is today. They’re investing based on what they think it will be worth in the future.”
One key way to improve a company’s value in the future is to show a path to improvements of EBITDA margin.
Three Fundamental Levers to Improve EBITDA Margin
Hopper says businesses should remain focused on three primary ways to increase their EBITDA margin. Each of the levers represents a key part of the income statement: Revenue, Cost of Goods Sold (COGS), and Operating Expenses.
Lever One: Increase Sales
Companies with low sales have a foundational problem in that until sales hit critical mass of revenues exceeding expenses, EBITDA margin is negative. This is quite common for startup companies, but is not a sustainable business position as a company with negative EBITDA margin is operating only on invested or borrowed capital.
In order to increase revenue (sales), Hopper says companies must focus on business fundamentals, including: Market, Product, Channel or Clients, Sales Network, and Value Proposition. Without these vital components in place, the other levers are meaningless.
“Business owners must understand their market in depth before even thinking about talking to investors,” Hopper says. “You have to understand your Total Addressable Market (TAM), where your company is today, where you want to be, and how you plan to get there.”
Hopper asks, “Have you built a better mouse trap or are you solving a market need in a fundamentally new way?”
Business owners should ask themselves if their product is competitive to target key markets. They should constantly analyze their product portfolio relative to competitors and to market needs. Successful products should be bolstered and unsuccessful products need to be evaluated for improvement or to determine whether they should remain in the company’s offerings.
Who are the major players in the market? Are you going after the right customer? Are you selling through the right channel? Can you sell more products to existing clients?
When investing in sales and marketing, Hopper says those investments should be “selective, strategic and profitable.” He stresses the importance of determining Return on Investment (ROI) for all investment.
Does your company have an adequate sales force to get your products in front of potential consumers? Even the best invention since sliced bread won’t sell if no one knows about it.
“A business without a go-to-market strategy has virtually no chance at success,” Hopper says. This doesn’t mean a business won’t be funded, however. Hopper says that many companies are started by software engineers who’ve built a great product, but don’t have the background in business to know how to launch their creation to the world. “Early stage venture capital firms will potentially invest in a great idea and then put a team in place to help business founders bring their product to market.”
What true value does your company/product bring to the market? Understanding what problem you’re looking to solve and for whom is key to business viability, Hopper says.
According to Hopper, “When you can answer all these questions in the affirmative, then you can dial into the next levers, which will help transition your company to operational excellence and enable you to shift focus to increasing EBITDA margin.”
Lever Two: Production Cost Reduction
Production costs refer to the Cost of Goods Sold for your product. These are the raw materials and costs associated with producing the products you sell. Revenue less production costs is your company’s gross margin. Gross margin is the cost of producing your product before deducting Sales, General & Administrative (SG&A) costs. Think of these as the variable costs tied to the production of each widget your company sells. They are not inclusive of property, plant and equipment, which are not components of the EBITDA calculation.
Lowering production costs allows companies to spend more on operations, which leads to better product and operational support. Keeping production costs low is a clear way to maintain EBITDA margin when the company grows top line revenue.
Lever Three: Operating Cost Reduction
Operating costs include the expense of staffing, marketing, advertising, and administering a business. When businesses lose focus on controlling operating expenses, they can find hard earned EBITDA margins eroding. There are numerous metrics that help companies track their operating expenses and compare their performance to other companies in their industry. Business leaders should use ratios like operating expense to revenue, operating expenses per employee, employee utilization rates, and marketing expenses to revenue.
With these three levers in mind, Hopper advises there are ten steps companies can follow to improve EBITDA margin:
How to Improve EBITDA in 10 Steps
- Analyze your costs: Understand the evolution of your costs, classify them as fixed or variable, and design an appropriate cost structure for each level of activity of the company. Monitor the level of operating leverage (the weight of fixed costs over total costs) and control your fixed cost structure. In times of growth, try to reduce the variable cost structure to amplify the profit zone or mitigate profit loss.
- Implement a spending policy: Establish clear levels of authorization for spending, identify cost generating centers, and compare costs by nature.
- Use budgets and budgetary control: Establish a system of budgets and budgetary control for each item of cost and by cost generating centers, and monitor deviations between reality and budgets.
- Understand and analyze expenses: Each expense must be managed in a unique way. Question every euro you spend in your company, and analyze how it behaves.
- Review and reinvent spending processes: Act on cost drivers (quantities, frequencies, times, and unit costs) to identify reduction levers with a multiplier effect.
- Negotiate with suppliers: Establish an annual or biannual negotiation procedure with suppliers, approve suppliers, and analyze the convenience of concentrating and/or replacing them.
- Reduce internal errors: Reduce or eliminate internal errors that produce excess spending, such as emergencies, incomplete loads, or bank overdrafts.
- Implement “lean manufacturing” philosophy: Implement a “lean manufacturing” philosophy in the plant to gain efficiency, economy, and effectiveness through measures such as OEE, SMED, 5s, etc.
- Implement “lean expense management” philosophy: Implement the “lean expense management” philosophy in the rest of the operating expenses, following all the previous suggestions. Establish performance indicators to measure all of the above.
- Have a firm, constant and regular attitude: Have a firm, constant, and regular attitude about the optimization of the cost structure. Rigor and discipline are the foundations of success. By following these steps, you can improve your EBITDA and increase profitability and competitiveness in your business.