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Profit: Don’t take your eye’s off it

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Profit: Don’t take your eye’s off it

Growth and the rate of revenue are indeed still important to investors, but as euphoria turns more and more into doubt, companies are required to present a horizon of profitability and reduce their spending on wages

Oren Bar-On | 09:46  05.05.2022

The venture capital industry model is largely based on the ability of technology companies to grow very quickly. The growth is mainly reflected in a rapid increase in revenue, which is the basis for the business model of those companies. Recent years, characterized by a low interest rate environment and technological advances accelerated during the pandemic, significantly increased investors' appetite for risk and thus the ability of companies to raise funds in amounts we have not seen before. Recent valuations have been based largely on revenue multipliers and Annual Recurring Revenues (ARRs), which have led investors and entrepreneurs to prioritize growth and sometimes abandon the bottom line - profitability.

Over the last two months investors have been in the process of a significant sentiment change and giving significant weight to growth companies that predict an improvement in the level of profitability, or at least a reduction in losses with a forecast for profitability in the foreseeable future. The change in sentiment is due to the moderation of the growth curve of the digital transformation in relation to the expected peak of the pandemic together with the inflationary pressures followed by the expected interest rate hikes.

To illustrate, we compared the performance of the index that combines Israeli technology stocks on Wall Street that are not profitable with the Nasdaq index and the S&P 500 index since the beginning of 2019. We found that the total return of those companies as of November 2021 was about 280%, while the Nasdaq yield at that time was about 130%, and the S&P 500 yield was about 86%. Since then, the index yield of those companies has decreased to about 75%, similar to the yield of the S&P 500, while the Nasdaq index led the way with a return of about 100%. The decrease in the return of those companies reflects the same change in sentiment.

Oren Bar-On. Photo: Courtesy Oren Bar-On. Photo: Courtesy Oren Bar-On. Photo: Courtesy

Pricing based on a revenue multiplier produces a partial picture of the company's position since the expenses that serve the growth and constitute a significant aspect in a sustainable business model are not taken into account. The change expected from entrepreneurs and managers is to place a more significant emphasis on the rate of cash burning.

In the world of venture capital backed companies, the challenges in the current situation are to maintain a future funding round at a valuation higher than that of the previous round while ensuring a sufficient amount of cash to meet targets and maintain a minimum dilution of investors.

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One of the expected results of the change in the trend will probably be reflected in the salaries and exceptional conditions of high-tech workers, which following the last two years have improved significantly compared to the other sectors of the economy. The salaries of those employees are the key cost component of technology companies competing with each other in the ability to recruit and retain talent. In a reality where investors are demanding that companies flood the issue of profitability and raise its position in the order of priorities, the wage increases we have experienced in recent years may be hampered.

The test of Israeli high-tech companies is the ability to create for investors, employees and themselves a clear picture of how growth translates into profitability in the foreseeable future. My call for Israeli high-tech on this Independence Day is to continue to grow as fast as possible, but to add to the equation the thought of profitability at the level of the individual sales unit and also at the level of the entire company.

Oren Bar-On is a senior partner at Ernst & Young Israel.

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