Being close to the generation of revenue is safest place to be in most organizations. While a few of us intuitively know that this is true – that making money for our companies will lead to increased job security, it’s not always clear why this is the case. This months lesson will dig a little deeper into why generating revenue is so important in most organizations.
The Importance of Revenue Growth
Say that a company is growing so fast that there is more work to be done than employees people available to do the work. In most cases, the natural reaction is to hire more people into positions that can do the work moving forward. This may result in a 10 person company hiring their 11th employee or it may be a 2,000 person company adding 5,000 new jobs to keep up with demand.
No matter the size of the company or the growth trajectory, these new positions are being added based on the projected revenue growth for the company. To hire that 11th employee, a company's financial team is projecting that there is enough revenue to support that employee into the future. The same logic applies to a company adding 1 or 5,000 new jobs at a time.
These revenue projections are often based on the revenue “run rate” being experienced by the business. A run rate is a projection of the future performance of a business based on recent results. For a growing business, this may mean taking your recent quarterly or monthly results/growth and projecting this amount of revenue growth into the future.
Revenue growth and achieving run-rates gives your CFO comfort that they can hire employees and continue to pay them with the revenue growth for the business.
While revenue in the near future may be guaranteed in contracts/commitments from customers for the rest of the year, projections into the future are far from guaranteed. They are simply an educated guess into how well the company will perform in the future.
This Year is Guaranteed, Next Year is Not
When you are hired as an employee of a business, you can take comfort in the company hiring you based on booked revenue for the current year. That means if you are hired in July, the company is pretty certain they can support your salary, benefits and bonus compensation for the rest of the year.
What this will generally mean is that if you are making $50,000 in total compensation for the year, your company is pretty sure that they will be able to cover the $25,000 due to you for the rest of the calendar year (assuming a calendar fiscal year).
In most cases, the revenue run rate for the business will indicate that they will not only be able to support your total compensation package for the rest of this year, but they will be able to support you next year as well.
However, the difference between your first partial year of employment and your second year can be quite staggering for two reasons:
- Your ability to stay employed is based on a projection of revenue, not a true revenue commitment from customers. This means the ability for the company to pay you in year 2 is not guaranteed until contracts are signed and clients pay their bills.
- If you started half way through the year, you are twice as expensive to your company in year 2 as you were in year 1.
In our scenario, the company has committed to pay you $25,000 in year 1 based on booked revenues and year 2 based on a projection of future revenue.
There is no guarantee that the company will meet their revenue projections in year 2. In fact, the chances are that a growing business will be well above or below those projections in the second year.
If You’re Not Growing…
For sake of simplicity, let’s say that you are hired into a 10 person company as employee #11. Let’s say that each employee receives $50,000 in compensation. In year 1, we have increased the salary commitments for the business from $500,000 to $525,000 by adding an employee in July. In year two the company is now on the hook for $550,000 in salaries. As long as the company can grow by 5% year over year, then the extra salary commitment should not affect the profitability of the business.
The 2,000 person company scenario is where things get a little tricky. Again, let’s say that each employee receives $50,000 in compensation and the company hires 5,000 new employees half way through the year. In year 1, salary commitments for the business will have grown from $100,000,000 for 2,000 employees to $225,000,000 for 7,000 employees ($25k/half year * 5k Employees).
In order to grow at this pace, the company will need to grow revenue by 125% in year 1 to pay the new employee salaries (or have significant funding coming in from venture capitalists).
In year 2, this company is now on the hook for the full salaries of the 5,000 new hires, which means that the company must earn $350,000,000 in year 2 in order to pay for all of their employees. This company needs to grow by another 56% in year 2 without adding another employee to the business!
As you can see, even though employees were hired in a year when the business was prosperous, they become more expensive in their first full year as an employee. Business decisions made in year 1 require the business to grow larger in the next year.
Now that we have seen the above scenarios, we understand that every time a business hires a new employee, they are expecting that the company will be growing revenue in year 2. But what happens when the revenue does not meet these expectations?
The short answer is that nothing good happens. If revenue does not grow to expectations, then the company will have to make a choice about what to do with their current commitments.
Do they lay-off employees to align their staff with the actual demand for their business in year 2? Do they decide to keep employees and forego profitability for year 2? Do they hire sales staff to try and boost top line revenue? Do they seek a loan or venture capital to keep the business afloat?
These are the tough decisions that a business has to make whenever revenue does not grow as expected. It doesn’t matter whether the company expanded by 1 employee and needs 5% revenue growth or if they expanded by 5,000 employees and need to grow by 56% in year two, the result is the same: the company needs to grow in order to support any new employees.
If your company is not growing, then something is dying. The business owners lose profit, employees, their own equity or they lose a combination of all three.
If you’re not growing, then you’re dying.
How you can use this information moving forward
This information can be useful in many ways moving forward. If you are an employee looking to join a new company, you can ask questions around revenue growth and projections for the business.
You can ask whether revenue is booked into year 2 or based on year 1 projections.
You can ask if you are going into a recently vacated position (very little risk) or a newly created position (more risk).
You can ask whether the company has ever laid off employees in the past, how many, and why it happened.
You can be selective and only interview companies with great margins, because there may be more room for profit even if revenue doesn’t grow.
You can ask the company you interview with what their attrition rates are for customers. How many customers do they lose each year and how many do they gain on average?
You can choose to be in a position that is responsible for generating revenue for the business. As long as you are producing revenue, you are allowing the company to keep employees and profits. This will be a future Career Advice post.
You can understand that certain types of business are more stable for employers. Retainer or subscription based businesses are often more revenue stable than businesses that have to earn revenue on a project-by-project basis.
If you are an employer, you can be prepared to answer these questions about your business honestly, and use this information to make sure that you are hiring properly.
Growth is Important
Almost every business plan assumes growth into the future. Hopefully this lesson will help you better understand why business growth is so important and why tough decisions need to be made when companies don't reach their targeted performance.