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Playing Favorites

Striking a balance between sales, profits and cash flow may mean giving one the upper hand.

Running a company is a balancing act, and striking the right balance is an important skill. But when it comes to raising money, achieving the perfect balance between sales, profits and cash flow might be the wrong thing to do. Strongly favoring one can create more funding opportunities.

Zorik Gordon, co-founder and CEO of online ad agency ReachLocal Inc., was definitely not thinking about balance when he went out looking for venture capital for his rapidly growing company. Founded in 2004 with $750,000 from a single angel investor, ReachLocal quickly proved that online advertising could be used to promote small local merchants. As sales picked up, ReachLocal needed serious capital to fuel growth. Profit was something to worry about later; Gordon was busy building the top line.

In Favor of Growth
"We are always hyperfocused on getting dollars in the door and showing that there's a viable business," says Gordon, 36, who's led ReachLocal through four rounds of VC funding totaling more than $67 million. "The analysis is that it is growing so fast, it will eventually throw off cash. If you want to get investors excited, companies that can really grow their revenue tend to be starting at the 50-yard line."

David Carlick, venture partner at VantagePoint Venture Partners, is among those who invested in ReachLocal early on. Venture capitalists know they will weather large short-term losses, he says. "A venture capital candidate has to show that they can grow rapidly and that their business model will be profitable. But they need the money to get there."

In Favor of Cash Flow and Profits
ReachLocal's focus on sales growth makes it an ideal target for equity investors, but also a poor candidate for bank debt. To take on a significant bank loan, a company must be generating steady cash flow, says Jamie Westmoreland, commercial relationship manager at Bank of York. "Ideally, the bank wants to see historical cash flow at levels [that will] adequately service the proposed debt. Revenue growth, profits and EBITDA are great, but historical cash flow demonstrates the ability to collect receivables and properly manage inventory and payables."

Likewise, some entrepreneurs will gun for profits and fall short on cash flow in the process. Those companies are typically candidates for nonbank debt financing options, like factoring.

Long-Term Trade-Offs
In the long term, all companies must generate both profits and cash to survive--and ReachLocal is no exception. During its latest round of fundraising--a $55 million infusion in late 2007--Gordon says he started to feel the pendulum swing back toward the middle: The New York City-based equity funds that invested have less interest in continuing a hypergrowth strategy at the expense of profits. "There's a much deeper probe by this stage of investor than at an early stage," says Gordon. "You have to be demonstrating that you are inherently profitable--or have a very strong case."

Gordon found himself explaining how ReachLocal could eventually become a more traditional, "bankable" company. "These [later-stage] investors are looking for a business that is going to grow really fast and throw off a lot of cash."

ReachLocal is on its way to finding that balance between growth and cash. In just four years, the company has grown revenue from zero to nine figures. Now Gordon is turning his attention to profitability. "At a certain point," he says, "you start getting held to your projections."

David Worrell is author of the e-book Finding Funding. Contact him at david@dworrell.com.

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This article was originally published in the September 2008 print edition of Entrepreneur with the headline: Playing Favorites.

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