Understanding Business Growth

Small and medium businesses experience a common set of problems in moving through growth stages and the choices of management in terms of finance have a radical impact on the ability of the organisation to break through growth barriers.

In the process of growth there will be various evolutions and transformations of decision-making, organisational structures and levels of autonomy of staff and management. The capital structure will also change fundamentally with greater influence of external funding.

If it was a simple formula that could be programmed, then there would be no need for critical analysis of funding but each business widely varies in its capacity and ability to grow. There are however common trends and similarities in the types of challenges experienced and the role of an advisor would be to understand these challenges and have good solutions to assist with these, while at the same time adding value through the financial products that support this level of growth.

The advisor and the business owner can benefit from a growth framework through being able to anticipate the key requirements at various points. If there is a clear understanding of when there is more human resources, more systems and management transformation that is required, not only can the owner focus their energies, but the bank can structure appropriate products to help with credit extension, expansion finance, loan products, debt factoring, asset finance and a range of other appropriate mechanisms to structure the financial aspects of the business.

Businesses also evolve to more complex structures where there are a combination of strategic and operational factors at play and where there may be subsidiaries, complex internal divisions and a wide variety of needs. In this type of environment there is a need to be able to evaluate the interaction factors between different streams of finance and to evaluate risk, reward and business needs with considerations of the implications. This requires an advisor to have an appreciation of strategic value drivers and their impact in a specific business. The financial factors in strategic financial management, mergers and acquisitions and structural finance come into view at this point.

Understanding the growth phase of the business

Figure 1: Characteristics of business at each stage of growth

Source: Churchill, Lewis, The five stages of business growth. Harvard Business Review

Figure 2: Evolution of companies

Adapted from Churchill, Lewis, The five stages of business growth. Harvard Business Review,

Stage I: Existence

In this stage the main problems of the business are obtaining customers and delivering the product or service contracted for. Among the key questions are the following:

Can we get enough customers, deliver our products, and provide services well enough to become a viable business?

Can we expand from that one key customer or pilot production process to a much broader sales base?

Do we have enough money to cover the considerable cash demands of this start-up phase?

The organization is a simple one—the owner does everything and directly supervises subordinates, who should be of at least average competence. Systems and formal planning are minimal to nonexistent. The company’s strategy is simply to remain alive. The owner is the business, performs all the important tasks, and is the major supplier of energy, direction, and, with relatives and friends, capital.

Companies in the Existence Stage range from newly started restaurants and retail stores to high-technology manufacturers that have yet to stabilize either production or product quality. Many such companies never gain sufficient customer acceptance or product capability to become viable. In these cases, the owners close the business when the start-up capital runs out and, if they’re lucky, sell the business for its asset value. (See endpoint 1 on Exhibit 4). In some cases, the owners cannot accept the demands the business places on their time, finances, and energy, and they quit. Those companies that remain in business become Stage II enterprises.

Stage II: Survival

In reaching this stage, the business has demonstrated that it is a workable business entity. It has enough customers and satisfies them sufficiently with its products or services to keep them. The key problem thus shifts from mere existence to the relationship between revenues and expenses. The main issues are as follows:

In the short run, can we generate enough cash to break even and to cover the repair or replacement of our capital assets as they wear out?

Can we, at a minimum, generate enough cash flow to stay in business and to finance growth to a size that is sufficiently large, given our industry and market niche, to earn an economic return on our assets and labour?

The organization is still simple. The company may have a limited number of employees supervised by a sales manager or a general foreman. Neither of them makes major decisions independently, but instead carries out the rather well-defined orders of the owner.

Systems development is minimal. Formal planning is, at best, cash forecasting. The major goal is still survival, and the owner is still synonymous with the business.

In the Survival Stage, the enterprise may grow in size and profitability and move on to Stage III. Or it may, as many companies do, remain at the Survival Stage for some time, earning marginal returns on invested time and capital (endpoint 2 on Exhibit 4), and eventually go out of business when the owner gives up or retires. The “mom and pop” stores are in this category, as are manufacturing businesses that cannot get their product or process sold as planned. Some of these marginal businesses have developed enough economic viability to ultimately be sold, usually at a slight loss. Or they may fail completely and drop from sight.

Stage III: Success

The decision facing owners at this stage is whether to exploit the company’s accomplishments and expand or keep the company stable and profitable, providing a base for alternative owner activities. Thus, a key issue is whether to use the company as a platform for growth or as a means of support for the owners as they completely or partially disengage from the company. Behind the disengagement might be a wish to start up new enterprises, run for political office, or simply to pursue hobbies and other outside interests while maintaining the business more or less in the status quo.

Success-Disengagement substage

In the Success-Disengagement substage, the company has attained true economic health, has sufficient size and product-market penetration to ensure economic success, and earns average or above-average profits. The company can stay at this stage indefinitely, provided environmental change does not destroy its market niche or ineffective management reduce its competitive abilities.

Organizationally, the company has grown large enough to, in many cases, require functional managers to take over certain duties performed by the owner. The managers should be competent but need not be of the highest caliber, since their upward potential is limited by the corporate goals. Cash is plentiful and the main concern is to avoid a cash drain in prosperous periods to the detriment of the company’s ability to withstand the inevitable rough times.

In addition, the first professional staff members come on board, usually a controller in the office and perhaps a production scheduler in the plant. Basic financial, marketing, and production systems are in place. Planning in the form of operational budgets supports functional delegation. The owner and, to a lesser extent, the company’s managers, should be monitoring a strategy to, essentially, maintain the status quo.

As the business matures, it and the owner increasingly move apart, to some extent because of the owner’s activities elsewhere and to some extent because of the presence of other managers. Many companies continue for long periods in the Success-Disengagement substage. The product-market niche of some does not permit growth; this is the case for many service businesses in small or medium-sized, slowly growing communities and for franchise holders with limited territories.

Other owners actually choose this route; if the company can continue to adapt to environmental changes, it can continue as is, be sold or merged at a profit, or subsequently be stimulated into growth (endpoint 3 on Exhibit 4). For franchise holders, this last option would necessitate the purchase of other franchises. more

If the company cannot adapt to changing circumstances, as was the case with many automobile dealers in the late 1970s and early 1980s, it will either fold or drop back to a marginally surviving company (endpoint 4 on Exhibit 4).

Success-Growth substage

In the Success-Growth substage, the owner consolidates the company and marshals resources for growth. The owner takes the cash and the established borrowing power of the company and risks it all in financing growth.

Among the important tasks are to make sure the basic business stays profitable so that it will not outrun its source of cash and to develop managers to meet the needs of the growing business. This second task requires hiring managers with an eye to the company’s future rather than its current condition.

Systems should also be installed with attention to forthcoming needs. Operational planning is, in the form of budgets, but strategic planning is extensive and deeply involves the owner. The owner is thus far more active in all phases of the company’s affairs than in the disengagement aspect of this phase.

If it is successful, the company proceeds into the takeoff stage. Indeed, this stage is often the first attempt at growing before commitment to a growth strategy. If the success-growth company is unsuccessful, the causes may be detected in time for the company to shift to previous stages. If not, retrenchment to the Survival Stage may be possible prior to bankruptcy or a distress sale.

Stage IV: Take-off

In this stage the key problems are how to grow rapidly and how to finance that growth. The most important questions, then, are in the following areas:

Delegation.

Can the owner delegate responsibility to others to improve the managerial effectiveness of a fast growing and increasingly complex enterprise? Further, will the action be true delegation with controls on performance and a willingness to see mistakes made, or will it be abdication, as is so often the case?

Cash.

Will there be enough to satisfy the great demands growth brings (often requiring a willingness on the owner’s part to tolerate a high debt-equity ratio) and a cash flow that is not eroded by inadequate expense controls or ill-advised investments brought about by owner impatience? more

The organization is decentralized and, at least in part, divisionalized—usually in either sales or production. The key managers must be very competent to handle a growing and complex business environment. The systems, strained by growth, are becoming more refined and extensive. Both operational and strategic planning are being done and involve specific managers. The owner and the business have become reasonably separate, yet the company is still dominated by both the owner’s presence and stock control.

This is a pivotal period in a company’s life. If the owner rises to the challenges of a growing company, both financially and managerially, it can become a big business. If not, it can usually be sold—at a profit—provided the owner recognizes his or her limitations soon enough. Too often, those who bring the business to the Success Stage are unsuccessful in Stage IV, either because they try to grow too fast and run out of cash (the owner falls victim to the omnipotence syndrome), or are unable to delegate effectively enough to make the company work (the omniscience syndrome).

It is, of course, possible for the company to traverse this high-growth stage without the original management. Often the entrepreneur who founded the company and brought it to the Success Stage is replaced either voluntarily or involuntarily by the company’s investors or creditors.

If the company fails to make the big time, it may be able to retrench and continue as a successful and substantial company at a state of equilibrium. Or it may drop back to Stage III or, if the problems are too extensive, it may drop all the way back to the Survival Stage or even fail.

Stage V: Resource Maturity

The greatest concerns of a company entering this stage are, first, to consolidate and control the financial gains brought on by rapid growth and, second, to retain the advantages of small size, including flexibility of response and the entrepreneurial spirit. The corporation must expand the management force fast enough to eliminate the inefficiencies that growth can produce and professionalize the company by use of such tools as budgets, strategic planning, management by objectives, and standard cost systems—and do this without stifling its entrepreneurial qualities.

A company in Stage V has the staff and financial resources to engage in detailed operational and strategic planning. The management is decentralized, adequately staffed, and experienced. And systems are extensive and well developed. The owner and the business are quite separate, both financially and operationally.

The company has now arrived. It has the advantages of size, financial resources, and managerial talent. If it can preserve its entrepreneurial spirit, it will be a formidable force in the market. If not, it may enter a sixth stage of sorts: ossification.

Ossification is characterized by a lack of innovative decision making and the avoidance of risks. It seems most common in large corporations whose sizable market share, buying power, and financial resources keep them viable until there is a major change in the environment. Unfortunately for these businesses, it is usually their rapidly growing competitors that notice the environmental change first. more

Key Management Factors

Several factors, which change in importance as the business grows and develops, are prominent in determining ultimate success or failure.

We identified eight such factors in our research, of which four relate to the enterprise and four to the owner. The four that relate to the company are as follows:

1. Financial resources, including cash and borrowing

power.

2. Personnel resources, relating to numbers, depth, and quality of people,

particularly at the management and staff levels.

3. Systems resources, in terms of the degree of sophistication of both information

and planning and control systems.

4. Business resources, including customer relations, market share, supplier

relations, manufacturing and distribution processes, technology and reputation, all of which give the company a position in its industry and market.

The four factors that relate to the owner are as follows:

1. Owner’s goals for himself or herself and for the business.

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2. Owner’s operational abilities in doing important jobs such as marketing,

inventing, producing, and managing distribution.

3. Owner’s managerial ability and willingness to delegate responsibility and to

manage the activities of others.

4. Owner’s strategic abilities for looking beyond the present and matching the

strengths and weaknesses of the company with his or her goals.

As a business moves from one stage to another, the importance of the factors changes. We might view the factors as alternating among three levels of importance: first, key variables that are absolutely essential for success and must receive high priority; second, factors that are clearly necessary for the enterprise’s success and must receive some attention; and third, factors of little immediate concern to top management. If we categorize each of the eight factors listed previously, based on its importance at each stage of the company’s development, we get a clear picture of changing management demands.