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The High Growth Conundrum: Surviving the Financial Risks of Fast Growth

by Bennett Voyles

February 8, 2013

Dollar from Bill David Brooks' Flickr photostream http://www.flickr.com/photos/8011986@N02/

Fast growth might seem like a dream come true for an entrepreneur. What could be better than watching your vision turn into happy customers and hundreds or thousands of busy employees? The reality, however, is that a period of hypergrowth can be extremely dangerous for a young company—sometimes even fatal.

Indeed, many fast-growing companies implode at precisely the moment the company seems on the verge of taking off. As David Packard, co-founder of Hewlett-Packard, once noted, more companies die of indigestion than starvation.

Precise numbers are hard to come by, but most studies say that only 30% of entrepreneurial companies survive their first three years, and by five years, that survival rate drops in half, according to Edward Hess, a Professor of Business Administration and Batten Executive-in-Residence at the Darden School of Business at the University of Virginia, and author of Grow to Greatness: Smart Growth for Entrepreneurial Businesses .

Running on Empty

“Hypergrowth is an enjoyable but very dangerous situation unless you have very high margins, because hypergrowth, of course, requires major investments and thus financing,” explains Hermann Simon, chairman of Simon-Kucher & Partners, a global strategy and marketing consultancy headquartered in Bonn, Germany and Cambridge, Massachusetts.

Perhaps the most common pitfall fast-growers face is a shortage of capital. “You’ve got to pay out money a lot earlier than you get the return, and people don’t know that,” says Hess. “They think, ‘Okay, I’m going to hire three people or buy this equipment or rent more space’, and they don’t realize that in some cases, it may be two months, three months, four months before they get the income in and they basically don’t have the reserves to pay that long. They don’t do the math.”

Hess focuses on US businesses, but the situation is no different in China, according to Stephen Perl, author of Doing Business in China: The Secrets of Dancing with the Dragon and CEO of 1st PMF Bancorp, a company with operations in the US and China.

Perl, whose company focuses on trade finance for small and mid-sized businesses, says that when he first opened the Chinese branch of his business in 2004 he was surprised to find that the problem fast-growing Chinese companies faced were exactly the same as those of his clients in the US: maintaining sufficient working capital.

Slow-paying customers are an especially tough problem in China, where companies have a tradition of taking their time with their payables. Payment cycles of as long as eight months are not uncommon, according to Perl.

The lack of a countrywide commercial code makes it even harder for Chinese companies to force slow-payers to up the ante. “The Chinese market doesn’t have a uniform commercial code yet, and that creates difficulties,” Perl says. Unlike the US, for instance, where many business laws are standardized throughout all 50 states, commercial law rules can vary substantially between provinces.

Russell Brown, managing partner of LehmanBrown, an accounting and business advisory firm whose head office is in Beijing, agrees that slow payment makes things tough for Chinese companies. “There’s a continual juggling between receivables and payables,” he says.

Companies use various other strategies as well to try and keep themselves solvent. One is through lines of credit. Another, still in its infancy in China, is factoring. This old financial structure, which goes all the way back to the Middle Ages in Europe, involves selling an invoice at a discount in exchange for an immediate payday rather than waiting for payment to arrive. The more common practice of modern factors is to make a loan against perhaps 80% of the receivable and retain the rest as collateral. A typical discount would be between 1% and 3% a month, Perl says, depending on volume and risk.

Perl, whose company offers factoring services, says there are fewer than 50 factors in the US now. “The financial crisis wiped out a lot of factors, big and small,” he says.

More often, private companies faced with a cash crunch in China turn to friends and family, says Brown. Other times, he adds, they may turn to suppliers or customers for an investment.

Mergers

Another common feature among fast-growing companies is an urge to acquire companies, but experts say this option should be exercised with caution.

Hess is not bullish on mergers. “Growth by acquisition is higher risk than growth by improvements or growth by scaling, and is very high risk unless you reach a stage where you’ve got the financial wherewithal to afford it and the managerial depth and talent that you can basically undertake it,” he says.

Simon also warns that in a fast-growing industry, companies tend to be selling at a premium, which can compound the existing financial challenge. “Usually in this phase, companies tend to be overpriced so you have a high multiple which you pay and what you get [in revenue] is linearly, directly related to the financing needs,” he says.

Beyond the due diligence that any company anywhere would need to do, Brown says that would-be dealmakers in China should be especially vigilant in uncovering all related party transactions, which might have a major impact on the value of the company.

For example, if the company you want to buy has some key suppliers, you should investigate whether those key suppliers are ‘arms’ length’ or whether there’s a relationship or ownership, and key customers as well,” Brown says.

IPO No-Nos

Of course, the ultimate dream for many entrepreneurs is the IPO, but experts urge caution.

“Where companies can go wrong is not understanding that the IPO is just the start,” Brown says. Where some Chinese red chips have gone wrong, he says, is that they celebrate their success with IPO and then don’t follow through with the story they sold investors. And if they do follow through, they may fail to publicize what they have achieved, he says. Investor relations are an important cost of doing business for a public company, but many newly public companies in China don’t realize it.

IPOs tend to be a mixed blessing, according to Simon. On the one hand, he says, it’s the best kind of financing, in that the original investors don’t have to take on any additional risk as the company expands. On the other, it can be hugely distracting. He said he recently asked the CEO of one company that had recently gone public how much time he spent on road shows and investor relations. The CEO’s answer: 30-40%.

Being public also creates pressure from shareholders for faster growth, which tends to translate into shorter-term thinking, Simon warns. It also does not seem to be a prerequisite for corporate success: in his research on Germany’s world-beating Hidden Champions, the midsize companies behind 70% of German exports, Simon has found that 70% are family-owned.

Price Wars

Making matters trickier still is that often a fast-growing company faces competitors who are also pursuing a fast-growth strategy. All their investment creates overcapacity–and over-capacity tends to lead to dangerous price wars, Simon says. He points to wind power and solar energy as two sectors where companies enjoyed a fast-growth boom a few years ago but are now fighting for survival.

Price wars are exceedingly common. A global study undertaken by Simon-Kucher last year found that 46% of the 3,095 managers surveyed said they were in a price war right now. They are also exceedingly bad, according to Simon, who calls them “the most effective means to ruin margins”.

Often, companies that find themselves in a price war start make a strategic mistake by trying to focus on market share rather than profitability, Simon says–which is exactly the opposite of what they should be doing. It’s better, he says, to “lose some market share points and become profitable and survive instead of going under with the highest possible market share”.

Slow and Steady Wins the Race

The prospects for hypergrowth companies might seem better for companies with major financial backing, but Hess warns that cash isn’t the only problem. “Everyone thinks that institutional funding is the answer, but it’s not that simple,” he says. Even companies that are backed with venture capital or private equity have trouble managing growth. Instead, he says, venture-backed companies tend to have a different set of problems. By focusing almost exclusively on top-line growth, they may neglect thinking about their operations or net profit.

Regardless of the source of funding, the commodity in truly short supply seems to be long-term vision. “Where entrepreneurs are caught off guard and don’t understand is they have to continuously upgrade all of the support systems for growth as they grow because growth outstrips current capabilities and that costs money,” Hess explains.

Hess advises easing up on the gas pedal. In his study of 54 private fast-growing companies, he says, he was struck by how many of the entrepreneurs in his study had run their companies to the ground. “I was surprised in my research to find how many of my successful entrepreneurs had blown up their first company by growing too fast and outstripping people, processes and controls. Growth overwhelmed them.”

Slowing down a little can make all the difference. “I usually recommend that companies, unless they are very strong financially, refrain from exploiting their full growth potential and rather grow a little more moderately or modestly and avoid overstretching, overleveraging on the financial side,” Simon says.

In the end, surviving financially during hypergrowth comes down to keeping a close eye not just on the speedometer, but on the gas gauge. “You’re computing, what’s my burn rate? What do I pay out every week?” says Hess.

“For most entrepreneurs, the best practice is to basically know where you are cash-wise every day, and manage your account payables and your accounts receivable. You know how much you’ve got in the bank and you know how much you’ve got to pay out in the next two weeks and either you’ve got surplus or not… you’ve got to watch the cash every day,” Hess adds.

After HP survived a near-death experience in its early years because of a working capital shortage, Packard always took care to make sure that HP never exceeded what he called “an affordable growth rate”, to make sure that the investments required to grow didn’t outshoot the company’s capacity to self-fund them.

The good news is that things eventually do calm down as the business matures, according to Hess. The bad news? Most of the time, it won’t happen until you hit somewhere between $250 million and $750 million in revenue. “Until you get there, it’s turbulent,” he warns.

(Image courtesy: Bill David Brooks’ Flickr photostream)

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