Growth vs. Profitability
High growth strategies are a myth and a recipe for reduced profitability. In “Understanding the Myth of High Growth Firms, The Theory of the Greater Fool” we demonstrate that the creation of profitable and sustainable ventures cannot result from fostering high growth. Such growth (often ill defined) is the agenda of investors, consultants, bankers, popular media, elected officials, policy makers, and even universities. Elected officials equate high growth with high employment subsequently getting themselves re-elected. Early investors push high growth in market share, creating excitement at an IPO, cashing out while hype is high. However, not all entrepreneurs want to cash out their ownership and certainly not family firms. Many want to pass their firm to future generations. To do that profitability is required.
Many assume growth drives value. Research shows only investors before an IPO or merger gain any real value with this strategy. Accountants will tell you, growth creates shareholder value through profitability. While the dream of having triple digit growth rates, sexy new technology, or a “rags to riches” story may grab media attention we should be paying attention to if, and how, a firm makes money. Even established family firms have to ask if their revenue model remains viable, as the music industry has painfully demonstrated. Without sustainable profitability any exit strategy requires the ‘theory of the greater fool.’ For example, the founder of Groupon said it was a “stupid, boring idea that just happened to resonate.” He watched as Groupon, valued at $13 billion in 2011, plummeted to 80 percent below its IPO.
Periods exist when sustainability is substituted with get rich quick schemes. History is littered with such cycles, be it tulip mania in 1637, the Klondike Gold Rush of 1896, the dot com bubble of 2000, or the real estate derivative collapse leading to the 2008 Great Recession. Remember, many were convinced internet businesses were different: it was a new economy. Market share replaced profit as the measure of success. A cash-flow problem was to be solved with an IPO. Profitability would magically come. Most of these dreams turned into nightmares. The fundamentals of economic theory remain valid.
What is the revenue model of Twitter or Instagram? We do not really know, and most of our colleagues say there is no revenue model other than the catch all phrase: “advertising revenues!” But, just how much can advertising budgets support new ventures whose revenue models are based on “eyeballs.” The founder of Twitter and investors were looking for an exit, and they found it in Facebook. The founder of Twitter made a fortune. He applied the theory of the greater fool.
But, this rationale for doing business is rarely if ever the rationale for anyone in family business or wishing to create a family firm. Most, we know, do not want to get rid of the firm, but to keep it! And keep it for generations. Family firms may need the involvement of investors, but these are rarely venture capitalists. Family firms seek to build capital for the family and the firm, not for somebody else. In most cases the very idea of selling the firm is so painful, even as an idea, that many decide to just quit and shut down!
An Inconvenient Truth
What does high growth mean in the entrepreneurial family business context? We certainly have to redefine high, and we even have to seriously consider if the concept of high growth is relevant or even applicable for most family firms.
Employee growth and revenue growth are two very different dimensions of growth that do not correlate very well. While politicians want employee growth, we have yet to meet any family business owner who tells us he or she created the venture because they wanted to hire lots of people — maybe to employ family members, but rarely unless they are needed. Most firms do not grow beyond 10 persons. Take any country and approximately 93 percent of that nation’s firms employ fewer than 10 persons. Large firms, employing more than 250 persons, account for less than one percent of all enterprises. Why are there no more than 10 employees? One explanation may be that the number of things a human can hold in working memory is 7 ± 2. More than 10 employees increases complexity. Previously unnecessary structures become necessary, bringing bureaucracy and inflexibility. Bureaucracy is a cost center, not a profit one. Remember only three percent of firms manage to grow beyond 100 employees.
Research shows creating consistent growth requires that the business first become profitable after which it can focus on growth. Even then, one company in ten can sustain above average growth rates for more than two years and make the transition into profitability. However a profitable start-up can become a growth firm. That is, growth does not lead to profitability, but the reverse. Sustained high growth is extremely rare, a bit like a unicorn. It takes money to make money, which is earned through profits, or borrowed, through additional equity. As a colleague used to say “nothing will kill you deader than success.”
The Role of Innovation
Some entrepreneurship may require innovation, most does not. If novelty is key, then pay attention to the degree of novelty. Is it new to the world; new to a market; new to a region/country; or new to the firm? Growth does not require new technology. Many firms with the highest growth rates are service companies. Creating a profitable and growing venture based on an innovation from either technology or service sectors will be both difficult and different. Business and revenue models will differ for each. The time it takes to reach sustained profitability will be very different. For example a biotechnology firm focusing on drug development will typically need eighteen years before commercialization. Compare this with starting a Bed & Breakfast (B&B), which becomes number 1 on Trip Advisor in two months (imitation). These are very different firms with different revenue models, needs for capital, and growth is measured very differently. The biotech firm will not have revenues let alone profits for years. A B&B should have revenues from day one, with profits depending on operational costs and debt service. Regardless, both are likely to occur within 18 months for the B&B, but not for 18 years in the biotech firm. But is high growth even desirable for the B&B? We suspect that profitability, low employment and the purchase of needed services from other providers are key.
In fact, we know of very few biotech family firms, but we know of many family firms in the hospitality industry. One reason is most likely the need for external capital, i.e., the need for venture capital. We are aware of one biotech company where the father and son created the firm. At first they had no problem acquiring the needed venture capital, but when they needed more and also in public declared they were a family firm, the venture capitalists stepped back. Why? Most likely because even the venture capitalists understood they do not share a future agenda with respect to growth, profitability and ownership expectations. Creating a shared understanding on all three dimensions is most likely impossible, or at least extremely difficult.
We argue that growth is complex and that profitable growth is the real challenge. Pay attention to how growth is measured, who is evaluating the growth rate, and with what agenda. Effective business strategies are highly dependent on understanding and balancing this complexity. Growth is not necessarily good, nor does it mean profitability. Employment growth means increased costs that can exceed revenue growth, thereby rendering the venture unprofitable. Employees are not the only cost factor and having no viable revenue model is far worse than having too many employees or excessive CEO pay.
Family firms should focus on the sustainability of the firm beyond the current generation. They might have lower levels of growth. Sustained profitability and firm survival are critical. This explains why some firms are more than 1000 years old and owned by the same family. Warren Buffet finds his best acquisitions are family firms which are profitable growth firms in a variety of industries, be it knowledge intensive or labor intensive; manufacturing or service industries; dynamic new sectors or mature ones. This article should challenge your own assumptions about what makes a successful venture and the importance of profitability over only high growth.
Brännback, M., Carsrud, A., & Kiviluoto, N. (2014). Understanding the Myth of High Growth Firms: The theory of the greater fool. Springer: New York.
Brännback, M., Carsrud, A., (2014) Are High Growth Firms really About Profits, or Just Greed? The European Business Review, July-August, 31-34
About the contributors:
Alan Carsrud is an FFI Fellow and professor of entrepreneurship and strategy at Finland’s Åbo Akademi University. He is also managing director of Carsrud & Associates, a consulting firm. Alan can be reached at firstname.lastname@example.org.
Malin Brännback is chair of international business at Åbo Akademi University. She can be reached at email@example.com.