The development stages of a business

Dear client,

Why is it that some business owners must work 15 hours a day to keep their businesses operating while other owners can go off and play golf as the business goes happily along on its own? Or how is it that some owners manage without any formal systems or overall strategies while others are driven to devote much attention to such approaches?

Although factors such as business size, diversity, complexity and management style is important, we want to focus on a noticeable factor.

Have you ever heard of the five stages through which small companies pass during their lifetime?

The stages have been labeled as:

  1. Existence
  2. Survival
  3. Success
  4. Take-off
  5. Resource Maturity

We want to help you in categorizing the problems and growth patterns of small businesses in a systematic way that is useful to the entrepreneur. They experience common problems at similar stages in their development. These points of similarity can be organized into a framework that increases understanding which can aid in assessing challenges, for example the need to upgrade an existing computer system to maintain planned growth.

The framework can help in anticipating the key requirements at various points, e.g. the time commitment for owners during the starting up period and the need for delegation and changes in their managerial roles when companies become larger and more complex. The framework also aids accountants and consultants in diagnosing problems and matching solutions to smaller enterprises.

The problems of a 6-month old, 20-employee business are rarely addressed based on a 30-year old, 100-employee manufacturing company. For the former, cash-flow planning is paramount, for the latter, strategic planning and budgeting are most important.

Growth are not always measured in terms of turnover, but other factors such as value-added services, number of locations, complexity of the product line and technology are also important.

We will discuss each of the stages over the next couple of months, so be sure that you do not miss out on our next newsletters!

Excerpts from Harvard Business Review

Stage one: 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:

1. Can we get enough customers?

2. Can we deliver our products/services well enough to become a viable business?

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

4. Do we have enough money to cover the considerable cash demands of this starting up phase?

The organization is a simple one: the owner does everything and directly supervises subordinates. Systems and formal planning are minimal to non-existent.

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 capital. The profile of a successful entrepreneur is that he/she is adaptable to change and comfortable with ambiguity, strongly individualistic and calculated risk takers.

However, many such companies never gain sufficient customer acceptance or product capability to become viable.

Common causes of failure are the following:

 

Business failing’s Human failings
Lack of resources e.g. cash Management neglect
Insufficient sales Excessive sales growth
Competitive weakness Lack of vision, expertise and experience
Excessive costs/assets Stubbornness and complacency
Collection problems Inability to adopt to change
Operational breakdowns Lack of delegation, planning
  Greed for personal gain

 

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 net asset value. 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 Two: 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 revenue and expenses.

The main questions are the following:

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

2.  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 limited number of employees supervised by a manager or general foreman. Neither of them makes major decisions independently, but carries out the 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.

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. They eventually go out of business when the owner gives up or retires. 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.

Common causes of failure in this phase are the following:

Business failing’s Human failings
Numerous or equally balanced competitors No creative insight
Slow industry growth No innovation
High fixed or storage costs Not willing to take opportunities
Lack of differentiation or switching costs Failure to seek help & remedial action
Capacity augmented in large increments Reliance on emotion and intuition only
Diverse competitors Lack of analysis
High strategic stakes Do not build a team of advisors, e.gaccountant, financier, legal advisor
High exit barriers (assets, labor agreements)  

 Stage 3: 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, the key issue is

  • whether to use the company as a platform for growth (Scenario A) or
  • a means of support for the owners as they completely or partially disengage from the company (Scenario B). Behind the disengagement might be a wish to start up new enterprises or simply to pursue hobbies and other outside interests while maintaining the business more or less in the status quo.

Scenario A

In this 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 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, as in Scenario B, 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 Stage 4. This is often the first attempt at growing to a growth strategy. If it is not successful, retrenchment to the survival stage is often the case.

Scenario B

In this Scenario, 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 require functional managers to take over certain duties performed by the owner. The managers should be competent and the main concern should be 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 an administrative controller in the office and a production scheduler. Basic financial, marketing and production systems are in place. Planning, in the form of 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 this 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 because 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. For franchise holders, this last option would necessitate the purchase of other franchises.

If the company can not adapt to changing circumstances, it will either fold or drop back to a marginally surviving company.

Stage 4: 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:

1. Delegation

  • Can the owner delegate responsibility to others to improve the managerial effectiveness of a fast growing and increasingly complex enterprise?
  • 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?

2. Cash demands

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

The organisation is decentralised and divisionalised, 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 is being done and involves specific managers. The owner and the business have become reasonably separate, yet the Company is still dominated by both the owner’s presence and 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 4, 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. If the problems are too extensive it may drop all the way back to the Survival stage or even fail. High interest rates and uneven economic conditions have made the latter all too real in the past few years. This is the stage of action and potentially large rewards.

Owners, who want such growth, must ask themselves:

a)     Do I have the quality and diversity of people needed to manage a growing company?

b)    Do I have now, or will I have shortly, the systems in place to handle the needs of a larger, more diversified company?

c)     Do I have the inclination and ability to delegate the decision making to my managers?

d)    Do I have enough cash and borrowing power along with the inclination to risk everything to pursue rapid growth?

Where the starting of a business requires of an entrepreneur an ability to do something very well (or a good marketable idea), high energy and a favorable cash flow forecast, these are less important in Stage 4, when well-developed people-management skills, good information systems and budget controls take priority. Perhaps this is why some experienced people from large companies fail to make good entrepreneurs or managers in small companies: they are used to delegating and are not good enough at doing.

The changing role of the owner clearly illustrates owner flexibility. An overwhelming preoccupation with cash is quite important at some stages such as in Take-Off and less important in others. “Doing” versus “delegating” also requires flexible management.

As the Company grows, other people enter sales, production or engineering and they first support, and then even supplant the owner’s skills – thus reducing the importance of this factor. At the same time, the owner must spend less time doing and more time managing. He or she must increase the amount of work done through other people, which means, delegating. The inability of many founders to let go of doing and to begin managing and delegating, explains the demise of many businesses in Stage 4.

 

Stage 5: 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 professionalise the company by use of such tools as budgets, strategic planning, management by objectives and standard cost systems, and to 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 decentralised, adequately staffed and experienced. 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 characterised 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 environment. Unfortunately for these businesses, it’s actually their rapidly growing competitors that notice the environmental change first.

Several factors, which change in importance as the business grows and develops, are prominent in determining ultimate success or failure. We have identified eight such factors in our research, four relate to the enterprise and four to the owner.

Factors relating to the enterprise:

  • Financial resources, including cash and borrowing power.
  • Personnel resources, relating to numbers, depth and quality of people, particularly at the management and staff levels.
  • System resources, in terms of the degree of sophistication of both information and planning and control systems.
  • Business resources, including customer relations, market share, supplier relations, manufacturing and distribution process, technology, all of which give the company a position in its industry and market.

Factors relating to the owner:

  • Owner’s goals for himself or herself and for the business.
  • Owner’s operational abilities in doing important jobs such as marketing, inventing, producing and managing distribution.
  • Owner’s managerial ability and willingness to delegate responsibility and to manage the activity of others.
  • Owner’s strategic abilities for looking beyond the present and matching the strengths and weaknesses of the company with his or her goals.

This model can be used to evaluate all sorts of business situations, even those that at first glance appear to be exceptions. Take the case of franchises:

These enterprises begin the Existence Stage with a number of differences from most start-up situations.

They often have the following advantages:

  • A market plan developed from extensive research;
  • Sophisticated information and control systems in place;
  • Operating procedures that are standarised and very well developed;
  • Promotion and other support such as brand identification;
  • They also require relatively high start-up capital

If the franchiser has done sound market analysis and has a solid, differentiated product, the new venture can move rapidly through the Existence and survival stages – where many new ventures founder – and into the early stages of Success. 

The costs to the franchisee for these beginning advantages are usually as follows:

  • Limited growth due to territory restrictions.
  • Heavy dependence on the franchisor for continued economic health.
  • Potential for later failure as the entity enters Stage III without the maturing experiences of stages I and II.

One way to grow with franchising is to acquire multiple units or territories.  Managing several of these, of course, takes a different set of skills than managing one and it is the lack of survival experience that can become damaging. 

Another seeming exception is high-technology start-ups.  These are highly visible companies such as computer software businesses, genetic engineering enterprises, or laser development companies – that attract much interest from the investment community.  Entrepreneurs and investors who start them often intend that they grow quite rapidly and then go public or be sold to other corporations.  This strategy requires them to acquire a permanent source of outside capital almost from the beginning.  The providers of this cash, usually venture capitalists, may bring planning and operating systems of a Stage III or a Stage IV company to the organisation along with an outside board of directors to oversee the investment.

The resources provided enable this entity to jump through Stage I, last out Stage II until the product comes to market, and attain Stage III.  At this point, the planned strategy for growth is often beyond the managerial capabilities of the founding owner and the outside capital interests may dictate a management change.  In such cases, the company moves rapidly into Stage IV and, depending on the competence of the development, marketing, and production people, the company becomes a big success or an expensive failure.  The problems that beset both franchises and high-technology companies stem from a mismatch of the founders’ problem-solving skills and the demands that “forced evolution” bring to the company.

Besides the extreme examples of the franchises and high-technology companies, we found that while a number of other companies appeared to be at a given stage of development, they were, on closer examination, actually at one stage with regard to a particular factor and at another stage with regard to the others.  For example, one company had an abundance of cash from a period of controlled growth (Stage III) and was ready to accelerate its expansion, while at the same time the owner was trying to supervise everybody (Stage I or II). 

Although rarely is a factor more than one stage ahead of or behind the company as a whole, an imbalance of factors can create serious problems for the entrepreneur.  Indeed, one of the major challenges in a small company is the fact that both the problems faced and the skills necessary to deal with them change as the company grows.  Thus, owners must anticipate and manage the factors as they become important to the company.

A company’s development stage determines the managerial factors that must be dealt with.  Its plans help determine which factors will eventually have to be faced.  Knowing its development stage and future plans enables managers, consultants, and investors to make more informed choices and to prepare themselves and their companies for later challenges.  While each enterprise is unique in many ways, all face similar problems and all are subject to great changes.  That may well be why being an owner is so much fun and such a challenge.

 

Extracts from Harvard Business Review

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