The Conditions for Controlled Growth

4th in a series on Strategic Growth

In last week's post we discussed the case for pursuing controlled growth.  But is controlled growth always viable?  No.  So what are the conditions necessary to viability?

First, you can't be in an industry where fast growth is a necessity.  These conditions were discussed in a previous post The Rationale Behind Fast Growth.

Assuming that these don't apply, the main condition for being able to pursue controlled growth is a company's ability to erect competitive barriers to entry or, in other words, the ability to create long term sustainable competitive advantages (LTSCA for short).  This term is most associated with Michael Porter, author of Competitive Advantage and develop of the Five Forces competitive strategy framework.

Creating Barriers to Entry

Creating a barrier to entry starts by first accepting the fact that you have competition.  Not that you might have competition in the future.  Not that you will have competition.  But rather that you have competition right now, right out of the gate.  Why the distinction?

Because I've noticed that entrepreneurs who don't believe they have competition right now (i.e. "there's nothing like it out in the market!") are vulnerable to problems associated with competitive substitutes.  A competitive substitute is a set of products or services that, when combined together, can serve the same function as your product solution.  For example, if I need to tally up a long string of numbers, I generally use a calculator.  But I could also use the calculator application on my smartphone, a digital watch, an abacus, a pencil & paper, or just my head.  All are competitive substitutes to the calculator.

What problems?

• Weak relative value proposition - In the quest for product/market fit, there are two elements of value that must be established.  The first is the intrinsic value to the customer - the value received by the customer using your solution to address a need.  The second is the relative competitive value of your solution versus an alternative.  By not downplaying competitive substitutes, these same entrepreneurs are then surprised when customer adoption is slower than it "should be."  Remember, status quo and doing nothing are legitimate customer purchase behaviors.
• Neglecting to search for barriers other than first mover advantage and scale - So what happens if the company can't grow as quickly as expected?  Does this mean the business is not viable?  A good question to ask is "assuming that someone else reaches the market first and grows faster, how would we then compete?"  This may uncover potentially lucrative sources of LTSCA.
• Surprised by fast followers or disruptive technologies - As discussed in a previous post, being a fast follower is at least as viable a route to market leadership as being a first mover.  Many times, fast followers come from fringe products that don't directly compete...at first.  This is classic Innovator's Dilemma.

It is not a goal of business to eliminate all competition;  this is impossible.  But one business goal should be to establish a defensible perimeter large enough and profitable enough inside of which it can thrive.  It's not good enough to play great offense;  a business needs to be able to play defense too.

Sources of Long Term Sustainable Competitive Advantage
So what makes an ideal LTSCA and where do they come from?  Ideally, an LTSCA must have significant value but be hard to replicate.  Without going into detail, here is a quick listof sources:

• Size - market share, financial deep pockets, economies of scale
• Lowest Cost - from superior operational efficiency
• Superior Capability - organizational performance, product leadership, technology
• Control of Limited Resources - natural resource (e.g. mines, oil), suppliers, sales channel, shelfspace, parter and customer networks, unique information, technical skills
• Switching Costs - functional (e.g. unique part), retraining, work habits, sunk costs
• Loyalty - brand, customer
• Legal - patents, trademarks, favorable regulations (e.g. electric power utilities)

Aside from size, one does not need to be IBM to cultivate the development of one or more of these LTSCAs.

LTSCAs generally build over time.  If a company sets out with the intention that every year it will continuously enhance its capabilities in a lasting way, over time, this can result in a formidable barrier to entry.  This incremental approach is often more robust than embarking on the massive change initiative of the year approach practiced by many companies.  This is the idea behind Jim Collins's Flywheel concept from Good to Great.  Small actions timed right can build lasting momentum.

So what does controlled growth mean?  Is it revenue growth of 5% per year or 50%?  The useless answer:  it depends.  It depends on your industry and your business.  The final post in this series will look at the useful answer.

Next week:  Determining Your "Natural" Growth Rate

The Case for Controlled Growth

3rd in a series on Strategic Growth

Last week we discussed some of the reasons that justify a fast growth approach.  This week, we discuss some of the reasons to pursue a controlled growth strategy, which I define as one where management restricts the growth of the business to be within the constraints of its ability to internally generate growth capital, hire the right people, and adsorb lessons.  Restrict the business?  How does one do that?

By limiting the acquisition of new customers (pause)....Are you out of your #$!$@!# mind!?

Before you answer that, let me digress to on the lessons taught by one of today's classic business books, Good to Great by Jim Collins.

Lessons from Good to Great
Good to Great is a favorite on most manager's reading lists.  While there are a lot of takeaways from the book, I want to focus on just a few relevant to growth.  First, Collins shows the hockey stick pattern that he uses to characterize good-to-great companies vs. standard comparables.  In this case, he uses a stock price chart as an indicator of growth:

Source:  Collins, James, Good to Great, Harper Collins, New York (2001), p.4.

Now the hockey stick forecast is a long standing joke of corporate forecasting, but strangely enough it does happen.  Here is a revenue case if you don't buy into stock prices as an indicator of growth:

Data from http://commons.wikimedia.org/wiki/File:Ipod_sales_per_quarter.svg

Collins then goes on to create the diagram below which represents his Good to Great framework:

Source:  Collins, James, Good to Great, Harper Collins, New York (2001), p.12.

What is significant about the hockey stick pattern is the existence of the buildup phase prior to breakthrough.  One message here is that high growth stems from what the company does during the buildup phase.  Collins describes these concepts Level 5 Leadership, First Who...Then What, Confront the Brutal Facts, and as the company achieves breakthrough, the Hedgehog Concept.  Read the book if you want more detail.

Depending on the nature of the business, the buildup phase can be quite long.  Why and what are the key reasons behind this?  My purely empirical observations:

• The ability to grow is dependent on the quality and robustness of the business model - By business model, I mean how a company delivers value to acquire customers, generate profits, and what the scaling factors are.
• The business model and its execution are dependent on the quality, creativity, and productivity of the company's people - They are the ones who tweak the model, build and deliver the product, service the customer, improve the system, and eliminate waste.
• It takes time to get the people right - It takes time to hire and to train.  It takes time for people to learn and master their jobs within the specific context of your business.  And it takes time to figure out who is working out and replace those who aren't.
• It takes time to forge people into a team - Creativity and productivity depend on having more than just a collection of talented individuals.  They need to be blended and forged into a team where one can reap the benefits of esprit-de-corp, shorthand communication, reinforcing work styles, and knowing how their teammates think.  This comes when people work together, fight with each, and reconcile with each other.

The common element is time.  Money is only a partial substitute to the degree that it allows you to hire experts (who have already put in their 10,000 hours towards mastery) or accelerate learning and experimentation.

Limiting Customers Acquisition
This brings us back to limiting customer acquisition.  When does this become important?  It's important when a particular customer brings "just revenue" that detracts from getting the business model and people right.  I'm not being flip about "just revenue."  There is a chicken and egg issue here that requires judgment.

In order to develop and tune the business model, you need some customer traction.  For a pre-revenue early stage startup, it's not a question of limiting customer acquisition.  Customer acquisition is the name of the game but more as validation of product/market fit than for the dollars, which are almost always small to start.

But once customers have been acquired and the company is attempting to validate and tune a scalable business model, the desire to prematurely scale, usually driven by dwindling cash and insufficient resources can lead a company to grasp for any customer.  This is where limiting customers becomes important.  A company at this stage needs to make sure it's accepting the right customers (i.e. target customers).  Not all revenue is created equal.

Taking on the wrong customers just for revenue can pull a company away from its core strengths and out to the fringes of your business model.  And projects operating on the fringes usually tie up a disproportionate amount of resources resulting in little net gain.  (After all, if a fringe project is highly lucrative, you might want to reexamine your business to see if this should be the business!) You need to say no to these customers.  The essence of niche segmentation and Collins's Hedgehog Concept is focusing to deliver superior value to the target customer set.

But what if they are the target customer?  Should you turn them away?  This is a matter of resources.  If by adding another target customer, you outstrip your ability to maintain the quality of your offering, then you need to seriously consider this.  It is true that if you don't accept the customer, they will probably end up with a competitor, so one must take into account the strategic ramifications (i.e. are they a marquee account).  But outstripping your ability means that you won't be able to sustain superior value to your existing customers, leaving yourself vulnerable to the competition.  And it is a sales truism that retaining an existing customer is easier than winning a new one.

Is Controlled Growth the Path to High Growth?
If controlled growth fosters the success of the buildup phase which Good to Great implies is the path to sustainable high growth, does this mean controlled growth is the secret to high growth?  Not necessarily.  First, for a variety of reasons, some businesses may never have the potential for high growth (e.g. limited market, regulation, high fragmentation).  Second, external financing can accelerate the buildup phase; in fact this is what angels investors and venture capitalists seek to do.

Third, the ability to pursue controlled growth is dependent on a number of conditions.  This will be the subject of the next post.

Next week:  The Conditions for Controlled Growth

The Rationale Behind Fast Growth

2nd in a series on Strategic Growth

Last week we discussed some of the pitfalls in uncritically buying into the Silicon Valley growth mystique.  This is not to say one should not pursue fast growth!  But because of these challenges, it is important that entrepreneurs understand their reasons for pursuing it.  Some of the common ones:

• Industry competitive dynamics require it
• To gain 1st mover advantage
• Industry is capital intensive
• To make an impact
• To create opportunities needed to attract and retain great people
• To get rich quick

Let's examine each of these.

Industry Competitive Dynamics

There are two cases where the nature of the industry may require fast growth. The first is where inherent barriers to entry are low or difficult to develop.  The second is where technology change is frequent and rapid.

Internet social media is an example.  In many cases, the core ideas and business models are not readily protectable by patents, the viability of the business is heavily dependent on network effects, the technology is constantly changing and because of SaaS ("software as a service") and cloud computing, the cost of entry is low and getting cheaper by the minute.  As a result, it's a race to see who can aggregate the most users fastest and perhaps build brand name recognition or create other switching costs before the inevitable industry shakeout.  Once consolidation occurs, most industries end up being dominated by 2-4 large players with a myriad of smaller players.

So how do small players survive?  Are they doomed to mediocrity and eking out a profitless existence?  No.  Smaller players thrive by effective segmentation - providing a superior offering to a narrower niche and erecting effective barriers to entry.  Of course, their business models will be vastly different than the market share leaders.  (E.g, a niche social media company might be heavily reliant on subscriber revenue vs. Facebook's which can pursue and ad share model.)  The more effective the barriers to entry, the more likely the company will be able to sustain healthy margins and have the ability to control its own growth.

However, if you decide that you don't want to or can't pursue a niche strategy, then at least don't kid yourself that you're going to bootstrap your way to dominance.  You've just entered the Red Queen's Race, you will need institutional money, and you will need to grow fast.

1st Mover Advantage
This is often closely related to the above, but even if industry dynamics don't require fast growth, there is a belief that being first to market yields strategic advantage.

Unfortunately, the evidence for this belief is shaky.

In fact, a 1996 study by Gerard Tellis and Peter Golder indicates that being a fast follower may be a better path to industry leadership than being a first mover.  Well known cases of fast followers cited by blogger Don Dodge include Google (over Alta Vista), Internet Explorer (over Netscape), and Facebook (over Friendster) just to name a few.

Being first is not necessarily synonymous with becoming the market leader, nor is is a precondition for fast growth.

Industry is Capital Intensive
Highly capital intensive industries often force companies to pursue high growth.  The medical device industry is an example.  Because of the highly regulated nature of the FDA product development and approval process, it takes millions of dollars to get an innovative new medical device to market.  For a medical device startup, this typically means venture capital money is required.  In order to get this funding, it is necessary to pursue a growth rate commensurate with the returns required by the VC funds.

Increase Impact
Another argument for fast growth is the entrepreneurial motivation to make a big impact.  Think Elon Musk with Tesla and SpaceX.  But making an impact is often more about scope than speed.  Certainly SpaceX is going to take a long time to grow given the technological, political, and other challenges associated with developing commercial space flight.  If fast growth were required, this venture would be dead.  Scope is not analogous to fast growth.

Create Opportunities Needed to Attract and Retain Great People
Growth is definitely a plus in providing opportunities for the best and the brightest.  But in this case, its not a case of more is better, but rather finding an optimum.  Too little and people stagnate, get bored, or depart for greener pastures.  But too fast and people don't have the time to learn, make mistakes, and receive the training they need to master the skills needed to grow.  And while promotions can be rapid in a hypergrowth environment, too often you end up with the Peter Principle in action, the situation where people are promoted to their level of incompetence.  What is the optimum growth rate?  In my experience it seems to be revenue growth somewhere between 15-50% per year.

Get Rich Quick
While rarely spoken of openly, this is an underlying motivation for pursuing fast growth and it's a bad one.  It's not bad because it's immoral;  it's bad because it doesn't work.  Maybe I hang out with the wrong circle, but I have yet to meet a successful entrepreneur who got rich because that was their main objective.  The ones I know who did get struck by financial lightening got there because they first and foremost wanted to achieve something and make a mark but also believed that they should be rewarded for it.

Why?  Because people who just want to get rich tend to flit from one hot opportunity to another.  They tend not to have the patience or perseverance required to work through the knotty difficulties that every startup encounters.  When faced with a brick wall, they zoom off in another direction (not always the wrong thing to do) or even another venture.  They are prone to making short term compromises that undercut the creation of long term value. Creating value requires the ability to say "no" to the expedient at times.

On the other hand, I do know several successful entrepreneurs for whom financial wealth came almost as a surprise.  While they all had a burning  desire to create something unique or great, they had modest ambitions with respect to how quickly they wanted to get there and for their own personal wealth.  The funny thing is that it's for these people for whom the lightening sometimes strikes and it's not entirely an accident.  Next week, we'll examine some of the reasons that may be behind this.

Next week:  The Case for Controlled Growth

The Growth Mystique: A Silicon Valley Parable

1st in a series on Strategic Growth

Once upon a time, a man wandering through Silicon Valley found a starving baby.  Wanting to help, the man took the baby home and fed it.  The baby was ravenous and required more and more food until one day, the baby was no longer a baby but a strapping 6'5" 290 pound teenager.  Hmm, wondered the man, maybe he could play football?  So he contacted a local football team and sure enough the teen proved to be perfect for their offensive line.  The team signed the teen to a multimillion dollar contract and gave the man a nice contract to develop more offensive lineman.

Thrilled that he had found the recipe for growing offensive linemen, the man rushed out to round up starving babies and force feed them to get them to grow.  Unfortunately, some died from the force feeding.  Some got fat and lounged around not doing much.  Others turned into perfectly ordinary young men, fine for most things, but not football.  However, a few of the babies did indeed turn into strapping successful football players such that the man was able to make a nice living taking money form football teams and using it to buy food to feed the babies.

The man's reputation for growing offensive linemen grew and he began to be sought out by boys wanting to be football players.  Inundated with applicants and trying to improve his success rate, the man began to conduct due diligence on the boys for growth potential based on his understanding of the formula for growing football players.  But the boys were smart and became adept at convincing the man that they were "scalable" provided that they had access to massive amounts of food.  As the man gained experience, fewer boys died from force feeding, but overall some boys just got fat, others turned into ordinary young men, and a few turned into strapping successful football players just like before.

Before long, other people began to copy the man by seeking out relationships with football teams and collecting children to feed with much the same results.  Consultants sprang up aimed at helping aspiring boys enter the force feeding programs of the man and his competitors.  Pretty soon the area gained a reputation for growing football players, not just offensive linemen, but defensive linemen, quarterbacks, and running backs too.  Boys from all over flocked to the area for a chance to be grown into football players.

And what about the ordinary young men?  A few died in utter despair.  Some continued to try to secure food from the man's competitors with some of the more golden tongued even succeeding, but it rarely changed the results and most remained ordinary young men.  Others, their dreams dashed, just drifted away.

But a few figured out that there was nothing wrong with being ordinary, at least in the height and weight dimension, and discovered other things they could do outside of football, which didn't require huge amounts of food, and for which they were well suited.  And they lived happily ever after.

OK, so Aesop I'm not, but perhaps you see my point.  Living in Silicon Valley, it's easy to get caught up in the growth mystique.  This is the land of the fast growth, scalable startup, from Apple to Zynga⁽¹⁾.  Silicon Valley is all about the scrappy entrepreneur with the big idea, who assembles a world class team, which living on Ramen in a garage, attracts venture capital, and hyper-grows the company in 5-7 years straight to an IPO (or at least an acquisition by Google).  Fame!  Fortune!  The crowd goes wild!!!

The only problem with this picture is that most startups will turn out to be ordinary young men and our view of ordinary is skewed.  Silicon Valley is probably the only place in the world where a company with $50 million in sales growing at 15-20% per year⁽²⁾ and a 10% net margin is viewed as underperforming⁽³⁾.

The problem with succumbing to the growth mystique is that it can be damaging to what could otherwise be a perfectly good business - one that meets a real need for customers, provides good jobs and opportunities for people, strengthens communities, and provides a fair return to investors.  The problem is not with scalability;  it is my observation that designing a business to be scalable almost always improves it.  The problem is with the expected growth rate.  While fast growth requires scalability, scalability is not the same as fast growth.

The growth mystique automatically assumes that fast growth is desirable.  Now this may be true, and we'll discuss some of the reasons in next week's post, but it tends to gloss over the problems associated with fast growth such as:

• Fast growth is cash intensive - Not only will you need to invest ahead in terms of people and infrastructure, but often just the growth in working capital alone required to float the business can be significant.  This almost certainly means raising institutional money, either in the form of equity or debt.  Fundraising can be a significant drain of management time and resources that will be diverted from the core business.  If you're raising cash via equity, the founders will almost certainly experience significant dilution with some loss of control.  If you're raising cash via debt, management freedom will likely be constrained by covenants.  The money ain't free.
• Fast growth is demanding in terms of hiring and people management... - Sometimes more than cash, finding enough of the right people can be the constraint.  As workload piles up, the temptation to fill a position with any warm body can cause one to sacrifice on the quality of hire which can create greater management issues.  A larger organization usually requires more formal structures and overhead to manage.  And if the company is growing quickly, there is a higher likelihood of reorganizations which disrupt lines of communications and workflow coordination.
• ...and stresses business systems... - Which means that you either need to overbuild systems, which can be expensive and cumbersome until you grow into them or that you'll be playing patch-up/catch-up with your existing undersized processes with the potential for increasing mistakes and dropped balls.
• ...often leading to customer service and quality issues - and losing customers is a sure way to put a cramp in your growth.
• Fast growth is intolerant of faults - When you're in fast growth mode, your company is more exposed to blowing up in the face of an external shock or operational hiccup, just like blowing a tire driving at 30 mph is a lot less of an issue than blowing one while driving at 200 mph.

In addition to these problems, fast growth can strategically weaken a company by keeping it from developing effective long term sustainable competitive advantages (i.e. barriers to entry) other than 1st mover or largest share.  This locks the company into a Red Queen's Race where it is forced to run ever faster just to stay in place.

So don't just assume that your business should be fast growth.  While this might very well be the case, it's important to understand the reasons why.  On the flip side, don't assume that you should pursue a controlled growth strategy;  it might not be an option.  Again, it's important to understand the reasons why.

Next week:  The Rationale Behind Fast Growth

Footnotes:
(1)  And from B to Y:  Brocade Communications, Cisco, Dionex, eBay, Facebook, Google, H-P, Intel, Juniper Networks, KLA, Lam Research, McAfee, Nvdia, Oracle, Plantronics, Quantum, Rambus, Symantec, Twitter, Ultratech, VMWare, Webex (now Cisco), Xilinx, and Yahoo.
(2) This means it will take the company 4-5 years (gasp! horror!) to double sales.
(3)  If you own such a company and would like to sell it, please give me a call!

Preparing for a Lucky Break

I got back last week from a week in the Sierra's at my son's Boy Scout camp.  One thing I really like about the Boy Scouts is their emphasis on the scouts learning from experience.  This applies to everything from merit badges, to outdoor skills, to leadership.  (The role of the adult leaders at camp is mainly to make sure the scouts don't get eaten by bears and that they shower at least once.)

In the process of learning, the scouts struggle, make mistakes, and are forced to deal with the consequences of their preparation, or in many cases their lack of preparation.  As a dad, I sometimes feel like my kids live by the motto of "never do today what you can put off until tomorrow."  As a result, I've gained a new appreciation for the genius beyond the Boy Scout Motto:  Be Prepared.

In listening to the tales of many successful entrepreneurs, a common element of these stories is the lucky break, of being at the right place at the right time.  But the more I listen to these stories, the more I'm convinced that a lot of being lucky is actually being prepared.

For example, if you win a free heli-skiing trip to the Canadian Rockies, is this a lucky break or not? Yes, but only if you can ski well.  It was certainly a lucky break for Calvin Klein when, in 1968, a buyer from Bonwit Teller accidentally wandered into his studio after getting off the elevator on the wrong floor.  But only because prior to that day, Klein had spent over six years as an apprentice designer after training at the Fashion Institute of Technology in New York and had something sufficiently impressive to get the buyer to place a $50,000 order.

So how does one prepare for a lucky break?

• Network with lots of people  - Most lucky break stories almost always involve a meeting with the right person.  The more you meet, the more likely someone interesting will turn up.
• Learn, learn, learn - Be curious.  Learn from other people's experiences.  Learn a skill.  The more you learn, the more likely it is that you'll actually know something that can be applied to taking advantage of a lucky break.
• Learn to recognize opportunity; expand your horizons - According to a study sponsored by the Kauffman Foundation, ~25% of the founders of U.S. technology based companies started between 1995 and 2005 were  foreign born. In Silicon Valley, this figure was 52%.  Why?  I don't believe it's because these people were any smarter or better trained than their native U.S. counterparts.  In fact, many of these foreign born entrepreneurs were educated in the U.S.  Instead, I believe it's because  having grown up in a different environment, these foreign born entrepreneurs were able to recognize opportunities invisible to the native born.  Fish don't see the water they are swimming in.  It's tough to take advantage of a lucky break if you can't recognize it.
•  Practice your skills by struggling with a problems - In a quote attributed to Arnold Palmer (among others), "the more I practice, the luckier I get."  Get into the trenches.  Apply your skills to solving a problem and wrestle with frustrating details.  The devil is in the details but so are the insights that lead to opportunity recognition.  Anyone can recognize a general opportunity at a high level.  But solutions only exist where the rubber hits the road.
• Step out of your comfort zone and try - As I tell my kids, I can't guarantee that if you try something that you'll succeed, but I can guarantee that if you don't try it you won't.

Or to quote from one of America's great early entrepreneur's:

"Diligence is the mother of good luck."

- Benjamin Franklin -

Get lucky.  Be prepared.