The Five Stages of Small Business Growth
Categorizing the problems and growth patterns of small businesses in a systematic way that is useful to entrepreneurs seems at first glance a hopeless task. Small businesses vary widely in size and capacity for growth. They are characterized by independence of action, differing organizational structures, and varied management styles.
Yet on closer scrutiny, it becomes apparent that they experience common problems arising at similar stages in their development. These points of similarity can be organized into a framework that increases our understanding of the nature, characteristics, and problems of businesses ranging from a corner dry cleaning establishment with two or three minimum-wage employees to a $20-million-a-year computer software company experiencing a 40% annual rate of growths.
For owners and managers of small businesses, such an understanding can aid in assessing current challenges; for example, the need to upgrade an existing computer system or to hire and train second-level managers to maintain planned growth.
It can help in anticipating the key requirements at various points—e.g., the inordinate time commitment for owners during the start-up period and the need for delegation and changes in their managerial roles when companies become larger and more complex.
The framework also provides a basis for evaluating the impact of present and proposed governmental regulations and policies on one’s business. A case in point is the exclusion of dividends from double taxation, which could be of great help to a profitable, mature, and stable business like a funeral home but of no help at all to a new, rapidly growing, high-technology enterprise.
Finally, the framework aids accountants and consultants in diagnosing problems and matching solutions to smaller enterprises. The problems of a 6-month-old, 20-person business are rarely addressed by advice based on a 30-year-old, 100-person manufacturing company. For the former, cash-flow planning is paramount; for the latter, strategic planning and budgeting to achieve coordination and operating control are most important.
Developing a Small Business Framework
Various researchers over the years have developed models for examining businesses (see Exhibit 1). Each uses business size as one dimension and company maturity or the stage of growth as a second dimension. While useful in many respects, these frameworks are inappropriate for small businesses on at least three counts.
Exhibit 1 Growth Phases
First, they assume that a company must grow and pass through all stages of development or die in the attempt. Second, the models fail to capture the important early stages in a company’s origin and growth. Third, these frameworks characterize company size largely in terms of annual sales (although some mention number of employees) and ignore other factors such as value added, number of locations, complexity of product line, and rate of change in products or production technology.
To develop a framework relevant to small and growing businesses, we used a combination of experience, a search of the literature, and empirical research. (See the second insert.) The framework that evolved from this effort delineates the five stages of development shown in Exhibit 2. Each stage is characterized by an index of size, diversity, and complexity and described by five management factors: managerial style, organizational structure, extent of formal systems, major strategic goals, and the owner’s involvement in the business. We depict each stage in Exhibit 3 and describe each narratively in this article.
About the Research
Exhibit 2 Growth Stages
Exhibit 3 Characteristics of Small Business at Each Stage of Development
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.
Exhibit 4 Evolution of Small Companies
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 labor?
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—a substage III-G company—or as a means of support for the owners as they completely or partially disengage from the company—making it a substage III-D company. (See Exhibit 3.) 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.
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.
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).
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.
Looking Back on Business Development Models
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, as in substage III-D, 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 III-G company proceeds into Stage IV. Indeed, III-G is often the first attempt at growing before commitment to a growth strategy. If the III-G company is unsuccessful, the causes may be detected in time for the company to shift to III-D. 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:
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?
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?
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).