CRITICAL STAGES OF SMALL BUSINESS GROWTH

When they occur and how to survive them

LAWRENCE L. STEINMETZ

Mr. Steinmetz is an associate processor, School o f Business, University o f Colorado.

A small business-if it is succeeding-is ines- capably committed to living through three critical phases of growth. The only alternative to forced growth is the demise o f the business and the probable loss o f nearly 50 percent o f the assets. The rewards o f survival can be phenomenal. Phase 1 occurs in the direct supervision stage; Phase 2 in the supervised supervision stage; and Phase 3 in the indirect control stage, when the firm has "arrived" at last. What can the small businessman do to ensure his progress through these stages and ease his own development from autocrat to professional manager? I f he does not solve the problems encountered at each stage he can expect to go out o f business. This article pinpoints these problems; recognition of them is the first step toward their solution.

Are you working longer hours and enjoying it less? Has it seemed that your business expands but your profits do not? Are the "little guys" taking all the gravy business? Do you feel you have to do something, but you don't know what? Maybe an explanation is in order.

Most men who have been successful in operating their own businesses seem to have

been able, intuitively or instinctively, to figure out what causes waning profits, organizational headaches, and acute personnel problems. They have managed to revitalize their businesses when-if not before-such problems occur. Unfortunately, many small businessmen have not had such insight. For these, this article will describe the three critical phases of small business growth. These phases are critical because failure to live through them will result in the death of the business, either because the business must be liquidated or sold to another company because continued operations would be unprofitable.

THE TYPICAL GROWTH CURVE

It has been known for some time that the growth pattern of the typical small business is S-shaped. This growth curve shows the stages of a firm's growth and their critical phases (see accompanying figure). The three critical areas are Stage 1, which occurs in the direct super- vision stage of growth; Stage 2, which occurs in the supervised supervision stage; and Stage 3, which occurs in the indirect control stage.

Stage 1 problems occur about the time the

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Lawrence L. Steinmetz

Stages of Organizational Growth and Their Critical Phases

30

Stage I-Direct Supervision

=r

25-30 Employees, $500,000- 750, 000

in Assets

g

Stage II-Supervised : Stage IlI-lndirect ! Stage IV-Divisional Supervisor : Control : Organization

•

:

• °

250-300 Employees, 750-1,000 Employees, $ 7-10 Million $25-50 Million

in Assets in Assets

organization has 25 or 30 employees and $500,000-$750,000 in invested capital. If the organization .lives through its problems and difficulties at this stage, it develops into a Stage II business. At this point, the organization experiences very rapid growth, increases in sales volmne, additions of personnel, and improved profitability. Most organizations having be- tween 30 and 300 employees, and with assets of perhaps $5-$10 million dollars, are in Stage

II. It is far and away the most profitable stage of growth for the small business, the time at which the rate o f return on invested funds will far exceed the returns in Stages I and III. Unfortunately, a critical point is reached in Stage II (when the firm has 250-300 employees, $7-$10 million in assets)-a point where the rapid rate of growth begins to hit its peak and, again, death of the firm may occur. Death here usually does not mean liquidation, but it does

BUSINESS HORIZONS

Stages of Small Business Growth

mean failure (usually via merger) and loss of identity of the original small business.

If the small businessman has enough fore- sight or luck, he will guide his business through this second critical phase and will arrive at Stage III. Stage III is delightful for the small businessman, because the odds of death of the business are now considerably reduced; the firm has "arrived" by most people's standards. It is characterized by total indirect control upon the part of the small businessman.

Now for the real question at hand: what are the tip-offs that should alert the small businessman that his business is approaching the critical phases in its growth, and what can be done to obviate the accompanying prob- lems?

STAGE I -L IVE OR DIE

The prognosis for the small businessman just starting out-even if he is successful-is a fairly limited rate of return on his investment. At this stage the small businessman is a rather pathetic individual. As Collins and Moore have said:

The image of the entepreneur as a great inventor and great promoter or the great and daring risk-taker simply doesn't square with the facts. Reality is far less spectacular than this. In fact, the beginning entrepreneurship turns out to be a mundane affair and not at all heroic. There is the entrepreneur without capital re- source, without apparent social skills, and without even a good idea. No respectable element in the community is even aware of him, let alone ready to help him. 1

In short, the stereotype of the small busi- nessman in the early stage of organizational growth is an unimaginative man who feels he has a good idea; whose role as a leader of his business is largely a result of his ownership rights rather than leadership talents; and who may or may not be able to develop a few loyal employees. Fundamentally, he is relying on

1. Orvis F. Collins and David G. Moore with Darab B. UnwaUa, The Enterprising Man (East Lansing, Mich.: Michigan State University Press, 1964), pp. 242-43.

personal skills or a unique product (or method or market) of which he can take advantage. He is usually not concerned about the rate of return, being more concerned with keeping the sheriff away from the door. However, assuming that he is successful-that he is not among the 50 percent of the people who will lose their business and 44 percent of their savings 2 -he will experience a slow but sure increase in sales and profitability. Unfortunately, this is where his problems come in; he is at the threshold of the first critical stage in his organization's growth.

A critical stage in growth is reached at this point because prior to this time the business has been a one-man operation, experiencing no real management problems other than "buying low and selling high." However, as the level of business increases a myriad of problems devel- op: paperwork multiplies, personnel must be added to the payroll, promised dates are not met, facilities get crowded, and so on. At first, of course, a few extra working hours are sufficient to cope with these problems. How- ever, if business is good these minor problems rapidly assume major proportions. Paperwork is not only time-consuming, but more and more is required; the Internal Revenue Service begins to demand more elaborate tax information; bills begin trickling in at all times of the month; and accounts receivable begin to lag merely because statements are not mailed.

Furthermore, the increasing number of personnel begins to complicate matters. First, of course, the manager must spend more and more time in recruiting, selecting, developing, and training new employees. Then there is the problem of maintaining an acceptable relation- ship with employees already on the payroll. Once enough employees are added, the small businessman must begin to comply with unemployment compensation, minimum wage laws, and so on. The problems confronted by the small businessman, once he achieves a

2. Lawrence L. Steinmetz, John B. Kline, and Donald P. Stegall, Managing the Small Business (Homewood, Ill.: Richard D. Irwin, Inc., 1966), p. 29.

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modicum of success, may be enumerated brief- ly.

His organization becomes too large to permit him to supervise the efforts of all his people directly.

With inadequate supervision, some of his employees become disloyal and begin to resent the hard-driving attitude of the owner, thus creating motivational problems.

Competition sets in and gets keener be- cause others see a "good thing" going and sense the possibility of quick or easy profit.

The owner-manager (who heretofore has not had to be a real manager but just an owner-worker) is under increasing pressure to delegate work. He usually delegates ineffective- ly because he is not comfortable in this role.

Some of the growth pains of the success image begin to set in- the garage-factory gets too small, the rented facilities somehow seem cluttered, and new quarters seem to be urgently (and expensively) in order.

The market for the unique skill (or product or service), of the small businessman begins to dry up, shift toward some other skill, product or service, or, worst of all, is stolen by a (giant) competitor.

The manager, is continuously pressed for "time to do what needs doing."

The manager experiences an overload of w o r r y .

All difficulties become problems of crisis proportions.

These problems normally beset the small businessman when he is hiring between ten and thirty employees, and indicate the point on his growth curve where he faces the first serious threat to the continued existence of his busi- ness. And the facts are that if he does not begin to think in terms of overcoming these prob- lems, he can expect to go out of business. His competition will become increasingly strong, he will have more personnel problems, his account- ing and record-keeping problems will become a "stone around his neck," and he may find that he is being outstripped by other small busi- nesses or by a giant that "doesn't like him."

At this stage, unfortunately, either the small businessman will succeed or he will fail. Statistics show that he cannot stagnate and stay small, nor can he even entertain the notion of hoping that his business will stabilize. He must press on or his business will die. Of course if he

is a man who is aware of what it means to manage-to plan, organize, direct, and con-

t ro l -he will pass through this critical phase, will move into Stage II, and become a capable supervisor of supervisors. If not, his business is doomed. But how does he move successfully into Stage II?

STAGE II-BEING A MANAGER

The activities of those small businessmen who successfully enter Stage II in the normal growth pattern of their firms are entirely different from those actions taken by the owner-worker of the Stage I business. The Stage II small businessman truly becomes a manager rather than a mere owner of his operation. He assumes a certain entrepreneurial aura, partly because of success (he has, after all, become successful) and partly because of charisma. Further, both of these images feed on each other and combine with the fact that normally he will be making more money than ever before in his l ife- probably more than 95 percent of the working population in his community.

Being a successful, charismatic individual is not the only characteristic of the owner of the small business during growth in Stage 11. Typically, he devotes a great deal of attention to being a manager. Suddenly, perhaps acciden- tally, he learns how to delegate. Furthermore, he learns how to delegate through one or two levels of command and develops good "lieuten- ants." Another characteristic of the manager in this stage is that he usually develops a new method or gimmick to enhance or capitalize on the unique skill, product, or service which he found so useful in Stage I. He may diversify his line or service, capitalize on the use of waste material, or perhaps even integrate horizontally or vertically.

In addition, he now becomes a far more adept financial manager and managerial expert. He becomes aware (by observing competition, talking to other successful small businessmen, reading, or other education) that there are accepted norms or standards of performance which he should be obtaining in his business.

B U S I N E S S H O R I Z O N S

Stages of Small Business Growth

He may discover, for example, that in his particular industry it is an accepted fact that a 12 percent return on investment is the mini- mum acceptable. Thus, he will begin to develop ways to measure his business performance, because at this point he will have left the stage of survival and can turn his attention to growth and expansion. Furthermore, his attention to the financial aspects of his business-like rate of return, profit margins, and so on-will take on a different meaning to him. Growth and expan- sion, for example, begin to concern him be- cause at this point his income will have gone up enough in absolute dollars to allow him funds to plow back into the business; in addition, he recognizes that he must make a more formal- ized investment decision. Thus, at this stage, his actions become far more typical of those of the true entrepreneur, being more concerned with taking calculated risks than simply keeping his doors open for business.

Fortunately, although the Stage II business manager is far more willing to take risks, he still tends to be a bit conservative because he can remember the wolf at his door. Therefore, even though he is willing to engage in diversification of activities, he looks primarily for lucrative opportunities and is concerned with target rates of return. This thought pattern, in turn, causes him to engage in the practice of management by objectives, a technique he finds useful in managing men, materials, and machines, as well as money. Furthermore, the results he obtains from this technique generally are most satis- fying both financially and emotionally.

Thus all would appear rosy in Stage II of the economic growth cycle of the normal firm. However, just as the firm in Stage I begins to sow the seeds of its own destruction, so does the small business in Stage II. The demon of success again emerges, and the resulting prob- lems are serious enough in their own way to merit separate attention.

Rigidity of thinking One of the first problems that crops up in Stage II is in the thought processes of the owner-manager. Whereas the very reason for his success is that he was able to change from the thinking of an

owner to a manager in going from Stage I to Stage II, many managers at the same time become very rigid in their thinking or too speculative as a result of their previous tri- umphs. Any hang-ups in thinking at this point can ring the death knell for the manager because he will not continue to adapt with the times or will commit "speculative" errors.

Surreptitious actions by subordinates A second problem that crops up in the supervised supervisor stage of small business growth is that the subordinates-particularly the lieutenants developed by the small business manager-often behave in ways not beneficial to the small business. This behavior manifests itself in sev- eral actions: fouling up projects and denying responsibility for it; becoming greedy and resenting the small businessman's financial success; fighting among themselves in an effort to enhance or establish individual positions; or the development of blind resentment of the boss's son (or wife, father, brother, and so on).

Business overhead growth A heavy in- crease in business overhead is another tip-off to entry into the second critical phase of growth. This usually happens as a result of real financial success in the business and manifests itself in increased travel by the owner, grandiose ideas about building new plants, moving to a new location, and particularly, the construction of a lush office with all the accessories, like a refrigerated bar, good-looking secretary, and two telephones. Unfortunately, most of these fixtures are deemed essential only when they

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are purchased, not being recognized as super- fluous until it is too late.

The union moves An additional problem that tends to complicate the life of the small business man approaching critical Stage II is that of unionization. Ironically, the prospects of unionization tend particularly to unnerve the hard-charging, successful, charismatic small businessman. He feels insulted because his employees no longer look to him as the "great white father" and because the union's philo- sophy of the strong helping the weak is thevery antithesis of his personal philosophy. Unionism per se runs against his grain, and he feels his employees have deserted him.

The informal organization gains power The informal organization becomes more and more of a burden to the succesSful small businessman in Stage II. The small businessman, who was successful in reaching the rapid growth phase of Stage II by learning how to be a manager, still has not learned how to be an administrator. That is, success through Stage I does not require human relations and employee behavior savvy by the small businessman, but success in Stage II does. He can no longer get by just by barking orders; he must truly learn to admin- istrate.

Diseconomies of scale Diseconomies of scale fo~m the sixth problem that normally accompanies movement into the second critical phase of economic growth. For example, H. O. Stekler has found that small businessmen in Stage II begin to encounter certain difficulties that theoretically should not even develop, but do. 3 For example, theoretically it is expected that the bigger the small business gets the more able it is to take advantage of such principles as buying in bulk quantities, selling at lower prices because of higher volume, and so on, and still make increased profits. However, the practi-

3. H. O. Stekler, Profitability and Size of Firm (Berkeley: Institute of Business and Economic Re- search, University of California, 1963).

calities of life teach otherwise. Stekler argues that there is relatively no advantage with respect to economies of scale realized by firms the size of those in their second stage of growth. In fact, the opposite seems to be true: diversification of products and markets causes some losses, which tend to force a reduced rate of return over what had been previously experi- enced by the small business manager in the rapid growth phase of Stage II.

Production problems The glow begins' to wear off the rapid growth phase of the small business as production problems arise. This does not occur because the manager fails to supervise his subordinates effectively, but because his organization has become big enough, with so many intermediate levels of managers, that some of them simply are no good. The manager may not know how to fred out about any unsatisfactory performance on their part.

Family problems The final difficulty that arises for the small businessman at critical Stage II is that of family problems. The difficulty here can be capsulized: either the man, his wife, or his children have not managed to grow up with his income. It is not uncom- mon for the small businessman at the peak of his growth years to discover that he is making ten times what he had ever dreamed of, but that he is spending eleven times that amount, his wife thinks he is stingy, and he resents his "social obligations."

MAKING IT TO STAGE III

The foregoing may lead the reader to believe that it is almost impossible for the small business manager to pass successfully through Stage II of his organization's growth. In reality, many small businessmen easily cope with the problems enumerated and manage to enjoy the good life of the relatively stabilized small business. However, all that glitters is not gold, and, as in the other two stages of small business

BUSINESS HORIZONS

Stages of Small Business Growth

growth, the critical point arrives at Stage III when the small businessman must successfully overcome his problems or be absorbed by the giant organizations. Fortunately, however, the small businessman at this stage is no longer small, and he is far better equipped to fight giant industry than is the tiniest of the small businessmen. Ironically, however, it is not really the giants that cause him the trouble at this phase; rather, his main problems are created by other small businesses. Let's briefly evaluate these problems so that the aspiring small businessman may duly be forewarned as to what awaits him at the end of the road.

The greediness o f others One problem that the small businessman must effectively cope with upon entry into the third stage in his organization's growth is the disloyalty of some of his divisional managers. If the businessman is successful in training his divisional managers to manage his small business, they will have learned to manage their own small business and may be induced to strike out on their own, leaving the small businessman holding the bag. s

New small businesses take markets This problem is partially an outgrowth of the first problem, but is nevertheless a singular problem in itself. If and when his divisional and depart- mental managers abandon ship, they usually end up in industries competitive with the business they have abandoned. When they do decide to take on the "old pro," they will do so in his most profitable lines because they know which ones are the most profitable.

The institutional toll Increasing overhead costs are a third nemesis of the larger business. These costs usually begin to mount when the small businessman feels the need for institu- tional advertising, "national" distribution, outlets, and so on. In fact, these costs are why real economies of scale never seem to be realized by the larger small-businesses, which one would theoretically expect.

4. Managing the Small Business, pp. 33-38.

The diminishing absolute rate of return The fourth problem of the small business in its plateau stage is that the rate of return on invested capital decreases. Innumerable studies attest to this fact, all of which add up to an "iron law" of small business ownership: once the small businessman has reached full bloom, a disproportionate and diminishing return on invested capital must be expected by the owner(s), s

Organization top-heavy with staff person- nel Overstaffing, particularly at the middle- management levels, is a serious problem with most businesses in the United States, including larger small-businesses. 6 Furthermore, it ap- pears that all businessmen at this stage of development seem to arrive at some point where they feel they must surround themselves with staff men who can "keep them informed." Obviously, such hired help are an expensive luxury and take a heavy toll on the newly- arrived small business' overhead.

The staff starts infighting As the business becomes top-heavy with staff personnel, most large small-businesses also experience a certain amount of infighting among personnel, which not only results in serious morale problems but sometimes causes vital breaks in their perform- ance capabilities.

A full line causes some products to become unprofitable Growing businesses in the matu- ritY stage must diversify in the products, or markets, or services they offer. This diversifica- tion, unfortunately, carries with it the inherent probability that some of these diversified fines

5. See, for example, Profitability and Size o f Firm; Ralph C. Epstein, Industrial Profits in the United States (New York: National Bureau of Eco- nomic Research, 1934); William L. Crum, Corporate Size and Earning Power (Cambridge, Mass.: Harvard University Press, 1939); and Joseph Steindl, Small and Big Business (Oxford: Oxford University, Institute of Statistics, Monograph No. 1, 1945).

6. Charles Lupton, "Watch Your Management Weight," Management o f Personnel Quarterly, I (Winter, 1962), pp. 11-17.

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will fail, and, as Stekler 7 says, this creates a high probability that any given marginal project will actually yield a return which is lower than the previous average rate of return for the firm's other projects. This, of course, reduces the new rate of return realized by the business.

E l l ill I There is no question smaU busi I11___11 nesses experience growing pains. The ability of the small businessman to cope with these pains will determine whether or not he will be successful. Unfortunately, however, he will never outgrow such pains and still be a small businessman. Therefore, those who under- take a venture thinking that all would be nice if he could stabilize his business at $2 million or

7. Profitability and Size o f F~rm, p. 82.

$10 million or $20 million may as well forget it. There will always be critical stages of growth for the small business.

Fortunately, these stages of growth arise only from success. Anyone who commits himself to managing a small business must recognize one irrefutable fact: the minute he commits himself, he is on the treadmill of forced growth, growth that requires his ability to change from an autocratic to a professional manager. Furthermore, there is no escape from this escalator unless he is willing to accept the demise of his small business and the probable loss of nearly 50 percent of his assets. On the other hand, the rewards for success are phe- nomenal and few successful small businessmen will fail to agree that it is the climbing of the stairs that is important, not the arrival at a plateau.

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In sensory terms, one might say that people like Charlie Chaplin and Thomas A. Edison, though great artists, were scarcely print-oriented. In later life, Edison, while still in possession of his sight, switched to Braille as preferable to visual reading . . . . Charlie Chaplin was so deeply aware of the processes of his art that he frequently acted his scenes backwards, leaving it to the technicians to run them frontwards. Tony Schwartz, a sound designer, has a tape of Chaplin pronouncing words and phrases backwards. When the technicians reversed these sounds, they came out as ordinary speech.

-Marshall McLuhan and Quentin Fiore War and Peace in the Global Village

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