Toxic Growth Syndrome

Why a sales-driven expansion strategy may be deadly

What is the leading killer of small enterprises? According to many experts it is growth. More precisely, it is the mistaken notion that the pursuit of top-line growth is the route to lasting success.

It’s only natural to assume that pulling more money in the front door will take your business to the next level. And certainly you can count on routine expenses—from insurance premiums to the electric bill—to rise every year, so a certain amount of revenue growth is essential.

While business owners fear that their companies will go under if they don’t increase revenue, the bigger risk may be too-rapid or poorly thought-through expansion, cautions Ira Davidson, director of the Pace University Small Business Center in New York. “Most of the companies that go bankrupt do so because they are growing faster than their capital bases can support,” says Davidson, who is also a business consultant and, through the New York State Business Development Corp., helps arrange SBA financing. Too often, he says, business owners don’t heed his advice to be profit-driven, rather than sales driven, when devising growth strategies. “You see it year after year,” he says. “It is very disheartening.”

When considering expansion, the first is to look for ways to sell more of what you make (or provide as a service) to existing customers. Or you can find new customers for your products and services. Where you don’t want to go—but where many business owners are convinced they can succeed—is to attempt to sell new wares to new customers.

Unfortunately, this forbidden zone (see table) is often the place where businesses focus their mergers and acquisitions strategies. Owners figure that if they buy a customer, say their distributor, or a supplier, they can cut costs and achieve some economies of scale. In both kinds of deals, you are taking on unknown processes and unknown customers—and that’s too big a stretch. Indeed, says Davidson, the impulse to make such a leap is a sign of bigger problems. “If you can’t find areas of expansion that are close to your existing customers or existing products, then something is wrong,” he says.

A sales-driven expansion strategy doesn’t have to take you away from your core businesses to leave you on the rocks. One of the most common mistakes is to confuse big clients with profitable ones. That’s what happened to David, the co-owner of a small direct-marketing advertising agency. He and his partner went into business five years ago, after the online ad agency they worked at collapsed. They both had big-agency experience and assumed that the way to build their shop was to land one or two high-profile clients and use those reference accounts to lure more business. They got one major customer and proceeded to lavish endless man-hours on this marquee account. The client grew accustomed to the attention and became increasingly demanding—even though the billings were not rising. By the time David and his partner resigned the account last summer, they had laid off most of their full-time staff and were veering toward bankruptcy. Now, they are working with a business consultant and focusing on smaller, more profitable accounts.

The “best customer” trap is common in manufacturing businesses, too, says Stephen B. Mischo, a professor of finance at Adelphi University in Garden City, N.Y., and past president of the Long Island Chapter of Turnaround Management Assn. “Companies that are sales driven often focus on their largest customer, but they are not looking at what that costs,” he says.

Instead of automatically granting the top customer the most favorable terms, he says, try risk-based pricing. This is, essentially, what the bank does: When you ask for a loan, it looks at your balance sheet, income statement and payment history to determine the rate.

For the business owner assessing his customers, the key metric is receivables. When receivables grow faster than sales, in essence, you are financing your customers’ debts—an insidious hidden cost that can destroy your net profits. “If management isn’t alert or its focus is exclusively on the growth of sales, the relative expansion of receivables can create a surprisingly dangerous increase in notional expense,” Mischo says. He offers this hypothetical:

Assume the business has a gross profit margin of 30% and its largest customer constitutes 40% of sales. Wrong-footed management (one that’s sales-oriented) might say that it is their “best customer. But the“best” customer isn’t paying on the standard 2/10 net 30-day terms; it’s paying 90 days on average. Here’s the basic math:
“Best” owes you $60,000 and hasn’t paid you for 90 days. Your gross profit margin or the price you charge all your customers is fixed, because that’s what the sales catalogue shows. Since Best does not actually pay you on time, you have to borrow (at your notional cost of funds) to support its payment habits. If your notional cost of capital is 9%, your “profits” on your “Best” customer will most likely be far less than what other sales produce. Cost this out over the entire year and you quickly see that management has no choice other than to make some hard decisions about Best.

Note that in this example the business owner didn’t fall into another common trap of the sales-driven company—letting his salespeople cater to the big customer by slashing prices; even without a discount the “best” customer can be your worst nightmare.

Davidson recommends that you approach any expansion plan with an analytical approach. Start with a business plan that describes your current enterprise (surprisingly few companies have such a document) and then create a business plan for what the company will look like after the expansion, including pro forma financials. Many business owners charge ahead with sales-driven expansion plans because they are not good at cost accounting, he says. But you don’t have to be an MBA to get it right. “When you get down to it, it’s not really such a quantitative thing. Just remember that you want to expand by selling existing products and services to new customers or new products and services to existing customers—nothing more profound than that.”