For most startups, the first real challenge is getting their foot on the ground.
At that point, the world is reeling. Questions are popping up where ideas were, competitors are catching a whiff of new opportunities, and the environment is in constant flux. In an attempt to survive the crashing waves, startup founders find themselves in the difficult position of having to decide what they’re all about.
For them, the process usually begins with a basic question: Where are we most needed?
That question defines the starting point of a long journey that eventually comes down to their MVP, namely the Minimum Viable Product that they use to enter the market.
With that in place, the world starts taking on a very different shape. The next question quickly presents itself as one that’s here to stay: How do we grow our business
Companies differ in the way they approach this question.
Some companies think to themselves, “well, since investors look at the return on equity, our goal here should be to get as much profit as we possibly can.”
To keep their heads above water, they try to grow and hack it, risking available resources on a hunt for short-term profit. Value creation goes out the window, and so do company culture, staff training, and return customers.
Others look a little further down the figurative horizon, keeping an eye on the future as they tread the path of success. For them, reward takes a little more time, but it soon takes a much better shape than their frenzied friends: they achieve sustainable growth.
And it’s not a stroke of luck either, there is a science behind it.
Calculated by multiplying a company's earnings retention rate by its return on equity, the sustainable growth rate (SGR) can be defined as the maximum rate of growth that a company or social enterprise can sustain without having to finance growth with additional equity or debt.
Knowing that, the question startups should have been asking themselves is How much can we grow before we have to borrow more money?
This sustainable growth model takes into account that a company wants to: maintain a target dividend payment ratio, pay a predetermined percentage of its earnings to shareholders, and boost sales in line with market conditions, all without having to borrow money.
Since growth is the most important factor in valuation, access to capital, and shareholder return, Return on Equity (ROE) also plays a major role in the sustainable growth rate calculation.
But for their hard work to reflect on equity and turn a profit without exhausting their available resources, companies must first reach a balance between their growth strategy and their realistic growth capability.
The reason for that is…not so simple: when the actual growth rate exceeds the sustainable rate, a quick and surefire exit is to borrow cash. However, when actual growth exceeds sustainable growth for an extended period, management is faced with a new set of tough decisions to make:
1) sell new equity, a high-cost solution that could lead to the possible dilution of earnings per share and unreliable equity funding.
2) take on more debt.
3) reduce dividends, which has a negative impact on the company’s stock price;
4) increase the profit margin through quick but value-reducing methods.
5) decrease the percentage of total assets to sales.
To break down the complicated equation behind the elusive sustainable growth rate, a 2014 McKinsey research segments companies into five main categories: Sustainable Super Growers, Super Growers at Any Cost, Sustainable Growers, Cash Generators, and Strugglers.
Sitting at the top of the mountain are Sustainable Super Growers, who are companies with more than 50 percent CAGR, and who consistently achieve sustainable margins of 3 percent or more. Examples include Alibaba and Google.
Although Super Growers at Any Cost achieve Super Grower status, their margins are usually a lot less than 3 percent. Often dominating large market share, Super Growers at Any Cost fail in the long game, often leading to lower near-term shareholder returns. Examples include eBay.
Sustainable Growers are companies that lie between 10 and 50 percent CAGR, with margins of 3 percent or more, who satisfy investors but tend to attract competition within the niche. To beat their category, they simply need to expand into new areas for growth. Examples of Sustainable Growers are Adobe and Autodesk.
Cash Generators, as the name suggests, are companies that achieve high margins by winning off their competitive advantage. However, their growth has more or less stopped at a CAGR under 10 percent. Their next step is to reinvest the cash into the business, examine cross-selling and up-selling strategies, or follow inorganic strategies like mergers and acquisitions to get access to new customers. Examples include Activision Blizzard.
Finally, the Strugglers are companies with stalled growth and low margins who must optimize value creation or look for a strategic buyer to give them an exit option.
Image Credits: McKinsey
Companies looking to jump categories must first understand where they stand. Armed with that knowledge, they can make several steps to improve their overall offering. These include:
Evolving their product to fit the unmet demands of a varied customer profile,
Evolving their business model to fit a constantly changing market,
Investing in team building to enhance the quality of life and, as a result, quality of work,
Optimizing their CAC during customer acquisition,
Ensuring that their cost of building is less than the sale price during product development,
And finally, enhancing their overall capital efficiency.
Each company story is different!