When Scaling a Business Isn’t Good: 7 Types of Bad Growth to Avoid
Scaling a business isn’t always good.
Let’s imagine for a second – if we were to describe a business that had increased its revenue by say 30% plus during the last 12 months, whilst returning a 20% EBITDA, you’d assume we were describing a very healthy and well-ran business, right?
It’s easy to fall into the trap of looking at a scaling business from the outside that appears to be superficially successful and making the incorrect assumption that everything is rosy.
Good Growth vs Bad Growth
Not all growth is good. In fact, bad growth is very bad because it has significant consequences. In some cases, it can destroy value or make a company unsaleable. In other cases, it can have an adverse effect on the business owner personally and their mental health.
Cold Hard Truth
Scaling a business can be a minefield – and its important you focus on good growth and know how to recognise bad growth.
Some business owners throw around vanity metrics for ego reasons. The ones who do this like to boast and self-aggrandise about how large their business is or how quickly its scaling whilst conveniently glossing over (or, worse, being oblivious to) the fact that there are actually serious underlying issues within the company that are likely to catch up with them and result in the wheels falling off the wagon.
So, without further ado, here are 7 examples of bad growth to avoid when scaling your business:
1. Growing Costs More Quickly than Revenue
Overhead increases are a by-product of growth. In fact, increasing cost is unavoidable if you’re a scaling business because you need to continually expand capacity – usually people (and therefore, salaries) or resources to scale.
The question is: are these things growing on a proportionate basis?
Revenue and Costs Do Not Typically Grow in a Linear Fashion
There will be times where you need to re-invest back into the business to move it to the next level. For example, this might be upgrading IT, infrastructure, systems or marketing, or where you make strategic investments into people (e.g. making a senior hire at a higher salary level than you have previously because the business now requires it).
The point is that revenue and costs do not grow at an identical rate and in a linear fashion – and that’s ok. Businesses always have to manage stress points where they make investments and then have to fund the period until that investment starts to generate a positive return.
For example, a sales person may eventually generate 10 X their salary in new business but they may take 3 – 6 months before they start to generate sales. The business has to fund their cost for a period of time where no return is being made until they start to generate value.
Micro Businesses Often Over-Trade
Secondly, bear in mind that micro businesses (sub 5-employees) often generate artificially inflated levels of profit because they over-trade (everyone works long hours and the business is usually over-committed) and they have a very lean structure (the owner is the sales, finance, HR and marketing department) without many of the functions required in a business at a larger level of scale. It’s important therefore to realise that the higher profit margins made possible at this stage aren’t usually sustainable so a reduction in margin as the business grows isn’t necessarily a bad sign.
Becoming Less Profitable as You Grow
However, what we’re referring to is where there is a medium to long-term trend of costs (over time) increasing at a faster rate of turnover and the business therefore becoming larger, but less profitable.
For example, a business generating £2.5m in turnover and £250k in pre-tax profit is actually less profitable than it was at £500k and £150k of pre-tax profit because its net margin has reduced from 30% to 10%. The company is more profitable in absolute cash terms but less profitable on a proportionate basis.
Reasons Why This Happens
This usually happens for a number of reasons, including:
- Over-hiring: recruiting more staff than you need;
- Hiring too prematurely when it isn’t justified: before your existing team are fully utilised;
- Over-bloating areas of the business that aren’t income-generating: e.g. HR, admin, finance etc.;
- Pricing terms not keeping pace with overhead growth: charging the same as you were 5 years ago;
- Over-spending: in non-essential areas, such as equipment you don’t need;
- Not leveraging purchasing power: failing to drive down costs in areas where you can.
The key principle when scaling a business is to increase your costs on a proportionate basis. Track your overheads as a % of sale and set an ideal threshold for what these should be maintained within as you grow.
As a business owner, you should be rewarded for the work you put in to scaling your business. Running a company with more complexity, more activity, more risk, more stress but no more reward is frankly stupid.
2. Growing with Increasing Customer Concentration
Scaling your business in such a way where a significant amount of your turnover becomes concentrated in say 1, 2 or 3 key clients is bad growth.
The reality in most businesses is that there is always polarisation in their client base – i.e. there are usually big clients who are important and account for big chunks of turnover and there are often many small clients who don’t.
But a situation where 1, 2 or 3 large clients account for the majority of your turnover is highly risky and something you should avoid.
Why is High Client Concentration Bad?
Client concentration is bad for the following reasons:
- The client(s) holds all the cards: even more so if they know it. They will drive you down on price and push hard on commercial terms. You will have a tendency to easily cave in because of the power they hold over you;
- You become all-consumed with them: processes get thrown out of the window and the business runs to simply keep, service and retain them, rather than operating in the way that it should;
- The business isn’t saleable: a business heavily exposed to one large client will not command a high valuation multiple. In some cases, if the client “is” the business, it may not even be saleable;
- Losing the client would be business-critical: you would have to significantly downsize and lose many employees if you lost the client.
What Concentration Parameters should you Consider?
Some businesses aim to have no one client amounting for more than 10% of revenue. In our experience this is often unrealistic, but certainly if 50% or more of the business is with 3 or less clients then you have significant risk.
What Should you Do?
The practical reality is that:
- A growing business will not turn down the opportunity of acquiring a large contract even if this were to become a large % of their turnover and;
- A business would not terminate a client relationship simply because the contract became too large.
Concentration is a balancing act. If you have concentration risk then recognise it. Your first priority should be to dilute that concentration risk by finding (or growing) other clients of comparable value to create a more even spread of revenue.
3. Scaling Too Quickly (Uncontrolled Growth)
Unchecked growth can be the downfall of a scaling business and something we have seen many times. Rapid, uncontrolled growth leads to many companies crashing and burning.
How Does Uncontrolled Growth Occur?
Uncontrolled growth can occur due to several reasons, but these are the 3 that we see most often:
- The Business has no Foundations: the Owner has not laid the correct foundations for the business to operate at larger scale. The business grows but it very quickly runs into scaling issues because, put simply, its built-on quicksand;
- The Management Team are Inexperienced: the business grows beyond the Management Team’s level of experience or capability and they fail to take advice, hire mentors or recruit other senior people who have been through the process before. As a result, they make naïve or disastrous decisions and the business grows in highly chaotic manner;
- The Business is Inadequately Funded: under-capitalisation (combined with over-expansion) inevitably means the business runs out of cash. This is further exacerbated if the Owner is stripping more cash out of the company (in dividends) than is justifiable.
What are the Signs You are Scaling Too Quickly?
Here are some of the warning signs to look out for that suggest you may be growing too quickly:
- Cash is Over-Stretched: inflows aren’t matching up with outflows; you haven’t built enough cash within the business to sustain this or secured sufficient credit lines with the bank or a funder;
- High Numbers of Complaints: service levels are become over-stretched, work turnaround times are increasing or there are increasing quality issues with products or services. Customer support isn’t adequate;
- Poor Hiring Decisions: you are hiring too quickly because you don’t have the luxury of time to carefully consider prospective new employees and its leading to poor hiring decisions or people not working out;
- No Controls: the company has limited or no visibility on costs, margins or pricing and can’t therefore make effective commercial decisions;
- Overwhelm or Burnout: the Owner can’t think straight, is emotionally volatile, works 70-80 hour weeks or is on the verge or burn-out because the business has become so overwhelming.
How Much Growth is Too Quickly?
There’s no “one size fits all” answer here because its relative to the circumstances of the business. 20% might be too aggressive for one business but 50% may be too conservative for another. It isn’t about creating an arbitrary number but, rather, understanding what the business can reasonably keep pace with.
Our mantra has always been that “good growth is controlled growth”.
4. Revenue isn’t Recurring (Having to Constantly Replace Clients as you Grow)
Trying to grow a business without recurring revenue is like running through treacle. If revenue isn’t recurring then the business is constantly caught in a cycle of replacing turnover, rather than stacking turnover on turnover (or client on client).
The Challenges with Non-Recurring Revenue
Consider a £250k business that has 25 x active clients with an average contract value of £10k. If none of these clients generate any form of retained income then the business has to re-acquire 25 x clients again next year just to stand-still, let alone grow!
This is an awful business model with high labour intensity that’s based on continually spinning the hamster wheel for very little gains.
It’s very difficult to grow a business based on continuous one-off sales and the moment you stop replacing clients, the business declines because there’s no longevity (or lifetime value) in the relationships you have.
Remember that if you’re trying to grow a business without recurring revenue then you will suffer in two ways:
- Limited Predictability: which creates constant cliff-edges in your turnover, makes hiring and resourcing decisions very difficult and risky and scaling far harder;
- Limited Saleability: companies with no recurring revenue command much lower valuation multiples because it’s very difficult to project forward growth.
High Customer Attrition
Of course, the other thing to consider here is that recurring revenue only works on the assumption that clients stay with you.
If, as previously mentioned, product or service quality becomes compromised because you’re growing too quickly then clients will leave and you will have high attrition rates. That puts you right back into the cycle of constantly replacing turnover even if your business model is based on recurring revenue.
Recurring Revenue Comes in Multiple Forms
Scaling a business is made much more possible with recurring revenue, which comes in multiple forms and (from most to least valuable), includes:
- Medium to Long-Term Contracts: ideally with a capped downside and limitless upside;
- Subscription Models (e.g. SaaS or membership): with no fixed end date and auto-renewal;
- Annuity Income: e.g. ongoing (annual) commission earned on the sale of investment products;
- Short-Term (e.g. 12-month) Fixed-Term Contracts: such as service retainers based on an annual value;
- Rolling Contracts (e.g. 30-day): client relationships that operate under month-to-month contracts;
- Framework Agreements: secures the relationship but no fixed value on the level of revenue;
- Repeat Business: clients who spend regularly (monthly or annually) but without any guarantee;
- Loyal Customers: clients who return to purchase semi-regularly but without any fixed pattern (e.g. retail)
If your revenue is non-recurring, then consider how you can re-package your products or services to move to a recurring model and create more predictability for your business to grow.
5. Staff are Burnt Out and Leaving
We’ve seen this regularly; the owner puts so much pressure on the business to scale that its people become over-stretched, over-whelmed and inevitably burn out and leave.
Why Do Staff Burn Out and Leave?
In a growing business, staff can burn out and leave due to a number of reasons:
- Highly Aggressive Targets: objectives, timescales and deadlines become ever more aggressive as the business grows, leading to physical or emotional exhaustion;
- Top Performers are Pushed More: when good people achieve results, their performance encourages their employer to give them more work which stretches their time and emotional state even further;
- Employees Find Themselves in a Role They Didn’t Choose: an early employee becomes a Manager by default because staff are hired underneath that person – a role they didn’t want and have limited experience in.
When Company Culture Becomes Toxic
Scaling businesses are often intensively performance-driven (and rightly so). But business owners need to be careful that this doesn’t spill over into a culture based on all stick and no carrot and where the work environment is no longer enjoyable. A toxic culture will lead to staff leaving and is caused by several factors including:
- Staff are Afraid of the Owner: which usually happens if he or she is aggressive, domineering, autocratic, belittling, unapproachable, a megalomaniac or emotionally volatile;
- Managers Start to Embody This Behaviour: the Owner sets the tone within the business so there’s a high chance that Managers will take their cue from this and start to behave in a similar manner;
- Office Cliques and Gossip: which creates tension, drama, back-stabbing, sabotage and a climate of mistrust, suspicion and paranoia. Staff stop interacting and engaging with each other;
- One-Dimensional: shortfalls are criticised, but victories are never praised or celebrated. People are motivated away from failure, rather than towards success. The Owner sees “culture” as fluffy.
The Problems with Trying to Grow When Staff are Leaving
It’s very difficult to grow when staff are leaving or burning out because:
- It’s Very Costly: recruitment involves (a lot of) time and often money (particularly if you pay recruiters fees), both of which are costing the business, whichever way you look at it;
- Its Stop-Start: staff aren’t building momentum in their roles. New starters take time to bed in which creates more opportunity cost as the weeks and months creep by;
- It Creates Constant Upheaval: people are plugging gaps created by those who have left. Teams are often temporarily re-organised to deal with departures. There is no settled pattern of work;
- Managers are Pre-Occupied with Managing Emotional Crisis: dealing with employee stress and breakdowns takes precedence over managing constructively.
A business ran like this will implode. We’ve seen it many times. Your job is to build the right culture that support your business to scale.
6. Processes Becoming Over-Stretched (or Failing) as You Grow
Many small businesses are run out of people’s heads and their processes are either inadequate or non-existent.
Scaling a business without effective processes will lead to balls being dropped, people working in different ways and staff running around like headless chickens.
Why Processes Become Over-Stretched as You Grow
One of the worst traps a business owner can fall into is taking the same approach to running the business when it’s at a larger size and scale that they did when it was much smaller (for example, running a business at £2m in revenue as if it’s still a £200k business).
In this example, at £200k in revenue, the business may have limited (or very rudimentary) processes. The owner will be in a direct contact with his/her staff and directly line-manage each. Some knowledge may be documented or systematised but the company will be largely people-dependent.
This is passable at £200k in revenue but certainly not at £2m. The point is that what is good enough to get you from A to B is unlikely to be good enough to get you from B to C. If processes fail to keep pace with the growth of the business then you’re going to have problems.
What Happens When Systems and Processes Don’t Keep Pace with Growth?
If you’re trying to scale without systematising the business then the following will happen:
- Good Things Won’t Replicate at Scale: for example, your level of customer service was intimate when you were a small business (because you were doing it personally) but because you haven’t created a blueprint for how others should do it, standards aren’t defined and levels of service are now poor;
- Chaos is Compounded: you can get by with some inefficiencies when you’re small but these just compound and multiply up when you scale and are usually caused by a lack of processes. Failing to correct this when small leads to much bigger problems down the line;
- Reliance on the Owner (or Key People) is Increased: systematisation allows the Owner to codify and template his or her knowledge into processes that others can follow. Without this, it becomes very difficult for the Owner to extricate themselves from the day to day running of the business;
- Poor Management Information: inadequate software (e.g. pipeline tracking, accounting, project management etc.) provides no or limited visibility on important key performance areas and leads to “finger in the air” decision-making;
- Massive Inefficiency: people reinvent the wheel (because things aren’t templated), work in different (inconsistent) ways (because there is no “how to” for key things) and bottlenecks appear (because the Owner demands sight on everything).
All growing businesses need to be systems-driven. If they aren’t, they’ll face significant challenges when trying to scale.
7. The Business Becomes More Reliant on The Owner as it Grows
When scaling a business, you should be decreasing its reliance on you as quickly as you are growing in order to create personal freedom and a business that can eventually be sold.
But, in many cases, the opposite happens and, as the company grows, so does the degree to which it relies on the owner who becomes ever more entangled in the day to day running of the business.
Some Examples of How a Business can be Reliant on its Owner
This can show up in several ways, including:
- All staff report to the owner who line manages everyone: as the team grows so too does the number of direct reports the Owner has who simply becomes a manager of people (rather than growing the business);
- Clients only wish to deal with the owner; because that’s who they have always dealt with and the Owner is too fearful to try to change that. More clients now means more relationships to manage and more demands on the Owners time;
- The Owner is the only person who can do certain things: retaining key technical knowledge or know-how which places more pressure on them for delivering services or products that paid employees are unable to.
Why is this Bad?
Well, if it isn’t stating the obvious, a business that becomes ever more reliant on its Owner probably means:
- The Owner will struggle to take any time off or time away from the business;
- The business is carrying massive risk and will collapse if the Owner is absent for any length of time;
- As a result, the Owner will have limited personal freedom;
- The Owner is at risk of burning out;
- The Owner has created a job not a business;
- The business is either unsaleable or unlikely to attract a strong sale valuation.
As you grow, more staff, more activity and more complexity should not equal more personal responsibility for you.
That can be avoided if you build a Management Team, implement systems and processes, constantly re-examine how you’re spending your time in the business, identify tasks and activities you should be eliminating or delegating and leverage your own knowledge into products, services and activities that other people can then deliver on your behalf.
In Summary: When Scaling a Business Isn’t Good: 7 Types of Bad Growth to Avoid
As we’ve seen in this article, not all growth is good. Scaling a business in a way that simply creates a bigger version of an inefficient, owner-dependent, unprofitable or unsaleable business makes no sense.
Drive your business from a top and bottom-line perspective yes but, at the same time, work on growing it correctly so that you can create value, saleability and personal freedom.
And remember, if you don’t have these things then its within your capacity to do something about it.