Bottom Line: The relationships among growth, profitability, and survival are complex for new firms. Attrition is high in the early years—and although profitability is crucial to keeping firms in existence, growth isn’t all it’s cracked up to be.
For new firms, an IPO is the dream, but survival is the goal. Given that a large proportion of startup firms fail, new companies have naturally focused on rapidly growing their operations and sales to ensure they stick around long enough to gain new clients and, eventually, claim a larger foothold in the market.
But a new study warns that early growth for new firms is a double-edged sword. If growth boosts profitability and leads to an expansion in firm size, there’s a stronger likelihood the company will survive. But expansion for expansion’s sake, especially in the early days, can spell doom for a firm down the line. The key for managers: Ensure your company’s growth flows from discernible profit streams, and don’t pursue expansion simply because conventional wisdom says you should.
For this study, the authors examined a unique and comprehensive set of 13,153 Swedish companies that launched between 1995 and 2002, tracking them for an eight-year period to see how they fared. The data set spanned 44 different industries ranging from mom-and-pop retail stores to high-tech startups, accounting for about 33 percent of all employment in the country and more than 40 percent of Sweden’s GDP.
Just as certain ominous evidence has demonstrated that new firms face a hard fight to secure survival, about 44 percent of startup companies in this study shut down within five years. Lack of profitability was the strongest predictor of which firms couldn’t last. By the eighth year, only 35 percent of the firms in the data set were left standing.
How did the survivors make it? Much like the proverbial tortoise, they followed a slow-and-steady methodology: They grew their profits gradually, expanding their workforce and sales volume without overextending their operations. Firms’ early-stage profitability significantly enhanced their chance of survival, the authors found, and also increased their ability to grow at a reasonable pace.
But managing growth was tricky. Whereas a mere 1 percent uptick in sales growth raised the probability of the company folding by 21 percent, on average, expansion paid off when it fueled future operations. For example, a 1 percent increase in a firm’s size was linked to a 12 percent decrease in the probability that the company would go under. And every year a firm survived and slowly expanded, it was 16 percent less likely to exit the market. More importantly, a 1 percent increase in annual sales boosted firms’ return on assets in the next year by 27 percent.
“Growth has a negative effect on survival but a strong effect on profitability, suggesting that enhancing operations as a ways to increase profitability or reduce uncertainty may be a rewarding strategy—but fraught with risk,” the authors write. The researchers speculate that early growth could help sink new companies because it takes money to grow, and in highly competitive or uncertain industries, funneling early profits or capital into quickly expanding operations may be a waste of precious resources.
The managers of new firms should think long and hard about their growth strategies. What’s the right pricing strategy to support sensible growth? How willing should the company be to invest early-stage profits? A schedule for expansion, based on predetermined performance metrics, could help inform the company’s decisions about the pace of growth. And alliances with other companies should also be considered, because they present a good way for young firms to share resources or acquire knowledge without having to expand their own workforce or operations.
Source: Untangling the Relationships Among Growth, Profitability and Survival in New Firms, Frédéric Delmar (Lund University), Alexander McKelvie (Syracuse University), and Karl Wennberg (Stockholm School of Economics), Technovation, August–September 2013, vol. 33, nos. 8–9