Most entrepreneurs seek to grow their businesses. Face it, if you are not growing, you are standing still or worse, getting smaller. However, there is a right way to grow and a wrong way to grow.
Let me tell you about a former client that illustrates this perfectly, adapted from my book, The Entrepreneur Equation.
Decades ago, a very smart and determined gentleman (I will call him Mr. X to preserve confidentiality) had a passion for producing a product (to further protect his identity, I will call the product a “widget”). He was really interested in the widgets and spent time carefully crafting his first ones.
His widgets were sold to specialty retail stores and marketed to adults -- no, they weren’t “adult products”, adults were just his target market. Mr. X was a thoughtful, methodical and conservative man. He continued to build more widgets. He continued to sell to stores that allowed him a high margin for the product. He was able to modify some of the widgets slightly, repackage them and create new products that appealed to new customers. It was a fantastic business that kept growing. A few years in, it was clear that the widget business was a good one. Its carefully cultivated attributes included the following:
- Very high margins: For each product sold, the company had a gross margin -- wholesale price less the direct cost of goods sold -- of more than 50 percent. This is a fantastic margin in any industry, and it made Mr. X’s widget enterprise quite profitable.
- Ideal retail relationships: The channels in which the widgets were sold had very attractive qualities. In addition to the margins on the products, the products were sold firm -- that meant that they were non-returnable by the retailers, taking away the prospects of major inventory risk from the company. Also, the retailers had set ordering cycles, which, in conjunction with the products being fairly easy to assemble, meant that the company wasn’t required to carry a lot of inventory.
- Evergreen products: The type of widgets that the company created were not fads or trendy products. They were tried and true and could generate sales year in and year out.
- Leverageable business model: The company’s products were relatively easy to produce, not requiring a lot of production support. The retail relationships were manageable with a small staff. This allowed the company to exist without needing extensive warehousing operations.
The widget business was a nice, profitable business. It grew into the high-seven figures in revenue and also generated a seven-figure profit each year. As time went on, Mr. X brought his son, X Jr., into the business to help continue the growth.
X Jr. had a particular affinity for the children’s product market, so he figured that maybe there was a way to make widgets directed at kids. He decided to develop a kid-oriented widget (I will call this the “kidget”) as a new offering. However, the business of widgets and kidgets, although similar in sound, were entirely different in practice.
Sales of kidgets took off, but there were a few issues:
- Kidgets needed to be sold to new channels, which meant a difference in the business model. Instead of selling them to the specialty retailers, who weren’t particularly interested in kidgets, kidgets were sold to mass retailers like Walmart and Target. Because a large percentage of the kidget business was sold through these mass retailers, the business was taking on increased risk in terms of carrying more inventory and having goods that these mass retailers demanded could be returned at their sole discretion.
- Kidgets, because they were directed at kids, needed to have more bells and whistles to make them attractive and interesting. It cost more to build a kidget than a widget, plus, mass retailers required lower price points. Therefore, the kidget was a substantially lower-margin product line for the company.
- Because of the more complex kidget product and the fact that mass retailers had different ordering cycles from specialty retail stores, more staff and overhead were required to make, sell and warehouse the kidgets.
- Kidgets were inherently more of a fad product. Kidget product lifecycles were much shorter than the evergreen widget products the company was used to selling.
While the sales of kidgets grew rapidly, the company neglected developing more widgets, and instead put more resources into kidgets. Over the next several years, company sales more than doubled, mostly due to the growth in the kidget business. However, these sales came at a lower profit margin, so while the company was profitable, it was so on a paper-thin net-margin basis.
The company was earning nearly the same amount of profits in dollars it generated when it was less than half its size and only focused on widgets -- i.e., the sales were twice as large and the dollar profits were the same, reflecting lower profits on a percentage basis for the company. However, the company was focused on the top-line sales number and moved its headquarters to a larger facility to accommodate the huge growth and inventory requirements of the kidget business.
Another issue that went unchecked was that a large percentage (around 25 percent) of the growth was based on the sales of one single type of kidget, a fad that would prove to burn out after a few years.
Maybe you can guess what happened next. The mass retailers decided to restructure their businesses and returned millions of dollars’ worth of merchandise. The once super-high-growth kidget turned out to be an extraordinary circumstance, and after the fad wore down, it contributed little in sales. And because of its earlier decisions, the company was supporting a huge staff and rent for the new, larger facility -- but its sales had declined nearly 30 percent. So, the company started to lose millions of dollars. Yes, millions.
When I came in at that point to analyze the company, I found that without the support of the fad kidget, the overall kidget business, although producing more than double the revenue of the widget business, was actually losing money for the company. For every dollar of sales produced by the kidget business, it cost the company more than a dollar to create and market that corresponding item.
By focusing on kidgets, the company substantially grew its sales, but without profits -- and in fact eventually ate up the profits of the neglected widgets.
The company was more profitable when they were at a fraction of the sales, but with high profits like they had been when they were just widget-focused than being four times larger in terms of revenue and losing money than they became by pivoting to kidgets.
The moral of the story is don’t grow for the sake of growing. Make sure that you are growing smart in ways that grow both the top and the bottom line, and don’t take on undue risk compared to the potential reward.