Managing in the New Economy
David L. Birch, the economist who's helped us understand the truth about America's turbulent business environment, on his own experience in company building* * *
For the past decade David L. Birch has made his name -- in Inc.'s pages and elsewhere -- as one of the clearest, most straightforward, and therefore most suspect of economists. Others theorize; Birch, mainly, counts.
Beginning as the director of a research program at the Massachusetts Institute of Technology in the 1970s, and continuing as founder and chief executive officer of Cognetics Inc., his economic research and consulting firm, Birch compiled a database that attempted to count -- and then track -- virtually every business enterprise in America and every job those enterprises provided. From such a project came some unforeseen discoveries, chief among them that small businesses, not large, generated the majority of the country's new jobs. More precisely, it was growth companies -- 98% of which have fewer than 100 employees, 86% of which have fewer than 20 -- that generated almost all new jobs. And growth companies represent just 10% of America's 7 million enterprises.
Questions about those 700,000 companies came to fascinate Birch in the 1980s. How do they grow? Where do they grow? What kinds of businesses are they, and in what industries? How old are they? How volatile? It was this last question that intrigued him most, because the picture that emerged was so unexpected, and so laden with consequence. Growth companies, it turns out, don't simply carve a smoothly climbing line on their chart of revenue over time. They move instead in great pulsating waves of ascent and decline, like a roller coaster gone dangerously out of control. It appears the road to success (or at least to 20%-plus annual growth) is paved with business reversals, layoffs, debt troubles, and crises of confidence -- in other words, with heartache.
In the midst of all this research, in 1983, Birch started Cognetics, which now employs 12 and grew quickly enough to rank among the elite 700,000. Given that, perhaps we shouldn't have been surprised when we revisited Birch in January at his offices in Cambridge, Mass.
We'd been regular guests during the time he was reporting his discoveries in a monthly column for Inc. But nearly two years had passed, and the Birch we met this time seemed changed. He was a little quieter and didn't move around as much. Though as enthusiastic as ever, he seemed every one of his 52 years, rather than preternaturally young as before. He seemed a little tired. He seemed, in short, just like a lot of CEOs we know.
So a planned interview with David Birch the researcher became instead a talk with David Birch the company builder. Birch the researcher confirmed our suspicion that business volatility, the pace of change in the typical growth company's fortunes, has only increased in the '80s, not slackened. Birch the company builder told us how understanding that turbulence helps him and his colleagues at Cognetics cope with it.
He talked with Inc.'s editor-in-chief George Gendron and executive editor Michael S. Hopkins.
INC.: A decade ago, when you began discovering the wild fluctuations of fortune suffered by most growth companies, your work must have seemed safely abstract. But for several years now you've owned one of those unstable enterprises. Has that changed the way you see them?
BIRCH: Not exactly. It's true I can empathize a lot better with the people who are in the midst of that instability. I know what it feels like. But that doesn't change what I measure, and the measurements still show the same instability -- fast-growing companies still rise and fall and rise again. Or don't rise again.
INC.: But hasn't your own company-building experience affected your understanding of that pattern?
BIRCH: It's more the other way around. My understanding of growth-company instability has affected how I run my company. For one thing, that awareness has given me comfort -- because I understand there's nothing pathological about my own company's tendency toward instability. Plus, I've been prepared for it.
INC.: Prepared? So you've operated differently as a CEO because of what you learned as a researcher?
BIRCH: Yes. All of us at Cognetics share a kind of knowledge; we've all studied the companies in our database and seen what the fast growers go through -- their extreme and threatening ups and downs. That's made us much more inclined to allow room for mistakes so that the bottoms don't kill us. We know they're coming, so we've built in cushions rather than going for the most rapid growth we could. We've tried deliberately to damp out the oscillations.
INC.: Can you be more specific? How do you allow a cushion?
BIRCH: Well, we keep a reserve of cash -- if we possibly can -- for when somebody gets sick or some client pulls out. We know we'd grow faster if we didn't keep it -- we could hire three more people, invest in a new computer, whatever. That's true. But we've made a very wise choice, I think. It's not that we want to stand still -- relative to the Inc. 500, we've grown pretty well -- but we don't want to try for 300%-a-year growth at the cost of keeping everything at the edge and possibly getting caught short.
INC.: And your employees have signed on to that approach because they know how dangerous the growth roller coaster can be?
BIRCH: That's right. I didn't have to impose some strategy that other people would then have to accept and resent. The group understands it's a choice we want to make. We've been more conservative.
INC.: So you bank more cash than you might have otherwise. Have you turned down business in order to control growth?
BIRCH: Yes. We've said no to a lot of stuff that -- if we were just desperately hungry to grow -- we might have taken. That's been very conscious. And we've spent a lot of time thinking about which businesses we wanted to be in next, rather than stumbling into whatever opportunity happened to come along. I think it's been accepted as a strategy by everybody here.
INC.: Was that consensus reached fairly early in Cognetics's development?
BIRCH: Yes, at the very beginning. We were already analyzing the volatility of growth companies when we founded this one in 1983. And we said, "Let's not fall into this yo-yo pattern that other people are falling into." We didn't want to have to fire half the work force and bring them back and hire them again. It's very inefficient to do that. We decided to try to avoid extremes and still grow.
INC.: The peaks and valleys aren't inevitable then?
BIRCH: No. We've been able to avoid suffering any dips that would require a layoff and the negative effect that a layoff would deliver to corporate morale.
INC.: Have you ever chosen to operate understaffed?
BIRCH: Yes, we have. We've asked people to work very long hours for extended periods -- months -- so we wouldn't have to hire people and blow our savings. We knew that if we didn't work those hours the alternative was pain of another sort. Which poison do you want to take? We took the poison of extensive periods of being understaffed in order not to get caught out on the edge.
INC.: As you've explained it so far, your familiarity with the dangers of volatile growth has led you to rethink: one, the way you handle money; two, the kind and amount of business you accept; and three, the way you staff your company. Anything else?
BIRCH: Financing. We've been conservative in financing. Very little long-term debt, heavy reliance on equity financing and bootstrapping. We have consciously avoided financing that would put us in a vulnerable position.
We also have an elaborate financial control system that allows us to anticipate where we'll be in four to six months, based on a clear understanding of the relationships between when we will make a sale, when we will earn revenue for it -- which is not, for us, when we've made the sale but when we've done the work -- and when the cash is likely to flow as a result. We sit down and update all our estimates every week.
INC.: Are there ways in which this helps you that a more conventional accounting system wouldn't?
BIRCH: It gives us the ability to decide to do things -- buy equipment, hire people, rent more space, create new products, make investments -- with confidence that we aren't going to hit a wall six months out and lose it. And it leads to decisions that are commonly accepted by my management team. We all look at the same numbers, and we don't have battles over "I need more." It changes your whole management style; everybody becomes more cooperative.
INC.: Do all your employees have access to the information?
BIRCH: The entire management team does -- all the key players who are involved in making the numbers happen. Every Monday morning we go through all the numbers and come to a shared sense of what our most urgent problem is. And we allocate our resources in response to that. Is there a short-term cash crunch coming? Get out there and sell.
INC.: You've been describing very technical responses to what your research has told you to expect as a growth company -- ways you manage that are designed to avoid the trap of volatility. But I wonder, are there psychic and emotional benefits to understanding growth, too?
BIRCH: I think so. Absolutely. It's terribly comforting to know what's in store, to know what the normal growth experience is -- especially because it doesn't feel normal when you're going through it. It's soothing to have reasonable expectations.
INC.: It's the reasonable-expectations part I'm curious about. As a researcher you invented the notion of the late-bloomer company; you discovered that the great companies of today weren't born great and that often they languished for years. Does that at all shape your own expectations or the expectations of others at Cognetics? Certainly a lot of growth companies have problems when the elation and novelty of starting up wears off. You hear of their panic because of the fear that if they haven't made it big already -- jeez, we're three years old! -- they never will. They'll never be players.
BIRCH: A lot of companies get hung up that way. They get so anxious about their lack of growth that they start doing foolhardy things -- overleveraging, overcommitting to new business, overexpanding. They push growth to the furthest extreme they can find. That's exactly what kills them.
INC.: Does understanding the late-bloomer phenomenon change the sense of the future that you and your colleagues at Cognetics share? Does it make a difference?
BIRCH: An important one, I think. I remember vividly a meeting we had six months before we started the firm, in which we all sat down and said, "We all know the numbers. We know this is a 7-, 8-, perhaps even a 10-year thing before we have much to show for it. Are we prepared for that?"
We've all known from day one, all of us who founded the firm, that this was a long-term proposition. I remember talking about how we're the people who know the numbers. We've done the research. We know how long it takes for companies to grow. We know what percentage of companies grow, and at what rates. We laid it all out at that very first meeting.
And it's been a big help. We've referred back to that meeting from time to time and said, "We're about halfway there, and we're on the trajectory we want to be on, so don't panic and don't try stupid things." It was a well-thought-out plan. That doesn't mean we don't do stupid things, but we don't do them out of anxiety about not growing enough. We can look back and say, "We knew it was going to be like this."
INC.: It strikes me that all the discipline you talk about -- the financial controls, the status meetings, the conservative staffing -- suggests how incredibly seductive the goal of rocketlike growth can be. And how difficult it is to keep reined in.
BIRCH: Relaxing the reins, abandoning caution, has killed a lot more companies than it ever helped.
INC.: Isn't the temptation always there, though, to loosen up, to grow faster -- because it would seem to solve a multitude of problems that are deadening for a leader to face every day. If you grow like mad, then people can be rewarded more financially. There's more opportunity for advancement within the organization. It's easier to keep people happy. That's got to make the pressure for fast growth almost irresistible. Then there are the pressures from outside the company. We're coming out of a period in which there were no cultural reinforcements to do anything other than grow like crazy. That's where all the adulation was. The hyper growers were the rock stars of the '80s. The guys who didn't hold on to the reins, they were the ones with vision.
BIRCH: A lot of those superstars are struggling right now.
INC.: But in our world, that's OK. That's the way to fail. In the '80s it was OK to reach, to fly too close to the sun. What was not as OK was to find a nice reason able altitude to fly at. . . .
BIRCH: Our strategy was not to race for the sun or be on the edge, but to get there in the long run. I will never grow at the risk of destroying the company. And every bit of our research shows that more CEOs should think the same way. I'll admit the pressures to grow are great, as you say. Our financial information system has saved us more than once. Without it -- a clear set of indisputable indicators that the entire management team can see -- it would be much tougher to go back and say, "We have to hold off for a while."
INC.: Have you ever faced a situation in which, because other people have access to those numbers, you want to push the company to grow and they come back and say, "David, no. Look at the numbers." Does it provide a system of checks and balances?
BIRCH: Sure, it goes both ways. I might want to go do something, and someone will say, "We don't have the cash flow right now," or "If you do that you'll jeopardize the project I'm already working on." We might conclude that if I'm going to pursue my project, I'd better figure out some way to finance it, because the numbers show that bootstrapping it inside the company would be dangerous.
That kind of financial information makes it a lot easier to pull back when you're tempted to go after things, a lot easier to say no to certain kinds of business or certain kinds of clients when you can see the results would be dicey.
INC.: We're all acquainted with the personal drain a founder suffers in starting and building a growth company. All this stuff -- the financial information and the understanding of how growth companies really evolve -- does it reduce the wear and tear?
BIRCH: Somewhat. I don't think you ever avoid the wear and tear completely -- there's always so much to do; you're always understaffed, always cash short, always constrained, working 14 hours to keep ahead of the ball that's rolling down the hill. But I do sleep a lot better because I don't have huge anxiety about what the next six months is going to look like.
If you have a sense of control, you're much less likely to worry. The greatest thing you have to fear is the unknown. The more things you can know about, the less concern you have.
INC.: Let's look at this body of knowledge from a macro view for a moment. Are there new things you've been learning about growth-company behavior? For instance, can you tell us what industries now claim the largest percentages of fast growers?
BIRCH: What's extraordinary about industry representation among growth companies is that it's almost exactly representative of the world at large. In other words, what's extraordinary is that it's unextraordinary. There is no predominance of plastics or biotech or even high tech. There isn't any one industry that has a propensity to spawn growing companies. It's uncanny, the extent to which that's true.
INC.: What about size? Is there a disproportionate number of small companies in the group of 700,000 fast growers?
BIRCH: The size breakdown, too, is fairly representative. I think 88% of all businesses have 20 or fewer employees, and about 86% of growth companies are in that category. About 97% of all businesses have 100 or fewer employees, and about 98% of growers fit in that category. The size of growth companies is representative of the size of the business population at large. What's even more interesting is that they're not disproportionately young or old, either.
INC.: The average age of those 700,000 growers is the same as the average for all businesses?
BIRCH: Pretty much. They may be a little younger than the population as a whole, but they're generally representative. It's nothing like you'd expect.
What's clear is that that source of entrepreneurship isn't what one might have hypothesized it to be back in the early '80s. The fast growers are not coming out of what we imagined to be the hot industries of the day. I think high-tech firms represent only 2.5% of the growing companies -- they're insignificant. That's about what they represent in the population at large. What's happened is that it's the application of technology, not the creation of the technology itself, that offers the greatest opportunities for rapid growth. There are just as many growth companies in wholesaling, low-tech manufacturing, and publishing as there are in high tech. In fact, people are finding niches everywhere in the economy and applying technology to exploit them. They're using a new kind of computer, a new kind of database, or a new kind of labor-saving device to innovate processes in every industry imaginable.
INC.: So what lessons do you, as CEO of a 12-employee company showing solid but not exceptional growth, draw from all that?
BIRCH: The necessity of staying current, staying informed. The ever-wider application of technology has sped up the rate of economic change, globalized markets, and brought unanticipated opportunity. Also unanticipated competition. You have to be smarter, because you're called on to spend your intellectual capital faster than ever before.
INC.: We've heard you talk before about this concept of intellectual capital -- the idea that people often start businesses with a fund of intellectual capital, specialized insight or know-how, that the firm then thrives on for years. But unless you replenish it, it runs out. And one of the great challenges CEOs face is how to replenish their own intellectual capital while being consumed by administrating and selling and putting out fires. How did you come to the realization at Cognetics that you had to focus on your own store of intellectual capital?
BIRCH: I say to myself, "What have you discovered that's new and different this year?" I tend to sit back in the week between Christmas and New Year's and ask myself, "What the hell have you done that's so great this year? How much knowledge have you created?" You have to be at the edge of something or somebody else will be there. You have got to keep producing new intellectual capital. I always take stock once or twice a year.
INC.: When did this start to become an issue?
BIRCH: It's always been an issue. Always.
INC.: But at one point you got concerned enough about it that you started to question how much time you were going to spend at Cognetics. You developed the idea of setting up separate, non-Cognetics research programs.
BIRCH: There was a point three or four years ago when I knew that if I was honest with myself, I had to work full-time at Cognetics to make it work. It was at a critical threshold where it needed more of my time, and I knew it needed more of my time. I got over that threshold, and got to the point where we have enough people to keep the company going without my constant attention.
Then I wondered, can I just keep managing like this or do I have to go back and generate intellectual capital -- either focused on new-product development or just generally, the intellectual capital that keeps us on the leading edge. The answer was that I had to go back to do more research. In the short run, I could make the company grow faster by not doing research. I could consume capital without replenishing it. In the long run, I can't. My company will die if I'm not involved in what's going on and pushing the current base of knowledge.
INC.: We hear a lot of people talk about this differently. They call it going stale. They started out by creating a business based on something they could do with incredible originality, and then somewhere along the line it turned into repetition. They say they're stale and start talking about the need to go fishing.
BIRCH: That's not the same thing. I don't do research to get away from what I'm doing. I do it because I know the difference between consumption and production of intellectual capital. If all I do is consume it, after a while I become very anxious. I liken it to having a tub of water in your head; as you use your special knowledge you can feel the water draining. And you know that if there isn't a faucet pouring water in at the same time, the tub is getting empty. You've got to keep it full. If I don't keep mine full, I know, the world tends to lose interest in what Cognetics is doing.
INC.: Can we broaden this idea to include more than just service businesses like yours that require intellectual capital so directly? One of the recurring discoveries in your study of fast growers is that the way to grow a company is to know something really well and to parlay your knowledge exhaustively. The way to grow a career in this time of ever-changing jobs is to get more knowledge, accumulate your own personal equity. Even someone running the lowest tech of manufacturing plants ought to be thinking all the time about getting knowledge -- finding ways, while running a business, to get smarter about the fundamental thing that that business does. Is that true?
BIRCH: It's particularly true of the CEO in a smaller company, where his position is more important and his impact more obvious. If the CEO goes stale, the company goes stale.
INC.: But for people in smaller companies, the likelihood that they're going to be able to satisfy that need for personal growth within their organizations is negligible. Small companies don't offer that opportunity. It sounds like those owners and managers need to get outside the organization just when there are a thousand pressures keeping them there.
BIRCH: That's true. But the good ones find a way. One of the things that's really striking about the small-business audiences that I talk to is their extreme intellectual curiosity. They are far more curious about what's going on in the world than most people imagine. The questions that I get asked when I talk to a small-business audience have almost nothing to do with my subject matter. They're after broader issues. What's going on in the world? What are the Japanese doing? I think CEOs need to keep learning, and I think more and more of them know it.
INC.: There are lots of roadblocks though, aren't there? We'd make the argument that for many people, owning their own companies can be an intellectually stultifying experience; you don't have a bunch of peers working with you on a day-to-day basis and challenging you. You may be extraordinarily bright and very curious, but your business can be brutally confining. Yet figuring out a way to routinely transcend that confinement is difficult, because your company probably doesn't have the management depth to let you get away.
BIRCH: I agree it's difficult, but it's got to be done. And I think that, increasingly, it is being done.
BIRCH: Small-business owners, entrepreneurs, are going back to school, taking courses, becoming involved in seminars. They'll go to a business school or even a nonbusiness school and take a 6-week course or a 14-week course in some subject they're interested in. They listen to cassette tapes, they read books.
And it's not how to fill out a tax form that they want to know, but a broad-based kind of subject matter. I never cease to be amazed at the extent to which audiences I meet want to elevate the discussion rather than narrow and focus it. It's not how to anymore. It's: what's going on out there? What new technology might I use that I hadn't thought about? What's in it for me in Eastern Europe?
INC.: Why would entrepreneurs be getting more concerned about issues not directly relevant to themselves?
BIRCH: Because deep down there is an anxiety that what's going on outside of the confines of your business will affect the ultimate survivability and value of the business. The space between one generation of technology and the next is getting smaller. Markets are changing faster. People are moving and shifting and relocating. All the things that took 5 to 10 years to occur can happen in 18 months. So I think there is a gut sense that you have to keep abreast. It's not pure intellectual curiosity.
INC.: So you think people are more aware of the costs of complacency?
BIRCH: Yes. Part of it is fear driven. If you don't change, something bad will happen to you. There are no safe havens anymore. In any field, anywhere.
INC.: What's the effect of this pressure to be knowledgeable on the caliber of the average business owner?
BIRCH: Positive in the long run. You'll have a much more aware, much more cognizant business owner. The ones that aren't knowledgeable are getting left behind, and the ones that are survive and grow and do well. That's in mundane, not just exotic, businesses. A chain of hair salons comes along and wipes out your barbershop.
INC.: What's the effect on that portion of the U.S. economy that we think of as mom-and-pop ventures? We've had the feeling that there's lots of anecdotal evidence, if not statistical, that that part of the economy is shrinking, that mom-and-pop businesses are becoming extinct. Is there evidence that that's true?
BIRCH: There's still a large number of small firms out there -- with four or fewer employees -- that don't grow or decline over a four-year period and manage to keep going from one year to the next. I would never underestimate the number of those. It's huge. And they're not just grocery stores; they're law firms, design firms, free-lance photographers or consultants, public-relations people.
INC.: Do they have to be savvier just to remain a part of that population?
BIRCH: I think they do, but much of what they do is still mundane enough that changes take place more slowly than in the companies I've been talking about. On the other hand, if I had to say there was a general trend, it's that they are an endangered species. If you think of the creation of technology as one wave of development and that technology's application being the next, then during the wave of technology creation, the mom-and-pop business wasn't very threatened. People were just figuring out how to make computers in the '60s and '70s. It took a while before we figured out what to do with them. But now, during the wave of application, there isn't a business in the United States that isn't threatened. Even in the most mundane businesses, there's somebody out there trying to do it more cleverly and more efficiently and with more pizzazz.