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Death by Unnatural Causes

Rapid growth causes a series of Inc. 500 companies to experience dramatic upheaval.
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Postmortem

Most small businesses get killed by sweeping shifts in technology or by global competition. For fast-growing companies, the real enemy is within

Just three years ago linda kesler started each day staring down the same stark choice. "I woke up every morning flipping a coin," recalls the founder of Create-a-Check Inc. (#290). "Either I'd go into bankruptcy or I'd see this thing through."

Kesler had founded the business--which makes check-printing and electronic-payment software--a little more than three years earlier, and she wasn't the type to cave in easily. She had, as she puts it, "had a few challenges" over the years, which is understandable given her status as "a non-Mormon, a smoker, and a drinker in Salt Lake City." She was also one of the city's pioneering female entrepreneurs, having started her first venture in 1974. "Early on," she recalls, "I went out to meet a potential client, who asked me why I wasn't at home taking care of the children."

By 1995, much to her chagrin, it looked as if she'd get more time at home. It wasn't so much the prospect of failure that stunned Kesler. Rather, the circumstances were what took her by surprise. Create-a-Check, after all, wasn't being overrun by some massive shift in the marketplace. The company hadn't been stomped by a swift competitor, walloped by a nifty new technology, or even destabilized by relentless regulatory shifts. Nothing in the outside world had preordained Create-a-Check's demise. If the company went under--and, given the hundreds of thousands of dollars it owed its vendors, closing shop appeared to be the sanest strategy--Kesler would have only one person to blame: herself.

Not that she wouldn't find plenty of camaraderie among other founders of fast-growing companies whose creations had gone kaput. Talk to those who have presided over the demise, or near death, of their fast-growing entities, and they'll almost never list external factors as the critical culprits. Despite whatever strains speedy growth appears to place on them, Inc. 500 companies are sturdier than typical small businesses. Much sturdier, in fact. According to a study of the class of 1985, the survival rate of Inc. 500 companies is about twice as high as that of traditional small businesses. (See " The Startling Truth About Growth Companies," State of Small Business special issue, 1996.) Often, Inc. 500 companies can withstand the enemies that snuff out their more ordinary counterparts. By contrast, they die of unnatural causes. "Ninety-five percent of the failures are due to internal problems," observes Dave Ferrari, president of Argus Management Corp., in South Natick, Mass., which specializes in turnarounds. "I can't tell you how many companies I've been to that have the fast-growing-company plaque on the wall and are about to go under. They don't have the systems and the people in place. Accounting is lagging. Purchasing is not done in the most efficient manner. Inventory gets out of control. All of a sudden, all these mistakes compound, and the least little burp kills them."

The collapse is swift--or seems to be, anyway, in part because CEOs are so busy scanning the horizon for threats that they overlook the nearby symptoms of internal bleeding. "They unravel fast," says turnaround consultant David Auchterlonie, CEO of the Scotland Group, in Los Angeles. "What you're seeing are the results of bad decisions pervading the organization."

Besides, founders of fast-growing companies aren't inclined to build much of a cushion for themselves: fast growth yields goals for even faster growth, with profits reinvested accordingly. Witness how many of this year's Inc. 500--148, to be exact--ranked on last year's list. "I always thought you had to take the company to the next level," says Hadi "Mike" Mahmoodi, founder of NIE International (#404), a three-time Inc. 500 winner, which recently endured its own upheaval.

But as Mahmoodi, Kesler, and others attest, CEOs of fast-growing companies can save their businesses from their own worst enemies--namely, themselves--by making some assumptions about the burdens that fast growth will likely impose upon them. Whether your own fast-growing company ranks among this year's Inc. 500 or not, it's a worthy priority to make yourself aware of these trouble spots, lest they turn into trapdoors.

You'll grow exhausted from managing fast growth
What took her years to build, Linda Kesler almost bankrupted in less than six months. "It takes very little time without paying attention to destroy a company," she reflects.

It started in the fall of 1994. Exhausted from running three businesses and newly remarried, she instinctively installed the only logical person--actually, the only person, period--to serve as president of Create-a-Check. Marketing director Alan Redd was promoted to president, enabling Kesler to take a break. "I wanted to live longer than my father's 54 years," says Kesler (now 52), who claims that her father, an entrepreneur, worked himself to death.

The transition took place quickly, as it had to. Although Kesler and Redd were supposed to talk weekly, they rarely did. "I was a newlywed and was tired," she confesses. Redd failed to meet sales budgets, Kesler claims, and expenses grew as sales stagnated. For example, she says, he hired several telemarketers to generate leads, an approach she opposed. He also brought on salespeople, who had to wait while the telemarketers struggled to identify prospects. "The telemarketing effort didn't work out as well as it could have," concedes Redd. Against Kesler's wishes, he spent at least $1,000 over the course of 60 days to prepare for a venture-capital fair that didn't raise a dime. "I knew she wasn't as happy about it as she could have been, but it was very good exposure for the company," insists Redd.

Beyond their specific disagreements, the fact remains that Kesler got herself into that situation by making a maximum-impact decision with minimal forethought. "It happened too fast," says longtime board member Mitch Feinglas. "One day Linda put him in charge. She shouldn't have given up control to Alan. He wasn't prepared to take it."

By the time Kesler returned, in February 1995, vendor lawsuits were pending. In one case, the company's failure to show up in court meant that it was forced to pay a $10,000 bill from a public-relations firm--plus $5,000 in court and lawyers' fees. In total, she says, Create-a-Check owed about $450,000 to its vendors. Redd claims any debts were incurred before he got there and says he had no authority to deal with accounts payable. "Individuals make all the difference in the world," he adds. "It's important to know if they're going to be able to let go of the control enough to let an organization be successful."

Whatever the cause, the arrangement wasn't destined to last. Kesler, refusing to let the company slip into bankruptcy, fired Redd and 50% of the workforce. Against her better instincts, she sold accounts receivable to a factor to boost cash flow. And she worked out payment plans with her vendors. For 1994 the company reported a $500,000 loss on sales of $1.4 million. This year Create-a-Check anticipates profits of $300,000 on sales of $4 million. Beyond a test of her survival skills, Kesler has taken away a valuable lesson: next time, she says, "I'd try someone out on a limited basis for at least six months rather than go through a baptism by fire." Of course, that would mean thinking about grooming a replacement ahead of time. "The energy level required to build an organization is tremendous," comments business professor John Kotter. "I've been at the Harvard Business School for 25 years, and I'm embarrassed to admit that we do almost nothing to help people understand that."

You'll have to surrender your casual ways
"With a cash-strapped company you don't want to spend money on lawyers," says Timothy Tulloch, former owner of Regency Coffee (#173 in 1992), in New Prague, Minn. That's how Tulloch and his cofounder (and wife), Therese Dotray-Tulloch, now agree that they made their first misjudgment.

As creators of a fast-growing coffee-roasting, wholesaling, and retail business, they reached a time in 1989, with $750,000 in revenues, when they felt desperate for cash and outside expertise. Frequent patron Ronald Burton seemed like the perfect candidate to help them. The experienced, older businessman offered $300,000, according to Tulloch. "When an angel comes, it can be a great relief," he says. So much so that the English-born Tulloch neglected to put anything in writing and didn't bother hiring a lawyer. Tulloch says he and his wife named Burton chief financial officer and gave him 50% of the company. "The company seemed so small at the time," says Tulloch. "You never know that the business you start could become successful."

At first the environment was exciting. Burton--who could not be reached for comment--was growing the company by opening stores. Revenues doubled, from $1.4 million in 1990 to $2.8 million in 1991. But soon the Tullochs realized that their original vision was fading from sight. "The first and second stores were fun," admits Tulloch. "Thereafter we were spread too thin as owners. We didn't get to know the customers." Six new stores opened in rapid succession. Before long Burton began importing espresso machines and espresso carts. He even talked of opening and franchising new roasting plants.

By late 1991 the Tullochs wanted Burton out. But it wasn't that simple. After all, Burton held a 50% stake. And there were no written agreements spelling out who would get what in the event of a split. "Loose agreements tend to get messy," says Tulloch. "I regret that we didn't get a contract of agreement prepared by a lawyer in the beginning." Eventually, the two parties settled out of court, with Burton buying the Tullochs' half at a discounted rate in return for not imposing a noncompete agreement.

By the time Tulloch's company appeared on the 1992 Inc. 500 list, he and his wife had already fled Regency Coffee. "It was sad," Tulloch recalls. "Whenever you build something up, it becomes like a child to you."

Your success will change everyone but you
Remember all those people who were grateful to have you shouldering the burden of getting the business off the ground? Once it's airborne, you'll be surprised at how comfortable they suddenly feel about squeezing into the cockpit.

Two weeks after his company appeared on last year's list, Mike Mahmoodi was sitting at his desk, ordering plaques to honor his two longtime board members at the upcoming Christmas party. They marched into his office and plopped down a severance package and noncompete agreement, asking him to sign it and then leave. "I asked them, 'Are you kidding me? NIE is me," recalls Mahmoodi.

Mahmoodi, an Iranian immigrant, had founded NIE International, previously a two-time Inc. 500 company (#32 in 1995 and #423 in 1996), in 1990. He's still unclear about what drove Dave Hann and Bob McKeon to boot him out of the Phoenix-based maker and distributor of computer parts. "A lot of people believe it was the spotlight that did it," says Mahmoodi, who had also been Arizona's Entrepreneur of the Year. "Everyone sees my name and not theirs."

Hann and McKeon had always, as far as Mahmoodi could tell, looked after his best interests. In return, they--along with a third partner--were given large equity stakes and eventually accumulated more equity than Mahmoodi. But Mahmoodi wasn't thinking about the consequences. From 1994 to 1996 sales doubled twice, before hitting a profitable $25 million in 1996.

Success only made Mahmoodi hungrier. Having worked himself up once from penniless beginnings (see " Unsentimental Journey," Inc. 500 issue, 1996), he had a mentality that was different from that of his board members. Mahmoodi believes that Hann and McKeon, who were both nearing retirement age, were less interested in risk. In October 1996, when Mahmoodi went to them with a plan to move into manufacturing, they said no way. McKeon says he was against entering a lower-margin business.

Such a move, Mahmoodi believes, worried them because it could delay a potential public offering. "If we took the company public in 1998, they couldn't cash out until after 2000," Mahmoodi speculates. "They wanted the money now." McKeon disputes his theory. "We didn't believe we would have much of a chance of going public that way," he says. Hann wouldn't comment on anything related to Mahmoodi's exile. "Mike was sad," says McKeon. "It made me feel bad. Many times I've wished that we could have taken a different approach. In retrospect I would have had a discussion rather than made an ultimatum."

"I was so pissed," Mahmoodi exclaims. "I worked 20 hours a day to make something worth something, and someone comes in and takes over. I couldn't go to sleep." Mahmoodi's brother also left the company, as well as a close friend, who had to go, McKeon says, since he was "an endless leak" back to Mahmoodi. Mahmoodi's wife, Parisa, went joyfully; she had been begging him for years to allow her to leave, since she had often worked long hours without pay.

With his lawyer, Mahmoodi drafted an offer to buy out his former board members, raised the money, and got his company back--all in 45 days. Then he ventured into the manufacturing business. "Now the company is going in the right direction," he says.

Your level of business sophistication will be tested
When the CEO of a $200-million-plus publicly traded company expressed interest in acquiring Adnet Telemanagement, Adnet founder Dave Wiegand couldn't help feeling flattered. "It was one of the few times in my business career when I felt like somebody was paying attention to what I had accomplished and was giving me feedback about how much value I had created," says Wiegand, whose company appeared on the Inc. 500 four times, most recently in 1996, when it ranked #288. "That doesn't happen to you too much when you're growing your business. You kind of get caught up in that." It was hard to resist the temptation to sell his $8.9-million company, a reseller of long-distance phone service.

The offer came along at just the right time, given the competitive landscape. "Consolidation is the wave," explains Daniel Zito, a telecommunications analyst with Legg Mason Wood Walker, the Baltimore-based brokerage. Zito says that, with the former Baby Bells entering the small and midsize business markets, long-distance resellers of Adnet's size can hardly survive. They need bigger volume, he says, to increase their buying power. "It's hard to grow a small long-distance company, because the competition is so great that most of your sales efforts do nothing more than replace customers you're losing to the competition," explains Wiegand. "So you sit there, growing maybe 10% to 15% a year."

The deal offered to Adnet by Midcom Communications Inc., itself a former Inc. 500 company (#183 in 1995), looked ideal. The Seattle-based telecommunications service company had already scooped up five other companies--along with the customer bases of other businesses--and rolled them up to create a $200-million company. Wiegand says Ashok Rao, then Midcom's CEO, told him the next step was to acquire its way to $1 billion in sales--which was believable, given that in the previous five years the company had shot from $10.9 million to more than $200 million. Wiegand says the deal also promised, among other things, better economies of scale through consolidated billing and increased buying power, and the opportunity for Adnet to take over all of Midcom's large nationwide accounts. A possible merger between Midcom and Telco Communications Group, a Virginia-based company, which was supposed to close within about 30 days, also sweetened the pot. "It would have probably increased the value of our stock 20% to 30% within a couple of months. And by 100% within a year," says Wiegand.

Due diligence seemed easy enough. Joined by his lawyer and his accountant, Wiegand says, he combed through the financial reports Midcom had filed with the Securities and Exchange Commission. Midcom, Wiegand recalls, sent someone to Adnet's headquarters, in La Mirada, Calif., to check the company out. At the end of 1995, he sold the company for $8.5 million in stock.

Almost immediately, with Adnet established as one of the country's top 10 long-distance companies, sales soared to an all-time high. Profit margins expanded. Recruiting troubles vanished. "It was one of our most productive times. Every department was going crazy," says Wiegand. "Every key indicator was up for the first quarter." And there wasn't much interference from the mother company. "They just left me alone to run the company as I always had," he says.

Then came March 4. On that day, Midcom issued a press release restating its 1995 third-quarter results, reflecting a much larger loss for the quarter--$8.3 million instead of a projected $3.8 million--as well as a $33.4 million loss for 1995. The change in fortunes, attributed to a new billing system, sent the company's stock plummeting from more than $18 a share to around $6. Midcom lost more than $200 million of its value. In 90 days "I lost more than half the purchase price," Wiegand says.

The worst wasn't over. Within 60 days of the restatement, Wiegand was getting less than half of the new business he expected. Competitors in the fierce long-distance business, he says, started highlighting Midcom's financial problems to potential customers. Employees exited. Midcom's president stepped down, and the company started restructuring--with Wiegand left feeling deserted. "In retrospect I realized that when you sell your company for stock, it's just about the same as selling it for cash, taking all the cash, and buying stock with it in one highly speculative growth company. No one would ever do that," he says.

Wiegand blames himself for not undertaking a more thorough investigation beforehand. In retrospect, he says, he should have called some of Midcom's other acquirees. What would the probing have turned up? "It turns out their strategy was flawed in how they were integrating the companies," says Wiegand. "They acquired so many so fast. No one was integrating billing or customer service or product lines. They'd ignored the companies, and key people were leaving."

Having entered a much more sophisticated arena, Wiegand had no idea what he was in for. He sued Midcom for $10 million last August, but eventually he agreed to put the litigation on hold. Wiegand, who is no longer at Midcom but who remains a large shareholder, will wait three years, hoping for a stock rebound. "It took me 15 years to build this company," he muses, only to watch its value evaporate "in a matter of 60 days."

Last updated: Oct 15, 1997




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