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OPERATIONS

Why Size Matters
 

When you outgrow smaller rivals and must compete with big corporations for the first time, you're entering a tricky stage of growth called No Man's Land.
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As cautionary tales go, Robert Schell's is a good one. Back in 1999, Schell owned Avico, a business in suburban Chicago that provided e-consulting services. Within a few weeks of finding out that the company had made the Inc. 500, Schell realized that he had expanded too fast and that the market for his services had cooled. He was forced to close down Avico. Even as he negotiated with creditors to avoid bankruptcy, however, Schell was laying the groundwork for a comeback company. That business, Prism Innovations, is No. 126 on this year's list.

Schell is thrilled to be back, but as someone who's experienced victory followed so quickly by agonizing defeat, he has a unique perspective on the achievement. "If a company doesn't have the right foundation, it can fall apart like a house of cards," he says.

Though that's a scary thought for anyone who's toiled hard to build an Inc. 500 company, it's one that must be faced. Yes, you've succeeded to a degree, so take a bow. But at the same time, beware: There's still danger ahead. The well-known business researcher David Birch notes that just one in three Inc. 500 companies is able to keep growing fast enough to make the list for two years running. The reason for the falloff is that they face far greater challenges than the average business. They're competing with bigger firms. They're stretching the capacities of their founders. And as Schell found out, they're burning cash like crazy.

Consultant Doug Tatum has his own name for this stage of company development. He calls it No Man's Land. The founder of Tatum Partners specializes in helping entrepreneurs survive heady growth spurts. Tatum, 47, spent the early part of his career as an accountant before serving as chief financial officer at several companies. He struck out on his own in 1993, and today his Atlanta-based firm has more than 425 partners who serve as CFOs and CIOs to many fast-growing companies.

After watching hundreds of these businesses evolve, Tatum began to recognize that no matter what industry his clients played in, most were facing the same set of challenges by virtue of their size. It was about seven years ago that Tatum began describing this time in a company's life cycle as No Man's Land. "Basically it describes a transition that every company has to go through between being too big to be small and too small to be big," Tatum says. "Once you get through No Man's Land, you end up reviving that growth again. But if your growth slows down, you're stuck."

Tatum regularly gives speeches on the concept, and he's published a booklet outlining the idea. "Like human adolescence, No Man's Land should be a place of self-discovery, acquired discipline, and positive but difficult transition," he writes. "Unfortunately, it often becomes an agonizing battle between the natural tendencies of a lonely entrepreneur and certain immutable forces of growth. The result is confusion, frustration, stagnation, and loss of employee morale, which, if prolonged, can lead to financial failure." Tatum goes on to describe four hurdles facing founders during this stage. Even as they celebrate their inclusion on the Inc. 500, many of the companies on the list are already facing them today.

1. The natural limits of the "We Try Harder" model

Whatever their industry, most small, growing businesses share similar beginnings. A founder and perhaps a partner or two scrape together funding, often using credit cards and home equity. They pay themselves below-market wages, work ridiculous hours, and convince a few early employees -- by using equity, charisma, or sheer force of will -- to do the same. Customers are thrilled with the service, and by word of mouth the business grows.

Sounds great, huh? It is, but only for so long. Tatum calls this scenario the "high performance, cheap labor" business model, and it's rarely scalable. As the firm grows, the laws of economics will start to kick in. Over time, managers will be forced to hire folks who aren't as dedicated as the owners and early employees. Whether it's the 10th employee or the 100th, eventually someone begins delivering -- gasp! -- $10 worth of effort for $10 in wages. To get better performance, you'll need to pay more, which means you'll need to raise prices or accept lower profits. That's when the model starts to fall apart. When Tatum hears a CEO say his success is based on "outstanding employees" or "working harder," he can't help but suspect there's nothing unique to the value proposition and that the company's model may not support long-term growth.

Companies also fail to scale if they're too dependent on the founder's talents, which may not be teachable to the rest of the staff. Tatum describes the owner of a $40 million business that buys and sells used airplane parts. The key to the business, the owner told him, is buying the right parts at good prices -- it's a skill that he'd grasped instinctively. But despite the founder's efforts to train his staff, so far his employees seem to lack his intuitive feel for spotting good deals. Unless something changes, that means it's a nice small business destined to never grow large. After all, no matter how hard he works, one man can only buy so many used airplane parts. The key to overcoming this first hurdle, Tatum says, is ruthless self-awareness. There's nothing wrong with businesses that have made it this far based on the innate talents of the founder or the overachieving service of a core group of employees. But only when firms are sure they've found a unique value proposition -- one that works just as well with 10 employees or 100 -- should they move forward.

2. Customers' needs and expectations grow along with you.

Last spring Glenn Burgess got a call from a longtime client. Burgess runs Burgess Construction Consultants in Dallas, No. 281 on last year's Inc. 500. The company does quality-control consulting for large homebuilders. The caller said, "Gosh, Glenn, you don't call, we don't have lunch -- I never see you anymore." The comments blind-sided Burgess. In the early days, he'd spent most of his time with customers, but with $6 million in sales and 85 employees, he now found himself stuck in the office, managing employees. The call revealed to him that customers, used to dealing directly with the CEO, were beginning to feel neglected.

It's one of the typical marketing challenges that companies encounter in No Man's Land, and it's not limited to customers who demand face time with the boss. It's also apparent when firms grow large enough that they begin to divide marketing from production. The employee who drummed up new business used to be the same person who did the work. Now a salesperson gets the contract signed, then hands it off to a production manager. That can lead to miscommunication, overpromising, and lots of customer dissatisfaction.

Customers also have a funny way of expecting more -- way more -- from a supplier as that firm grows larger. Harry Taxin, the CEO of MegaPath (No. 127), says that clients anticipate the same dependability from his $68 million business as they'd get from the huge corporations he increasingly finds himself competing against. MegaPath provides the computer network expertise that connects the nation's 5,000 Radio Shack locations, allowing the chain to track sales and inventory. "The size of our company doesn't matter to them -- they want 100% quality no matter what," Taxin says. "The network has to be up, and if we screw that up, we're wiped out."

Meanwhile, as MegaPath's sales force trolls for bigger clients, they often find themselves outgunned. "We have eight salespeople in the field," Taxin says, while competitor AT&T has "eight salespeople on the West Side of New York." He'd like to hire more salespeople, but it usually takes months before they earn their keep, straining cash flow.

Growing companies must also contend with strict notions of how a company's size should change the way it does business. When the payroll at military contractor Odyssey Systems Consulting (No. 388) hit 50 employees, the company passed the threshold at which the government requires its vendors "to ramp up HR," says CEO Michael Sweat. Later, when the firm passed $10 million in revenue, a new set of accounting regulations kicked in. Then there's the issue that many of the contracts Odyssey wins are designated for businesses with less than $23 million in sales. If the company, which now posts $14 million in sales annually, grows beyond that point, Sweat will "go from competing against small businesses to competing against the McDonnells and the Lockheeds," he says. That's a place where, for now, he doesn't want to be.

Anticipating these growing pains is half the battle, Tatum says. Even before they pop up, begin to make adjustments. Since getting that one customer complaint, for instance, Burgess has put customer service back at the top of his to-do list. He now spends much of his time traveling to his firm's distant offices to see clients. Of course, Burgess Construction still needs someone to oversee day-to-day operations and to manage the staff. That's why its CEO embarked on the third crucial step company founders go through in No Man's Land: Burgess has begun hiring to replace himself.

3. At some point, a founder has to share power.

Tatum says this is usually the trickiest of the four hurdles facing companies in No Man's Land. First, it requires a founder to begin delegating to a new generation of senior managers. Second, it's expensive: Experienced CEOs, CFOs, and COOs -- the three jobs that are often the most necessary hires -- command big salaries, big chunks of equity, or both. Often this feels like a circular dilemma: A small business can't get bigger without these key managers, but the business isn't yet big enough to afford them.

Inc. 500 owners routinely complain that getting seasoned executives to join small companies is a real challenge. Rod Hill, co-founder of Integrated Management Services in Jackson, Miss. (No. 432), says folks in his part of the country prefer working for big, well-known companies. "They may not see much of a future in a young, emerging organization," he says. "They're looking for something that's perceived to be more stable." Hill has also faced challenges getting veteran managers to relocate to Mississippi. However, his firm has used local connections to recruit two seasoned vice presidents, and he and co-founder John D. Calhoun are looking to add to their top management team soon.

Even when filling management posts that don't command six-figure salaries, entrepreneurs can face tough economics. Tatum recalls talking with the owner of a chain of sandwich shops. Every night, the owner collected the cash from each of his three stores. And during the day, if a store manager called in sick, the owner would fill in behind the counter himself. He worked hard. The chain was profitable. Things were going well enough that he expanded to eight stores.

That's when trouble started. With eight stores the company needed a bookkeeper to track and manage cash, an HR system to track employees, and an extra manager to fill in when regular store managers took time off. Those expenses drove the operation into the red. Analyzing the costs, Tatum figured the chain might return to profitability when it had 11 stores, which would generate enough revenue to cover the extra management costs. Trouble was, by the time the owner was losing money with eight stores, he lacked the capital to expand to 11. Either he'd have to backtrack by closing stores or find a way to finance his expansion. "He was stuck," Tatum says.

The key to meeting this challenge, paradoxically, is that "you need to overhire your management," Tatum says. In contrast to the sub shop owner, an entrepreneur who's adding to his management team needs to make sure he plans to grow big enough to support the new costs. Making the offer still requires courage because you're hiring employees even though current sales may not justify them. "The critical issue is 'How do I attract and build the infrastructure ahead of the revenue?" Tatum says, "because if I don't, I won't be able to get there."

4. Money is hard to come by.

While most company founders use their personal net worth to get their business going, there comes a point when capital tied to the CEO's credit history becomes insufficient. Banks often consider these firms too risky for loans. "It's hard to credit score something in No Man's Land beyond the net worth of the individual," Tatum explains. And both banks and venture capitalists often shut out the owners of a business looking for, say, a half million dollars to fund expansion because, Tatum says, "their own cost structure can't have them out there doing small deals." It's simply inefficient.

Tatum sees this betwixt-and-between problem as evidence of a "capital gap," or a structural flaw in the way lending institutions treat small business. To solve it, he's worked with Congress to propose legislation -- H.R. 3062, known as the Bridge Act -- that would offer small, fast-growing businesses a way to defer income taxes during their early years to help fund growth. It's a nice idea, but so far it lacks political legs. So in the meantime, Tatum and other experts say the real way to improve the odds of getting financing is to focus on the first three pieces of his No Man's Land puzzle: fixing the business model, realigning with your marketing, and hiring management. Clearing that last hurdle, by hiring experienced executives, can be particularly pivotal.

Ben Dyer, a general partner in Cordova Intellimedia Ventures in Alpharetta, Ga., recently consulted to an electronics company that had tried for months to line up venture funding, without success. Then its entrepreneurial founder hired an experienced CEO. Voila: A month later, it had a $2 million deal. "The insertion of a new CEO made that company look much less risky," Dyer says. "Venture capitalists are comforted by dealing with somebody who's demonstrated the ability to generate returns for investors and deal with the ups and downs of companies and growth."

Tatum says he routinely sees venture capitalists who'll recalculate a company's value after a big hire. "There's a direct monetized value to having folks who've been there and done that," Tatum says. "Sometimes we've found a critical hire or two is the difference between getting capital or not."

The takeaway here is that if banks and investors aren't buying your pitch, it may be time to rethink the fundamentals that underlie the company and its growth prospects. Is the business model really scalable? Does the company understand its customers? Is the right team in place? Tatum's experience suggests that when a company focuses on those issues, the financing becomes far less of a problem. "The bottom line is the risk," he says. "If you can articulate how you've removed those risks, you'll get capital."

For the men and women running Inc. 500 companies today, Tatum's message could be disheartening. People working 24-7 to build a company hardly need more items on a to-do list. The good news: You can put yourself on course to avoid the fate Tatum describes. Consider Robert Schell, the guy whose first Inc. 500 company quickly went belly-up. This time around he's managing his firm much differently. The new company, Prism Innovations, is focused on a tiny niche, handling maintenance contracts for big companies that use Cisco databases. Last year sales hit $6.8 million. "To take this to the next level and scale it would take a ton of money," he says. If a big company wants to talk about funding that (or even buying Prism outright), he's all ears. But for now, he's happy to keep the growth curve more manageable. "We have a nice little business: eight employees, money in the bank, zero debt. We're working a lot smarter in this business than we did in the last company." Rather than run into No Man's Land, he's determined to keep managing via a simple mantra: Small is beautiful. (He's not alone in opting for slower growth. See "How Big Is Big Enough?" page 40.)

Other companies will continue to surge ahead. Lendia (No. 174), a mortgage brokerage in Worcester, Mass., has prospered since its founding six years ago. Today co-founder Gregory O'Connor oversees a staff of more than 100 people. Helping consumers find and refinance mortgages is a notoriously cyclical industry, so for the last year O'Connor has been working to transform Lendia into a firm that also supplies technology and consulting to other mortgage brokers.

"It's a very scalable business model that we feel we've carved out, and a very differentiated niche," he says.

To help fund the expansion, Lendia is in the midst of a private placement that will net it $15 million in new financing. And by the end of the fourth quarter, O'Connor hopes to have engaged a recruiting firm to hire both a chief financial officer and a chief operating officer -- "a replacement for myself, quite frankly, someone who has a lot more breadth and depth," O'Connor says, describing the ideal candidate as someone with corporate and global experience. Hearing about O'Connor's efforts, Tatum voices approval: "He's aggressive, and he's ruthlessly self-aware about the cyclical nature of the business, how it scales, and what it needs in terms of senior management." Maybe, just maybe, Lendia will be the rare company that beats the odds and makes the Inc. 500 for a second year in a row.

Sidebar: Is your company too big to be small, but too small to be big?

Here are 30 key questions Doug Tatum uses to assess if a company is in "no man's land"

Understand Your Model

Are you experiencing unprofitable growth because the growth rate of overhead is exceeding the growth rate of sales?

Are your employees misinterpreting sales growth as profit and thus raising their compensation expectations?

Are you unsure of the true cost of each individual product and service?

Are you unsure of how much it will really cost to increase sales?

Are you feeling an inability to follow through on compensation promises to employees?

Do you know how much additional cash you will need to fuel accelerated growth?

Realign With Your Market

Do customers only want to deal with you?

Is there undue stress between sales and operations?

Do you have dissatisfied customers?

Are you forever putting out fires?

Are you having difficulty distinguishing your products and services from those of your competitors?

Have your sales stagnated?

Do you have an apparent lack of competitive advantage?

Are you bored with your core business and beginning to focus on new products and services?

Are you living on past reputation?

Do new product and services reflect your personal interests and not necessarily your customers' needs?

Hire To Replace Yourself

Is your company outgrowing the abilities of certain long-term loyal staff?

Is everybody waiting on you to do something?

Are you the only "senior" management?

Are you anxious about letting employees learn from their mistakes?

Is your company confused with regard to priorities and direction?

Do you fear losing control to new management?

Do you have too many meetings?

Are there dotted lines in your organizational structure?

Does your staff feel you attempt to implement the management theory you read most recently?

Raise Your Money

Are you experiencing poor cash flow?

Have you been repeatedly turned down by banks and others for financing?

Are you unable to make needed capital investments?

Are you unable to hire key people because they view the business as too risky?

Are you unable to recruit key people because you cannot afford to pay them?

Key

If you answered yes more than 15 times, you're in No Man's Land. Ten to15 times, your antennae should be up. Nine or fewer, just keep an eye on these issues.

Daniel McGinn is a national correspondent for Newsweek based in Boston.

Last updated: Oct 15, 2004




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