Growth. It’s a word that’s on almost every company’s list of goals. There’s even “conventional wisdom” sayings like “If you’re not growing, you’re dying.” Corporate growth is good for investors, employees, and the communities they reside in. So it stands to reason that more growth is always a good thing and makes for a healthier, more successful company.
Except it doesn’t.
Let’s say you’re going to start a bank. After renting a building and getting your affairs in order, you’ve got $1,000,000 in cash available to make investments. As a bank, much of your revenue is going to be interest payments; banks make money by loaning out money at a rate exceeding the interest they pay on savings. So the best way to grow the business’s revenues and income is going to be to issue loans to customers. Seeking growth, you issue ten $100,000 mortgages at a 5% interest rate. Excellent. Your cash is deployed in solid investments that are going to make you a good amount of money. If you issued 30 year mortgages, you’ll make over $90,000 in interest payments over the life of each loan – excellent return on investment. Well hey, we’re boosting revenues and income, let’s see if we can grow some more!
But wait… when we issue a mortgage, we have to shell out cash to buy the property in the first place. We’ve locked up all of our available cash for growth investments already, and it’ll take us 30 years to recover all of the initial investment plus profit. It’ll take 19 months for our 10 mortgages to produce $100,000 in cash to issue another one, and 15.5 years to recover the whole $1,000,000 in cash that we started with, assuming there are no additional investments in that time.
In order to get more cash for growth, there are only a couple of options. One is to take out debt. If you can borrow at a rate less than your net margin, it’s technically a gain financially. It increases your leverage, and therefore risk, but hey, it’s for growth, right? The second way is to gather money from investors. In this case, you get cash in hand, but you give up a little piece of control of the company. This is what happens in a stock issuance – the company is trading control for cash. And again, anything for growth, the holy grail of business sustenance, right?
You can probably see the problem with both approaches. Corporate debt feels really similar to household debt. Leverage can help you do things that you couldn’t otherwise do, like buy a house. But utilized excessively or unwisely, it can cause your finances to be a wobbly stack of dominoes, balanced on a razor’s edge. The same is true in a company. Debt can help us grow our business and make new investments, but too much debt or poorly deployed debt can kill us.
Even “equity financing” – the term for when a company trades control for cash and issues stocks to investors, has its threats. If you give up enough control, you can lose the company or find yourself tugged around by investors who own as much of your company as you do. This is what venture capitalists do. They capitalize on small business owner’s desire for growth and inability to generate the cash to grow sustainably. The business owners, so focused on growth that they’re blinded to the long-term impacts of selling part of their company, accept these deals and eventually get pushed out or bought out when their pursuit of growth hits a tipping point and they no longer truly own their company.
Interesting side note, this is how massive companies with huge market share produce growth. Microsoft, for instance, has as much market penetration as they could possibly have in their core business. They can’t really generate substantial growth in Windows or Office products; they’re already practically everywhere they can be. Instead, Microsoft will become equity investors in smaller, high-growth business, until they can buy them out and grow them sustainably using their huge cash reserves. Some of the businesses they buy are just trying to cash in on this demand for growth, hoping to catch the attention of a whale like Microsoft or Google and be bought out for millions. Others are less willing, and succumb to hostile takeovers due to shortsightedness and necessity.
So what’s the best approach to growth?
There are two concepts that should be considered in every business’s growth strategy: internal growth rate and sustainable growth rate. Both of these terms rely on the company’s plowback ratio or retention ratio, which is simply the amount of their earnings that they reinvest versus distributing. A 75% plowback ratio means that $0.75 of every $1.00 of earnings is put back into the business, and 25% (the payout ratio) is given to investors as dividends.
These definitions are pretty easy to swallow, they’re just not talked about very often because “conventional wisdom” says growth is always good. The internal growth rate is the amount a company can grow using no extra debt of any kind. They grow using only the earnings that they retain. The sustainable growth rate is always higher unless the company is debt free (then the two rates are equal), and is the amount a company can grow while maintaining a constant debt-equity ratio. In other words, if a company has $0.50 of debt for every dollar they have in cash, the sustainable growth rate determines how much the company can invest in “sustainable growth” using the following formula:
Cash for Sustainable Growth = (Earnings x Plowback Ratio) + (Earnings x Debt-Equity Ratio)
Most companies will target this sustainable growth rate, as it doesn’t increase their leverage ratio, and doesn’t require any equity financing (giving up more control). So yes, growth is good, but only if it’s smart and sustainable growth.
On the opposite end of the financing spectrum, companies can also buy back (repurchase) their shares from the market. This is the opposite of equity financing — it’s giving cash to gain increased ownership of the company. Rather than signaling desperation or excessive, unsustainable growth, this action says that a business is becoming mature. In a mature business, control and ownership — which are intangible and conceptual rather than budgetary or operational — are more vital than cash, because the company’s investments are generating enough cash to grow without leverage of any kind.
It’s a good sign if leadership is talking about capital expenditures and revenues growing, and no further financing is being considering, equity or otherwise. It means that the company is still growing, but generating enough cash through operations that they can do it without anybody’s help. They even have enough breathing room to reclaim some ownership of the company. It means they’re not just growing, they’re growing up.
