Growth is one of the most prominent business objectives of many firms. In recent years it has become almost self-evident that a company has to grow in order to be successful. No matter what firm or business, there always seems to be a need for further expansion. In other words, growth has become an imperative.
Admittedly, this may not come as a surprise, considering we live in an economic system that builds on constant growth (see also Do We Really Need Economic Growth?). In that sense, companies would need to grow simply because they are a part of the system and all the others are doing it too, right? Well, fortunately it is not quite that simple.
In fact, the need for growth firms experience depends on several factors. These include the owners' ambitions, the age, the markets, the current size, and the ownership structure of the company. The most important of these determinants is the ownership structure, or more specifically, whether a company is privately or publicly owned.
In general, privately held companies do not depend on growth as much as public firms. Obviously in the beginning they require a certain level of growth to establish a presence in the market and to become self-sustainable. However, once they reach this critical size, their need for growth may actually decrease for the following reasons:
- Low complexity: Private companies are often small, entrepreneurial firms that sometimes consist of not more than a single member. In these companies there is little need for complex governance and compliance structures. As a result, they have to deal with less bureaucracy and can focus on their core business instead.
- Limited capabilities: Small private companies have a limited capacity. Some of them deliberately chose not to expand their business even though they are working to capacity (or even beyond). Often, the reasons for this is that the managers (i.e. entrepreneurs) lack the necessary capabilities to manage a larger firm or they want to rather focus solely on the technical part of what they are doing.
- Long-term orientation: Family firms in particular are generally managed with the intention to pass them on to future generations. Hence, they are seen as legacies that derive their value from tradition and emotional attachment, rather than just high growth rates and short-term profits.
- Niche markets: Many private firms supply very specific niche markets. Since these markets are usually quite limited, there is no need for these companies to grow beyond the point where they can sufficiently supply their niche. This is especially true if the expansion into other markets would require substantial and risky investments.
- Capitalization: Private firms often have a closed circle of investors who are also highly involved in the company. As a result these firms do not depend on traditional capital markets and financial ratings as much as public companies. This is important to note because capital markets generally value firm growth extremely high (as we will see below).
Ultimately, there are several reasons for private companies to stay small (once they are self-sustainable). Of course this does not hold true for all private firms. There are still plenty of privately held companies that have a strong need for growth. In fact, some of the worlds largest companies are privately owned. Nonetheless it is safe to say that it is not always necessary for private companies to grow continuously in order to be successful in the long run.
Unlike private companies, public corporations usually experience an extremely high need for growth. This is mainly due to the fact that the shareholders (i.e. the owners) mostly see their ownership stake as a short- to midterm investment. Thus they demand high payout ratios and dividends as soon as possible. If corporations do not grow continuously, they will not be able to meet those demands in the long run for the following reasons:
- Competitive edge: Companies can use their size to get a competitive edge. For example, they may be able to realize economies of scale, i.e. to produce large numbers of a certain product while at the same time reducing costs per unit. However, if they stop growing, they will lose this advantage eventually, since competitors will catch up and maybe even pass them.
- Customers: If corporations do not grow, they risk losing existing and potential customers. As the customers expand their businesses, it will become increasingly difficult for these firms to supply the additional goods or services demanded. As a result, the customers will eventually have to look for another supplier.
- Market valuation: Financial markets value firms by how much they have grown in the past and by how much they can potentially grow in the future. Thus, a company that does not grow will not be valued very high, because its projected future cash flows (i.e. dividends) are stagnant. As a result it will lose a significant amount of its market valuation.
- Raising capital: If the market valuation of a corporation decreases, it will become increasingly difficult for that company to raise capital (i.e. equity and debt). As we said, investors generally want to increase their return on investment and creditors want to make sure they get their money back. Both becomes more unlikely if the company does not grow.
- Resource allocation: Big companies have a lot of bargaining power, thus they can usually get a substantial share of resources over the course of an allocation process. This is especially relevant for firms that depend on limited natural resources. If they lose bargaining power, they essentially lose access to those resources.
In conclusion publicly held companies can only survive if they are able to provide attractive investment opportunities. If dividends don't grow, shareholders could have just bought government bonds with a similar interest rate but at a much lower risk. Once again, there may of course be exceptions to this rule, but in general it can be said that corporations have to either "grow or go" in the long run.
In a Nutshell
We live in an economic system that builds on constant growth. Accordingly this is also one of the most prominent goals of many companies. However, the need for growth that companies experience depends on several factors including the owners' ambitions, the age, the markets, the current size, and most importantly the ownership structure of the company. Privately held firms often do not need to grow beyond a certain point, because they are characterized by low complexity, limited capacity, long-term orientation, niche market positioning, and less dependence on capital markets. Public companies on the other hand need growth because they are at risk of losing their competitive edge, customers, market valuation, investment capital, and resources if they stop growing. In that case they cannot pay increasing dividends anymore and thus become a less attractive investment opportunity.
Labels: Business, Economic Growth, Firm Growth