01 Aug What’s your growth rate: too fast, too slow, or just right?
We’re often asked what is considered a healthy growth rate for companies in the IT services space.
Among the broader business universe, it’s accepted that growth companies are growing faster than the overall economy, mature companies are growing at about the overall rate of the economy, and companies in decline are growing slower than the overall economy. Most economists generally peg good economic growth in the 2 percent to 4 percent range of GDP, with the historical average around 2.5 percent annually.
The technology industry appears to be operating within its own special universe, as most companies would consider a 2 percent to 4 percent growth rate rather tepid. So we set out to see if my company could arrive at a growth rate formula for IT services that’s reasonable, advisable and achievable for companies competing in this unique industry.
Before we arrived at the formula that seemed to make sense, we scoured the literature for any data on growth rates that might apply to the industry. One of the interesting studies we came across was done by Eric Flamholtz and Yvonne Randle, whose book, Growing Pains: Transforming from an Entrepreneurship to a Professionally Managed Firm (Jossey-Bass, 2007), identified five annual growth-rate levels for small business firms:
- Less than 15 percent: Although many may consider this rate rather unspectacular, a firm will double its size in five years while growing at a 15 percent rate.
- 15 percent to 25 percent: Rapid growth.
- 25 percent to 50 percent annually: Very rapid growth.
- 50 percent to 100 percent annually: Hyper growth.
- Greater than 100 percent annually: Light-speed growth.
We’ve seen growth rates of this enormous spread in the IT industry — from the smallest companies to the global behemoths. This brings up these questions: Where in this far-too-broad range should IT services executives focus their efforts? What’s the growth rate sweet spot? What’s the ideal rate between growing too fast and not being able to keep up with demand, or growing too slowly and not having the resources to create demand?
While there are some formulas for arriving at this rate, in simple terms, think of the break-even point as the floor for your sales growth. This is the absolute minimum in sales you need to make in order to stay in business. The sustainable growth rate then is the ceiling for your sales growth. It’s the optimum level your sales can grow without new financing and without exhausting your cash flow.
We set out to locate the optimal sustainable growth rate for IT services firms, and came up with the Revenue Rocket Growth Principle. In a nutshell, after studying a number of our clients (those with revenues greater than $5 million), this principle postulates that a company’s top-line, year-over-year (YOY) growth rate as a percentage — plus your Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) as a percentage of revenue — should not exceed 45 percent if you want to grow profitably. The ideal mix between the two components of this principle works out to be a 30 percent YOY top-line growth, and a 15 percent profit growth, thus equaling the 45 percent number.
It’s been our experience that firms that outrun this 45 percent target are likely not growing profitably. They’re probably borrowing from the past with accumulated cash on their balance sheet, or they’re stealing from the future, sourcing funds from a credit facility or an investor. Neither scenario is good. Taking cash off the books to fund profit robs the business of operating monies, and borrowing money to fuel profit only increases the need to grow faster to satisfy the creditors, and the craziness begins.
As a growth consultancy, we advise and encourage companies on responsible, manageable and sustainable growth. We worry when we talk with executives whose business model, or whose dreams, have hyper growth or light-speed growth in their sights. Be careful what you ask for.