Executive Summary
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Small and medium-sized enterprises (SMEs) are increasingly important to long-term regional, national, and global economic prosperity.
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While growing, many SMEs encounter periods that require investment in assets and/or research and development (R&D) in advance of any resulting increase in turnover and associated profits.
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During this period, known as the “valley of death,” key performance indicators such as return on investment (ROI) can be adversely impacted and limit the scope for future investment.
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To manage growth, SMEs must determine the right timing and response to customer demands.
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To recover ROI, SMEs must control costs and balance long-term prospects with short-term profitable opportunities.
Introduction
Small and medium-sized enterprises (SMEs) are, more than ever, the lifeblood of regional and national economies. The structural shift from goods to service sectors favors the creation of more small firms, where a smaller size is an economic choice for a business vehicle. This shift was exacerbated by technological changes such as the extensive use of microchip technology, which now makes smaller-scale production more economically viable.
SMEs can be more flexible and responsive to new market opportunities and economic recessions. In periods of high unemployment many former employees start their own enterprises, relying on their experience, education, and managerial skills. Furthermore, large firms increasingly place part of their work outside the organization—providing a further incentive for the creation of new small firms, since subcontracting and outsourcing can reduce production costs. However, as SMEs grow and develop, they face strains on their profitability that impact on a key performance indicator—return on investment (ROI). Furthermore any deterioration in ROI will compromise a firm’s ability to obtain finance for further expansion.
Definition of Return on Investment
Return on investment, often abbreviated to ROI, is a ratio that takes the firm’s profit for a given accounting period (normally one year) and divides this by its invested capital, as measured by the balance sheet. The capital invested is calculated as stock and long-term debt. ROI is a measure that demonstrates the effectiveness of the management to use the capital available to generate profit, and hence a return for those investing in the company. The higher the ROI, the better the performance, and the happier existing investors will be. A higher ratio will also improve the company’s ability to find new investors.
The Valley of Death
A problem occurs for SMEs during their growth and development phase, when expenditures on asset acquisition and R&D need to be funded and financing obligations must be serviced. Debt finance, in particular, adversely impacts profitability because interest payments reduce the net profit available for distribution to equity investors. This difficult period, known as the “valley of death,” or “death valley curve” (see Figure 1), is experienced by all SMEs as their need for funds increases and they rack up large accumulated losses before profits from sales can be realized. SMEs that engage in technology transfer and new product development face the greatest difficulties in making it through these challenging times.
Case Study
DeepStream Technologies
UK-based DeepStream Technologies was founded in May 2003 by chief executive Mark Crosier, along with ten other people. They worked unpaid for almost a year to realize their ambition for the product and the company, designing and manufacturing intelligent embedded sensors for remote service enablement in, for example, energy management and building efficiency applications.
Early in 2004, DeepStream secured a total £2.8 million (then US$5.2 million) investment, raised between Doughty Hanson Technology Ventures and the company founders. Later that year DeepStream was awarded two contracts for over US$15 million to design and supply contracts for miniaturized electronic protection modules for switchgear products. A number of business awards followed in 2005. Second tier funding was obtained in September 2006—£5 million (then US$9.5 million) from 3i, a world leader in private equity and venture capital, and a further £2.8 million (then US$5.3 million) from initial investor Doughty Hanson; additionally, they were awarded government grants of £1.5 million (US$2.9 million).
More success came when DeepStream was named a 2007 Technology Pioneer by the World Economic Forum1 in Davos, and Mark Crosier was named Ernst & Young’s Science & Technology Entrepreneur of the Year for the United Kingdom’s northern region. In July 2007 employee numbers reached 60. Further long-term contracts were obtained in 2008 and employee numbers expanded to 80, with a new production facility opened as the company announced plans to double in size by 2010.
This case study is of a company that is a huge success story, but what do the figures say about this SME during its growth and expansion phase? The large contracts, though headline-grabbing, are long term, and realized annual sales over the period 2004–07 averaged less than £0.3 million (US$0.6 million). During this time, the costs of expansion continued to rise until by March 31, 2007, the company had accumulated a total loss of £7.8 million (US$15 million). The effect on ROI was devastating, with negative returns reported, and yet the long-term prospects for the company are good, the investors are content, and the credit rating of the firm is measured as stable.
Growing and Maximizing SME Profitability Without Compromising ROI
So how can SMEs grow and maximize their profitability without compromising ROI? The first rule is that growth must be carefully managed, with expansion financed through a series of stages. DeepStream had backers with deep pockets and a lot of patience. Venture capitalists are in it for the long term, but many companies are financed by debt provided by banks, who expect their interest and capital payments to be made on time, regardless of the firm’s position on the death valley curve.
Instead of diving headlong into expansion at all costs, SMEs need to manage their customers’ aspirations, planning where they want to be and when. In this way the size of the valley can be limited and it will be possible to return to a profitable position far sooner than would otherwise be the case. It is far better to have a series of planned growth phases between which ROI can be allowed to return to acceptable levels. This will demonstrate to potential equity investors that management is in control of the company’s destiny and that it is not being controlled by any unrealistic demands from customers.
The second rule is to manage your costs, as it can be quite easy for SME managers to accept the loss-making situations that are experienced as a company expands and to lose control of expenditure. Debt blindness sets in as the figures become ever larger and managers lose sight of the original business plan.
Finally, focus on the more short-term profitable options available to the business. Long-term contracts are fine and can keep investors happy, but economic conditions may change and a bird in the hand is worth two in the bush. The contentedness of investors will quickly change if the long-term contracts fail to come to fruition because customers go bankrupt or file for administration.
Making It Happen
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Control the growth of your company; don’t let its growth control you.
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Who is in charge—the management or the customers? Sure you have to respond to customer needs, but they are not going to deal with the bank manager when your overdraft exceeds the agreed limit.
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Keep the costs under control and according to plan. Don’t think that because you are investing in a growing company you can’t keep on top of purchases and investments.
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Don’t chase the end of the rainbow. Some large orders may appear very attractive and profitable in the long term, but would you really be able to cope in the meantime?
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Take smaller strides forward and allow profitability to return. Let the business catch its breath, and then take the next steps to further growth and development.
Notes
1 The World Economic Forum is an independent international organization committed to improving the state of the world by engaging leaders in partnerships to shape global, regional, and industry agendas.
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