When hearing the word life cycles, perhaps your biology classes’ discussion of animals and plants is the first thing that comes to mind. However, in the world of corporate finance, we often hear businesses classified as if they are going through life cycles of their own. A corporate life cycle refers to a business’s stages, from its inception to growth, maturity, and eventual decline.
Many explanations in economics and finance look to simplify models to explain real-world scenarios. In this article, we will look at the simple example of a lemonade stand to explain corporate life cycles. At every stage of the corporate life cycle, a business’ goals can be simplified to the singular aim of maximizing its value. Our lemonade stand functions identically. Throughout this article, we will look at the different ways corporations operate to maximize their value as they go through the various stages of the corporate life cycle.
Although there are many ways to distinguish the different stages a corporation can be in, we will be looking at four main categories: seeding, growth, maturity, and decline. Based on the figure below, we can see that profit, cashflows, and sales all change between the different stages. What is not included in the figure but is just as important to corporate life cycles is how a corporation acts regarding management and financial decisions in each stage.
The first stage of a corporation is the startup stage, where the “seeding” or initial development of a corporation begins.
Think back to that summer you wanted to earn money by selling lemonade. Before you could begin selling your lemonade, you had a few things to consider. You first had to decide what your product would be. To do this, perhaps you tried different lemonade recipes to determine which one tasted the best. After asking your friends and family to try your drink and eventually settling on a recipe, you had to build your stand. But before you could make your stand and buy supplies for your lemonade, you needed to find someplace to get money from. But you had to be careful with how much you borrowed; you didn’t know if your lemonade stand would be a huge success or a complete failure. For that reason, you had to make sure you only borrowed money you thought you’d be able to pay back because otherwise it would be very risky.
Just like plants grow from a seed sprouting, a business initiates its development by making prototypes, receiving feedback, or seeking out potential investors. In the case of your ideated lemonade stand, you tested prototype lemonade, received feedback from friends and family, and considered how to finance your business venture. You were making headway by getting into the first stage of the corporate life cycle, but getting out of the startup stage isn’t easy.
When looking at startups, it is important to consider their riskiness. Startups are far from stable because they don’t have a strong customer base or a well-known product. For that reason, around 90% of startups fail. The riskiness of a startup also comes into play when business owners consider how to finance it. Startup costs are usually high because they require a good amount of capital to initially get their foot in the door. They use that funding to make meaningful capital investments that will be the backbone of their business. Capital investments are simply assets a business intends to use in the long-term to further its value. For example, in your lemonade stand business, your stand is a capital investment.
The startup stage is all about setting your business up for success. For that reason, startups will usually not make much of a profit, if they make any profit at all. Instead of focusing on profit, startups focus on growing their customer base, making relationships with investors, and perfecting their products.
When we look at how corporations finance themselves, we usually split their approaches into two main categories: debt-financing and equity-financing. Debt financing is the act of borrowing money through a loan and eventually paying that loan back with interest. In the case of your childhood lemonade stand, this would be the act of borrowing money from your parents on the contingency you have to pay them back with interest. On the other hand, equity financing is when business owners sell a portion of the equity (i.e. ownership) in their company to finance their endeavors. In the case of your lemonade stand, this would mean bringing on your friends as business partners with the promise that you all split the costs and the profits. Debt financing obligates the borrower to repay the debt they take on, while equity financing does not. On the flip side, if the business does very well, equity financing obligates the borrower to split the profits with the person who equity-financed the company, while debt-financing only obligates the borrower to pay the fixed interest rate on the loan they received from the loaner.
As we have established, startups are very risky. For that reason, fewer people want to offer loans to startups out of fear that the startup will default. It is also less beneficial for a startup to take on debt because it is likely the money they borrow will be loaned at very high-interest rates. With equity financing, startups can choose to bring on investors and sell equity so that they can finance their capital investments.
Overall, startup companies have the obvious goal of developing a customer base and making it past the high failure rate for startups. This includes the goal of reaching a stage of profitability, which means having sales and earnings that exceed the cost of management and production in the business. This leads us to our next stage in the corporate life cycle: the growth stage.
Once a company has passed the startup stage, it is now in its growth stage. Growth companies are companies whose earnings increase at a rate that is significantly faster than the rate the economy grows at. By this stage, the business’s basic products and culture have been established. Accordingly, the company is generating consistent income, with increasing cash flows and revenue.
After your lemonade stand is up and running, your business has successfully reached its growth stage! This is because after gaining your first few regular customers, your stand has begun generating a consistent income. Along with finally making a profit, your business’s customers are increasing by the day! When you first opened the stand, not many people knew about it. However, from word of mouth, you started gaining more and more customers. This stage is when your business’s customers and sales are increasing at the highest rate they will throughout your entire business life cycle, which is why your lemonade business is in its growth stage.
We often see growth companies sprouting in the technology industry, as the industry encourages new innovation. Although growth companies come early in the corporate lifecycle, they aren’t always small companies. For instance, Google is a multi-trillion dollar company that has consistently grown its revenues and cash flows since its initial public offering (IPO) in 2004. Because it has increased its revenues and continued to grow its customer base and partnerships since 2004, Google is a prime example of a growth company.
Because growth companies are expected to grow at above-average rates, their financials look different from stagnant, or mature companies. In your lemonade stand, if you are rapidly gaining customers, you may decide to build another stand on the other side of the neighborhood to attract more customers. Remember, we considered our stand to be a capital investment. To pay for that new stand, you will need to direct some of your profits into building it. This leaves you with the question: would you rather pocket the profit you have made from your business or reinvest it back into your business to grow it and potentially have higher returns in the future? This is the same question that business owners of growth companies come across, and in most scenarios, they opt for the latter option. Business owners know that while they are in the growth stage, their company has the highest potential to produce greater returns. Because the potential for greater return outweighs the current returns, they reinvest profit into their business to drive earnings growth. So in the case of your lemonade stand, this would mean saving your profits to set up a new stand rather than cashing your profits in and keeping them.
A growth company’s value lies in the future. Because growth companies are expected to generate higher returns in the future, they are valued with high price-to-earnings ratios. A price-to-earnings ratio is a metric used to value a company by comparing its current share price to earnings per share (EPS). Let’s apply this idea to your lemonade stand. Say a heatwave is expected to hit your town soon and your friends believe that when the heatwave comes, your lemonade stand will generate more earnings because more people will want to purchase lemonade. If your friends believe your business will grow, they are more likely to want to join your lemonade business than if they believe your business won’t grow. Their prediction of the future for your business gives your business a higher value even though your current earnings have not changed. Because growth companies such as your lemonade stand are often valued based on future expectations rather than current earnings, we see that they usually have a high price-to-earnings ratio.
Just like we discussed with startups, growth companies are risky but have high potential. For that reason, they finance themselves mainly through equity financing just like startups did. Remember, as a growth company, you are looking to reinvest your profit back into the business to stimulate further growth. If you choose to take on debt, however, your business’s profit will be sucked out because you will be obligated to make interest payments to your debtors. Because a growth company’s value lies in the future, it will be much less beneficial to take money out of the business to make interest payments to debtholders, which is why it is more beneficial for a growth company to finance capital investments through equity financing.
As we discussed earlier, the typical goal of a business at any stage in the corporate life cycle is to maximize its value. Because a growth company’s value lies in its future, it is only plausible that a growth company’s goal is to continue to grow. Growth can be stimulated through gaining more investment opportunities, continuing to innovate, and staying relevant in the industry. Staying relevant in the industry is key for growth companies because if their products and services are no longer wanted or needed, they will no longer attract investors or customers.
A company’s earnings may not increase at a significantly fast rate forever, and once their profits plateau, they have entered the mature stage. At this stage, a company will follow clear trends in clients, customers, and products. Profits will continue to increase, but at a steady level that is for the most part predictable. With a solid customer base, mature companies are relatively stable compared to growth or startup companies. Just because a company is in its mature stage doesn’t mean it can lose focus with its products and business. Mature companies need to stay at the forefront of their market to ward off competitors and adapt to their changing industry.
After you opened the second lemonade stand, your lemonade businesses earnings seemed to steady off. You decided that you could open a third stand halfway through the neighborhood, but you don’t think you would gain many more customers if you did. Occasionally, a new customer will stroll past your lemonade stand and buy a drink so profits aren’t entirely stagnant, but they have a much slower rate of increase than they did before. That’s not all bad though. Your lemonade business is well-established in the neighborhood, you have loyal customers, and profits are coming in steadily. What’s even better is that now that your business isn’t growing exponentially, you don’t feel the need to put all your profits back into the business. Instead, you can finally keep some profits for yourself and your friends!
Earlier, we looked at how the most strategic option for growth companies is to reinvest their profits back into their business to stimulate growth. That was because growth companies expected more growth in the future. But if we keep trying to reinvest the cash into a mature company, although that may have some payoff, it will result in diminishing returns for the owners’ investment. Let’s go back to our lemonade stand example. After you opened the second stand on the other side of the neighborhood, your business’s overall profits increased at first but then they steadied off. You decided that you could open a third stand halfway through the neighborhood, but would that truly be worth it? Buying a new stand and bringing more friends into the business is a costly capital investment. Asking yourself if that investment is worth the cost is the same question mature companies often ask themselves. Oftentimes, the risk of the investment doing poorly outweighs the reward. That is why instead of reinvesting profit back into the business, mature companies can do other things with their earnings.
By the time a company has reached the mature stage, it looks to finance its operations by taking on debt rather than bringing in more equity investors. With a large amount of retained earnings (meaning profits) saved over and few investments to make, mature companies can afford to take on debt because they have cash available to pay it off. Another factor to consider is that equity financing means giving an investor ownership stake in your business. In the case of your lemonade stand, if you brought another friend in to help with your stand, they would get a portion of future profits all for themself. By doing so, this would mean you would get fewer profits for yourself. Giving away more of the ownership dilutes the existing owners’ equity position and share of the profit. For that reason, equity financing is not always the best option for larger companies that produce a steady profit if they can afford to pay off debt instead.
Other than paying off debt, mature companies can do other things with their retained earnings. One thing mature companies do is offer their investors cash rewards, in the form of dividends. For example, if your parents pitched in to help you buy your lemonade stand, an example of a dividend would be you giving them a certain amount of money every quarter as a way to show them their investment was worthwhile and that your business is strong. By being able to pay dividends, companies are showing their investors that they are stable and have financial strength. However, if a company believes that it will be able to increase its value by reinvesting the profit, it will choose to not pay dividends.
Mature companies have similar goals to growth companies, which is to maximize their value by staying relevant in their industry. This can be from innovating or staying competitive with other competitors, possibly by making new acquisitions or doing things like lowering prices.
Decline Or Exit
All good things must come to an end, and in the corporate life cycle, this is when the company reaches the decline or exit stage. However, for corporations, that end can be the door to a new beginning depending on how the executives of a company choose to act.
Your lemonade stand has been thriving all summer; you have your regular customers, your business partners, and your steady profits. But sadly, summer does not last forever. With the leaves falling and gusts of wind blowing through your neighborhood, it seems that considerably fewer people want an ice-cold glass of lemonade. What’s worse is that your neighbor Billy has started his very own hot chocolate stand! His profits are soaring while yours are declining. As you frantically search for options on what to do, you come across a few ideas. You could possibly reinvent your business to make hot coffee in the winter rather than lemonade? But that would mean a complete rebranding of your business, and you would lose many of your loyal lemonade lovers. Perhaps you could sell your lemonade stand to Billy’s hot chocolate stand? You are losing money by continuing to run your stand even though no one wants lemonade anymore, so by selling it, you would get it off your hands and get money for doing so. All of these are viable options and hit upon the key principles of the declining stage of the corporate life cycle.
As a struggling lemonade stand owner, you are watching your business enter its decline or exit stage. People’s wants are changing, (from lemonade to hot chocolate), and your business is no longer what people come to when they want a drink. On a much larger scale, this is the same struggle declining companies face. Companies like Google constantly reinvent their products and technologies to stay up to date with their industry, which is why they stay growth companies. Other companies like Coca-Cola are staples that people haven’t grown tired of for decades, allowing them to continue as mature companies. Some companies, however, slip through the cracks of changing industries and are unable to keep up with customer wants and expectations. It is important to note that a declining company is not necessarily an old company. Corporate life cycles operate based on customer wants and needs rather than company ages. For that reason, by no means does a company need to reach a certain age to be in its decline or exit stage.
Just like you had a couple of options with what you could do with your lemonade stand in the winter, the executives of declining companies can try to expand or reinvent their business, either by changing branding or by revamping products. To start the process of reinventing a business, business owners will have to reinvest the cash into the company to try to jump-start their business back into the growth cycle. Many executives don’t want to take this risk, and would instead choose to cash out by selling their business. This option is just like how you thought about selling your lemonade stand business to Billy, your neighbor who runs the hot chocolate stand. That option is called an exit, and it is when business owners give up control of their company to a different group of owners.
Our lemonade stand has successfully made it through the stages of the corporate lifecycle! With so many things to consider ― from products to investors and future goals ― the corporate life cycle provides business owners with a way to better make financial decisions. So the next time you hear the word life cycles, perhaps rather than your biology classes’ discussion of animals and plants, the importance of corporate life cycles will come to mind.