Editor’s note: This article was first published in March 2012. EnterBio had just closed an 800,000-euro funding round to expand from Madrid to the rest of Spain, and the remark about banks reflects the credit squeeze in Spain in 2012. The company’s later fate is not covered.
A business has to grow; otherwise, these days, fierce competition would end up “wiping you out”. As we said in our previous article, the greatest risk of running into problems in a business comes when the entrepreneur takes the step from small business to medium-sized or large business. There are two ways to take this important step. The first is to do it gradually, laying solid foundations. This may be much slower and take more time, but it’s also the safest. We’ll explain it in detail in part two.
For now we’ll focus on making the leap by taking on debt. We’ll look at it using the example of a young company that is making this leap right now and that we’ve already covered: EnterBio, an organic food store. This company recently closed an 800,000-euro funding round. The money will be invested in winning new markets, new routes, new delivery vehicles and hiring staff.
Setting the scene
EnterBio is a company physically based in Madrid. Until now, the area where it operated and delivered its products was limited to Madrid and the surrounding region. The business was doing perfectly well, which is why the time had come to expand to the whole of Spain.
That requires more infrastructure, so the company needs investment. Of course, this company doesn’t have the savings or capital to acquire what it needs by its own means. At that point, it has two options: ask a bank for the money or look for private investors. With banks being the way they are right now, they opted for the second option. In the end, they got the capital.
The company’s situation once it receives this investment
Right now, this company has only one option, and that’s to sell more. The investors want a return; that’s why they invested in the company. If the money had come as a bank loan, the situation would be exactly the same, because the bank would want its share every month.
If EnterBio maintains (but doesn’t increase) its sales, the company will close. If EnterBio sells less, the company will close. If EnterBio increases sales but its profitability is lower than the return offered to investors, the company will close. In other words, this business has no choice but to work and to earn profits above its new costs.
The leap is dangerous, because over the coming months, and maybe even the first year, this company will make losses as it starts receiving one-off orders from different parts of the country. In some provinces they’ll have to deliver three orders in a day, and in other cases they’ll have to deliver a single order 500 km away, and for a while that will cost them money until they have an established route.
I haven’t had the pleasure of speaking with the founders of this company, so I’ll base this on some assumptions, imagining they’ve agreed a grace period on payments to the investors for a while. Let’s say that grace period is vital so the entrepreneur isn’t suffocated.
How should this leap be made?
This company will have to invest heavily in advertising, and even in awareness campaigns to promote organic food (personally, I believe in organic products and I eat them). Many provinces already have organic food stores, so they should have done market research to find out whether they can compete on price with these local shops, because otherwise, why would I buy the same product when I can get it cheaper close to home?
Adjusting the price to the new routes
Clearly, when we decide to expand, we’ll have to adjust our price to the following factors: a higher profit margin so we can supply distant routes while the new route is being built up, and a price adjustment for the areas where we face stronger competition. The problem for this company is that, as an online store, the price is the same for someone living in Madrid as for someone living in Andalusia, even though the cost of delivering the product varies depending on how far away the customer is. That factor is extremely important when we decide to make the leap, because we may enter new markets but could run into two problems:
- Delivering the product costs us money.
- By adjusting the price so delivery is profitable for us, our product is no longer price-competitive in the new market.
Choosing the right strategy
When expanding a business, we can choose between two strategies:
1. Strengthening our fleet and workforce so we supply individual customers ourselves: This is the strategy this company has chosen.
The problem with this strategy: I see two main problems they could face. The first would be having few orders, but spread widely and far apart, so the issue is no longer just the cost of delivery but also the cost of the driver’s time (unless delivery is subcontracted to courier companies). The second problem would be death by success, which is receiving more orders than they can fulfill. In theory, that’s every business owner’s dream at first, but in practice it ends up turning into a nightmare.
2. Strategic alliances or a distribution network: There’s no better way to grow than to build a good, solid distribution network. That means having points of sale in different provinces, each one responsible for selling and delivering in its assigned area. That way, EnterBio would only have one delivery point in each province rather than 100. That means savings, presence and visibility in every province. A distribution system can take the form of a franchise, a distributor…
For my part, I would always place much more trust in the second option, since the first carries many more risks by increasing costs.
I’ve seen many other companies take on debt to win new markets and fail to get the results they expected, so before they knew it they were caught in a cycle of losses: if they didn’t sell, they lost money, and if they did sell, they also lost money because each sale cost them.
These situations arise when no thorough research is done and no proper strategy is drawn up. It’s not only a matter of drawing up the right strategy; we also have to try to “guess” how long it will take us to get the results we expect, so we can take on the debt we’ve incurred to make the leap. Hard as it may be to believe, many companies enter new markets without knowing the local competition, thinking that because they’re a big company they’ll end up dethroning the local business. Sometimes that doesn’t happen, especially when the local business realizes what’s going on and decides to up its game to prevent it.
In short: To make the leap from small to large business, before taking on debt, study in depth the strategy you’re going to follow (supplying customers yourself or building a distribution network), the markets you’re going to enter, and the national and/or local competition. Along the way, we’ve briefly shown some of the things you need to analyze when you’re going to invest in a company, because you have to analyze the company as a whole, even looking at possible future problems that sometimes not even the entrepreneurs themselves may have thought of.
Further reading
Featured image: Andy Roberts, CC BY 2.0, via Flickr.
