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GROWING PROFITABLE OR GROWING FROM PROFITS: PUTTING THE HORSE IN FRONT OF THE CART?

Authors:
  • QUT and Jönköping International Business School
  • Manipal Academy of Higher Education, Dubai

Abstract

How do firms that show above-average growth and profitability reach that desirable state? Is it because growth allows them to become profitable, or is it rather that their profitability allows them to grow based on retained earnings? While arguments in support of both scenarios can be derived from established theories the extant empirical literature has not been able to settle the issue despite its arguably central interest to entrepreneurship theorists and practitioners. Using a large, longitudinal data set this research tests the hypothesis that SMEs that show high profitability but low growth, and those showing high growth but low profitability, are equally likely to achieve high growth and high profitability in the subsequent period. Our results turn out a rather dramatic rejection of that hypothesis. In several year-by-year analyses firms originating in the high profitability/low growth category are about three times as likely to reach simultaneous high growth and profitability, as are firms originating in the high growth/low profitability group. The latter group is instead markedly over represented among firms that regress to low growth and low profitability. Over a four-year interval the difference is smaller but still very substantial. Over all, the results presented in the paper are strong reason for entrepreneurs and policy makers as well as entrepreneurship researchers and educators not to embrace a universal and uncritical growth ideology. Our results indicate that firms that first show an ability to generate above average profits are the ones most likely to embark on a sound, profitable growth trajectory.
QUT Digital Repository:
http://eprints.qut.edu.au/
Davidsson, Per and Steffens, Paul R. and Fitzsimmons, Jason R. (2009) Growing
profitable or growing from profits: putting the horse in front of the cart? Journal
Business Venturing, 24(4). pp. 388-406.
© Copyright 2009 Elsevier
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GROWING PROFITABLE OR GROWING FROM PROFITS:
PUTTING THE HORSE IN FRONT OF THE CART?
Journal of Business Venturing
Per Davidsson
Ph.D., Professor in Entrepreneurship
School of Management; Queensland University of Technology
and
Jonkoping International Business School
Ph: +617 3138 2051
Fax: +617 3138 5250
Email: per.davidsson@qut.edu.au
Paul Steffens
Ph.D., Associate Professor
School of Management; Queensland University of Technology
Phone: +617 3138 4243
Fax: +617 3138 5250
Email: p.steffens@qut.edu.au
Jason Fitzsimmons
Ph.D., Lecturer
Brisbane Graduate School of Business; Queensland University of Technology
and
Universitas 21 Global
Phone: +617 3138 2036
Fax: +617 3138 1299
Email: j.fitzsimmons@qut.edu.au
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GROWING PROFITABLE OR GROWING FROM PROFITS:
PUTTING THE HORSE IN FRONT OF THE CART?
EXECUTIVE SUMMARY
Top lists and praise of the economy’s fastest growing firms abound in business
media around the world. Similarly, in academic research there has been a tendency to
equate firm growth with business success. This tendency appears to be particularly
pronounced in – but not confined to – entrepreneurship research.
In this study we critically examine this tendency to portray firm growth as
more or less universally favorable. While several theories suggest that growth drives
profitability we first show that the available empirical evidence does not support the
existence of a general, positive relationship between growth and profitability. Using
the theoretical lens of the Resource-Based View (RBV) we then argue that sound
growth usually starts with achieving sufficient levels of profitability. In summary, our
theoretical argument is as follows: In a population of SMEs, superior profitability is
likely to be indicative of having built a resource-based competitive advantage.
Building such a valuable and hard-to-copy advantage may at first constrain growth.
However, the underlying advantage itself and the financial resources generated
through high profitability make it possible for firms in this situation to now achieve
sound and sustainable growth—which may require building a series of temporary
advantages—without having to sacrifice profitability. By contrast, when firms go for
high growth starting from low profitability it often indicates lack of competitive
advantage and hence that the growth must be achieved in head-to-head competition
with equally attractive alternatives, which would make profitability deteriorate rather
than improve. In addition, these low-profitability firms are unlikely to be able to
finance strategies towards building valuable and difficult-to-imitate advantages while
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growing. Hence their growth would neither be sustainable nor lead to improved
profitability. Based on these RBV arguments, we hold that although exceptions exist
it is in most situations advantageous to let profitability (and the competitive advantage
it reflects) be the horse that pulls the growth cart, rather than the other way around.
Consequently, we develop two hypotheses about growth-profit configurations over
time.
Hypothesis 1: Firms that show high profitability at low growth are more likely to reach a state of
high growth and high profitability in subsequent periods than are firms that first show high growth
at low profitability.
Hypothesis 2: Firms that show high growth at low profitability are more likely to reach a state of
low growth and low profitability in subsequent periods than are firms that first show high
profitability at low growth.
We test these hypotheses using two longitudinal data sets of small and
medium-sized enterprises (SMEs) from Sweden and Australia. The results clearly
support these hypotheses both for 1-year transitions and over the longest time span the
data sets cover. The results also show a high degree of robustness across cross
alternative bivariate and multivariate testing techniques aw well as across sub-
categories by firm age, firm size and industry. All in all, the results suggest that
“profitability first” rather than “growth first” is the preferable strategy for achieving
high overall firm performance.
For academics these results suggest that positive theory should not portray
SME growth in its own right as “success” and that normative theory should attempt to
better specify how and under which conditions firm growth contributes to outcomes
that enhance company value. Further, empirical research aiming at explaining firm
success ought not to rely solely on growth as the outcome variable. For business
practitioners the results suggest they would often benefit from focusing on attaining
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high profitability before pursuing high growth. For those situations where growth may
be considered necessary for attaining high profitability, we suggest that managers
develop precise ideas about how growth can enhance the future profitability of their
particular firm, rather than relying on growth automatically improving profitability.
With respect to external investors the results suggest they should often resist the
temptation to encourage rapid growth before securing a sound level of profitability.
Finally, for policy makers the results imply that policies should be developed that
encourage firms to achieve the goal of being profitable rather than adopting policies
that urge firms to grow as the primary goal. As firms that demonstrate high
profitability often become growing firms that still enjoy above-average profits,
policies that help firms become more profitable will also lead to more growth.
As with any empirical research this study is subject to certain limitations. Since our
study did not include direct measures of the firms’ resources it is possible that
mechanisms other than the RBV-based ones used to develop our hypotheses may – at
least in part – explain our results. However, given the strength and robustness of our
findings we maintain that this research provides sound reasons to caution against both
an uncritical view of ‘growth’ as a measure of ‘success’ and pursuing high growth
before the firm has attained a sufficient level of profitability. Future research should
test the generalizability of our results to longer time spans and other contexts. Future
studies should also try to assess the resource-based mechanism in a more direct
manner. This is a complicated matter that probably requires customized, longitudinal
survey studies of relatively homogenous samples of firms.
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ABSTRACT
Firm growth is almost universally portrayed as a good thing, and is commonly used as
a measure of success. Applying resource-based reasoning, we argue that growth is
often not a sign of sound development. Specifically, we hypothesize that firms which
grow without first securing high levels of profitability tend to be less successful in
subsequent periods compared to firms that first secure high profitability at low
growth. Empirical tests using two large, longitudinal data sets confirm that the
profitable low growth firms are more likely to reach the desirable state of high growth
and high profitability. In addition, they have a decreased risk of ending up performing
poorly on both performance dimensions compared with firms starting from a high
growth, low profitability configuration. The results suggest that academics, managers,
investors and policy-makers may benefit by adopting a more nuanced view of firm
growth that explicitly incorporates its intricate relationship with profitability.
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INTRODUCTION
Few things could be easier than growing the sales revenue of a firm. All one
would have to do is to buy or produce the business’s products or services at going
market rates and sell them for significantly less. With the exception of a few, special
cases, demand would soar and the firm would experience tremendous sales growth.
However, this growth would obviously not reflect effective value creation and
appropriation by the firm, and hence be neither profitable nor sustainable.
Despite this obvious fact, researchers, practitioners and policy-makers alike
place a great deal of emphasis on firm growth per se as an indication of business
success. Although the notion that growth can be harmful is not new (Ramezani et al.,
2002:65; Markman and Gartner, 2002), adverse growth is usually treated as a
relatively rare exception. In business media around the world, top lists and praise of
the economy’s fastest growing firms are ubiquitous (Nicholls-Nixon, 2005). Policy
programs designed to stimulate and assist the growth of individual firms are common-
place, presumably in the hope that this will result in increasing employment and tax
revenue (Storey, 1994). Teaching cases and textbooks devote much space to the
problem of how to achieve expansion for the firm (e.g., Hisrich et al., 2005;
Wickham, 2004; Winn, 2004). Further, academics frequently use firm growth
uncritically as an operationalization of business success; especially in
entrepreneurship research (see Davidsson, Steffens and Fitzsimmons, 2007). Some
researchers go so far as to make growth “the very essence of entrepreneurship”
(Sexton and Smilor, 1997:97) or include growth more or less as part of the definition
of entrepreneurship (Stevenson and Jarillo, 1990:21, 25).
While we agree with Davidsson, Delmar and Wiklund (2002) that venture
growth is an important topic for entrepreneurship research, we also agree with
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Alvarez and Barney (2004) that value creation (they use the term ‘rent generation’)
and appropriation are the central tasks of entrepreneurial firms. As we emphasized
with our opening ‘high growth recipe’, growth is not direct evidence of effective
value creation and appropriation. It is therefore an important task for entrepreneurship
research to investigate the relationship between growth and profitability.
Through the theoretical lens of the Resource-Based View (RBV) we argue in
this article that sound growth usually starts with achieving sufficient levels of
profitability, i.e., that profitability is the ‘horse’ that should pull the growth ‘cart’
rather than the other way round. We also argue that firms which embark on a growth
trajectory starting from low levels of profitability usually do not achieve high
profitability as a result of their growth. Instead, as their growth is unlikely to be
sustainable (Ramezani, et al., 2002) they run an increased risk of becoming low
performers on both dimensions. We test these hypotheses using two longitudinal data
sets of small and medium enterprises (SMEs) from Sweden and Australia.
Although we use RBV logic to develop our hypotheses and interpret our
results, it is important to point out that this study does not include direct measures of
the firms’ resources and hence we do not regard it a strong test of or contribution to
resource-based theory (Arend, 2006). Our contribution concerns the understanding of
the phenomenon of firm growth relative to how it has previously been conceived in
the entrepreneurship literature. We employ a theory-driven configuration view of the
interrelationship between profitability and growth. Rather than trying to explain as
much of the variation in firms’ growth or profitability as possible, we focus squarely
on the following two questions. First, which firms are more likely to reach the
preferred state of high growth combined with high profitability is it high-growth
firms with low initial profitability or high-profitability firms with low initial growth?
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Second, firms with which of these two original performance configurations are more
likely to end up at the negative end of the performance spectrum, i.e., having low
profitability and low growth?
In the following section we will briefly examine the theoretical arguments for
firms becoming more profitable as a result of their growth. We then review the
empirical literature to demonstrate the lack of general support for this notion. This is
followed by the development of our RBV-based case for focusing on profitability
before going for growth, which leads to two hypotheses that we test empirically. In
the Method section we describe our samples and measures as well as our approach to
the challenging problem of analyzing growth-profitability configurations over time.
After presenting our results we discuss their implications. We suggest a research
agenda for future studies, thereby also addressing the limitations of our study.
DOES GROWTH MAKE FIRMS PROFITABLE?
The assumption that sales growth is positively associated with profitability
appears in a variety of literatures pertaining to scale economies (Besanko et al., 2004;
Gupta, 1981), experience effects (Stern and Stalk, 1998), first mover advantages
(FMAs) (Lieberman and Montgomery, 1988) and network externalities (Katz and
Shapiro, 1985). These theories suggest growth will drive profitability either through
the lowering of costs or by establishing a stronger market position. However, there is
little empirical support for a strong and general growth-profitability relationship. For
example, research in industrial economics have shown that scale economies are not
much of a barrier to entry; that surviving new entrants operate for long times at sizes
far smaller than the industry average; that minimum efficient scale is typically reached
at a rather small size; that very limited cost advantages are usually gained beyond that
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minimum, and even that it is possible to operate significantly below it without severe
cost disadvantage (Geroski, 1995; Hill, 1988; Siegfried and Evans, 1994).
In studies reporting association between growth and profitability measures the
correlations range from relatively substantial positive (Cox et al., 2002; Chandler and
Jansen, 1992; Mendelson, 2000), to those that are weakly positive yet statistically
significant (Baum and Wally, 2003; Cho and Pucic, 2005; Kim et al, 2004; Peng,
2004), to those finding no statistically or practically significant relationship (Roper,
1999; Sexton et al., 2000; both based on very sizable samples), to those showing a
significant negative relationship (Markman and Gartner, 2002; Reid, 1995). The most
comprehensive assessment of the issue is a meta-analysis by Capon et al. (1990). A
close examination of their results reveals that a significant positive association
between growth and financial performance is only found in across-industry studies. In
within-industry studies, the effect is very small in magnitude and statistically non-
significant (Capon et al., 1990:1154; Table 5). Thus, the results do not establish that
firms that grow more than their direct competitors consequently become more
profitable. Rather, the findings suggest that firms in growing industries benefit from
the higher growth- and profit rates of their industries; a theme well-known also from
Product Life Cycle theory (Day, 1981). Similarly, studies of the relationship between
market share or market share growth on the one hand, and profitability on the other,
suggest that any positive relationship may be either industry-specific or spurious
(Brush et al., 2000).
In summary, the empirical evidence on the relationship between firm growth
and profitability is inconclusive. Despite the theoretical arguments there is little
evidence of a general tendency for firms to become more profitable as a result of their
growth. This indicates that although the two dimensions of performance sometimes
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move together there are frequent other instances when the growth-profitability
relationship is neutral or negative.
THE RESOURCE-BASED VIEW AND PROFITABLE GROWTH
The Resource-based view (RBV) is in its historical origin very closely
connected to the core topic of our study, profitable growth. Penrose (1959) focused
her entire study on firm growth. Similarly, Wernerfelt’s (1984) seminal paper
explicitly addresses the profitability of different routes to growth. Hence, it is with
considerable justification that Kor and Mahoney (2004:190) claim that profitable
growth is one of the “cornerstones of a resource-based view of strategic
management.”
Thus, we hold that RBV is a natural starting point in considering small firm
growth and profitability. We use the label RBV’ in a rather broad sense. We include
in this notion extensions such as ‘dynamic capabilities’ (Teece et al., 1997), the
‘knowledge-based view’ (Kogut and Zander, 1992) or any other theoretical argument
for efficiency-based, intra-industry performance advantages deriving from resource
heterogeneity (Peteraf and Barney, 2003) whether or not the original contributors
position their work as contributions to, critique of, or unrelated to original RBV
formulations. Consistent with RBV, our focus is on growth and profitability
comparisons of firms within industries (Peteraf and Barney, 2003).
The RBV attributes superior firm performance to competitive advantage.
Barney (1991) presents the now-familiar argument that the sustainability of the
advantage is contingent on the extent to which the firm’s resources or resource
bundles are valuable, rare, hard-to-copy and non-substitutable (VRHN). In a later,
equally well-known reformulation the desirable resource qualities are specified as
11
valuable, rare, inimitable, and organized (VRIO) (Barney, 1997). The ‘O’ in the
latter formulation can be regarded an increased emphasis on the importance of having
an effective business model in place including an effective revenue model thus
assuring both value creation and value appropriation by the focal firm (Alvarez and
Barney, 2004; Amit and Zott, 2001).
The RBV does not deny the existence of other sources of superior
performance such as scale economies, FMAs, or behaviors like anti-competitive
collusion; strategic ploys, and efforts to blunt competition (Peteraf and Barney, 2003).
However, if based on scale per se a cost advantage is unlikely to be sustainable by
Barney’s (1991; 1997) criteria. Further, within a population of SMEs only a small
proportion of firms would be recent entrants in emerging industries where FMAs are a
major issue. When present, it is argued that FMAs become sources of sustained
competitive advantage only when they are based on VRHN resources (Barney,
1991:105; cf. Wernerfelt, 1984:173). As regards ‘strategic’ behaviors that are not
value-creating we hold that their successful pursuit is unlikely in a population of
SMEs where each firm has very limited market power. Hence, we argue that in the
context of SMEs, RBV provides a plausible explanation for why some firms show
above-average profitability. With its focus on within-industry differences among
firms competing in the same product markets RBV may actually be more applicable
to SMEs than to large corporations (cf. Davidsson and Wiklund, 2000; Peteraf and
Barney, 2003).
Therefore, our theoretical argument starts from the fundamental RBV-based
premise that resource heterogeneity which has been successfully transformed into
product market offerings with superior economic value is a major source of within-
industry profitability differences for SMEs. Hence, without trying to explain the
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‘how’ questions a silence RBV has been criticized for (Barney and Arikan, 2001;
Priem and Butler, 2001; Sirmon et al., 2007) we accept the original RBV
assumptions that resource heterogeneity exists (Barney, 1991) and that it is (often but
not deterministically) transformed into product advantages (Wernerfelt, 1984) that
create value to customers (Sirmon et al., 2007). However, we also consider the
criticism that the original RBV employs a static view of competitive advantage (Priem
and Butler, 2001) and embrace later developments suggesting it may be more
realistic that firms need to develop a series of temporary advantages through valuable
and hard-to-copy strategic moves in order to reach and maintain superior performance
(Morrow et al., 2007; Sirmon et al., 2007; Zahra et al., 2006).
What implications does this have for firm growth? To facilitate our thinking,
we sketch growth-profitability configurations in a simple 2x2 matrix (see Figure 1)
where firms are positioned as either above or below their industry average on each
dimension. This gives us four cases, which we label Star (high on both), Profit (high
profitability/low growth), Growth (high growth/low profitability) and Poor (low on
both). For the moment we can disregard the Middle category, which is created for
empirical reasons in order to consider only substantive deviations from the average on
either profitability or growth.
_____________________________________
INSERT FIGURE 1 ABOUT HERE!
_____________________________________
By the logic of RBV, firms should pursue growth opportunities that match
their resource advantages. This would allow them to grow profitably, which is the
essence of value creation (Sirmon et al., 2007). If they pursue other opportunities
growth may destroy rather than create value (Kogut and Zander, 1992). Conversely, if
13
they refrain from growth opportunities that match their resource advantages they may
enjoy high levels of profitability based on a sub-optimally small volume of business,
thus under utilizing opportunities for value creation and appropriation. Hence, from
the perspective of RBV firms should strive to maximize profitable growth. Profitable
growth in our scheme is reflected in the performance demonstrated by firms in the
high growth, high profitability (Star) category in Figure 1.
In an interpretation relying on RBV Star firms have been able to establish a
resource-based advantage to create superior value for customers (Peteraf and Barney,
2003; Sirmon et al., 2007). They are successfully exploiting this advantage through
profitable growth. If maximization of value creation and –appropriation is the goal,
achieving Star status is what firms in the other performance categories should be
striving for.
Therefore, we now turn to the probability that firms in the Profit (high
profitability/low growth) and Growth (high growth/low profitability) categories,
respectively, can successfully make the transition to the desirable Star category. As
regards Profit firms, by resource-based logic their above-average profitability
suggests they have attained the ability to both create and appropriate value above the
industry average. Developing this advantage may take its toll in terms of growth. For
example, the study by Mishina et al. (2004) suggests that a product expansion logic –
which Morrow et al. (2007) portray as exemplifying valuable and hard-to-copy
strategic action – is negatively related to sales growth in the short term. Yet, Morrow
et al. (2007) demonstrate that such strategies are positively associated with value
creation as reflected in investors’ expectations; a result consistent with Cho and
Pucic’s (2005) observation that profitability has a much stronger influence on
company value than has growth.
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This is presumably because first developing a resource based advantage and
translating it to superior market offerings at low growth sets the seed for sound,
profitable growth in the future. Thus, we argue that Profit firms are in a good position
to now expand while retaining their high profitability and thus transition to the Star
category. Relative to low-profitability firms, the Profit firms are in a better position in
at least two resource-related ways to make that transition. First, they have the
underlying competitive advantage that enabled them to achieve above-average
profitability. Unless the market potential for the current products is already exhausted
these firms are likely to be able to grow organically through market penetration – the
dominant form of SME growth, see Davidsson et al. (2006) without the
profitability-reducing tactics of price cutting and/or heavy advertising that would be
needed to gain market share from firms with equal offerings (Peteraf and Barney,
2003). Second, the profitability of these firms creates greater cash flows and
associated lower cost of the financial capital needed to enable growth (Marris, 1967;
Scott and Pascoe, 1986). The cost-of-capital advantage holds for a comparison of
retained earnings to external capital but likely extends to the cost of external capital
itself, as a more profitable firm is likely to get external loans and equity on better
terms than a less profitable firm with less financial slack (Bourgeois, 1981).
By contrast, we maintain that Growth firms (high growth and low
profitability) are relatively unlikely to be able to exploit their growth to build resource
advantages and subsequently attain superior profitability. We have noted above that
there is no strong empirical support for firms gaining profitability advantages as a
result of their growth. Growth firms’ low level of profitability indicates that they are
less likely than Profit firms to have established resource advantages that have been
transformed into superior value creation for customers. Hence, assuming growth by
15
organic market penetration, their expansion may require price cuts or costly marketing
efforts to win over customers facing several equally appealing offerings (Peteraf and
Barney, 2003). As regards product expansion, Mishina et al.’s (2004) findings make it
appear unlikely that small firms would be able to grow at above-average rates based
on such a strategy, not least because small firms are commonly constrained to basing
their growth on internal finance (Carpenter and Petersen, 2002). If that constraint can
be overcome, Mishina et al.’s (2004) results in combination with those obtained by
Morrow et al. (2007) imply that infusion of external capital may help firms develop
valuable and hard-to-copy strategies to create value through sales growth. However, if
the development of a resource advantage is attempted concurrently with above-
average expansion the firm is likely to face time-compression diseconomies, as
discussed by Dierickx and Cool (1989). This may well be part of the reason why other
research has found that while access to financial capital may facilitate growth it
usually does it at the expense of profitability rather than helping the firm to achieve
above-average profitability through growth (Florin et al., 2003).
All in all, our analysis suggests that while Profit firms are in a good position to
achieve high growth without significant loss of profitability, Growth firms are not
particularly likely to become more profitable as a result of their growth. On top of
their apparent lack of a resource-based, superior market offering our reasoning
suggests they also suffer from a cost-of-capital disadvantage compared with Profit
firms. This suggests the following hypothesis:
H1: Firms that show high profitability at low growth (Profit firms) are more likely
to reach a state of high growth and high profitability (become Star firms) in
16
subsequent periods than are firms that first show high growth at low profitability
(Growth firms).
Firms that are unable to reach Star status would at least want to avoid ending
up in the Poor category, i.e., to perform below average on both dimensions in Figure
1. In order to avoid such development, Growth and Profit firms need to sustain above-
average performance on one dimension; most likely the one on which they currently
have high performance. We now turn to the probability that these two categories can
avoid transition to the undesirable Poor category.
We have argued above that Growth firms are not particularly likely to become
profitable as a result of their growth. If they lack resource-based competitive
advantage as our RBV arguments suggest many firms in this category do the
expansion would be gained in costly, head-to-head competition that, if anything, puts
an additional downward pressure on profitability. The combination of high growth
and low profitability puts the firm under financial strain that makes it difficult (and
perhaps not desirable) for the firm to sustain its growth (Churchill and Mullins, 2001).
Consequently the firm would slide into the Poor category. Infusion of external capital
could make it possible to sustain the growth. However, when the firm does not show a
promising development of profitability as result of earlier growth, external investors
will become reluctant to plow money into further volume expansion. In all, Growth
firms appear to face a relatively high risk of not being able to sustain their growth and
instead at considerable risk of relapsing to the low growth and low profitability (Poor)
category. The well established fact that the serial correlation of firm growth over time
tends to be low (Coad, 2006) suggests this is a common phenomenon.
17
We have noted already that recent developments of RBV suggest that long
term sustainability of a given advantage is unlikely. Consequently, Profit firms face
the risk of transitioning to Poor because competitive advantage underlying their
earlier high profit performance has eroded. However, they are in this regard no worse
off than Growth firms, which we assume usually lack distinguishable, resource-based
advantages. Further, because of the financial resources their earlier high profitability
has provided them with, Profit firms are in a better position than Growth firms to
invest in the development of the series or valuable and hard-to-copy strategic moves
that may be required for sustained advantage (Morrow et al., 2007; Sirmon et al.,
2007; Zahra et al., 2006) and hence high profitability. This seems particularly likely
when the resources are not concurrently demanded for the financing of high growth.
In all, compared to Growth firms, those in the Profit category appear to have better
chances to avoid degenerating into showing low performance on both dimensions in
subsequent periods. Hence our second hypothesis:
H2: Firms that show high growth at low profitability (Growth firms) are more
likely to reach a state of low growth and low profitability (become Poor firms) in
subsequent periods than are firms that first show high profitability at low growth
(Profit firms).
In Figure 1 the hypotheses are represented graphically with thicker arrows
denoting the transition our hypotheses suggest is relatively more likely. Note that our
hypotheses are strictly probabilistic. We are thus not suggesting any route to high,
combined growth/profit performance is inherently impossible. Some Growth firms
may well be pursuing a sound strategy of maximizing value creation and
18
appropriation over time by temporarily foregoing profits (Cowling, 2004; Florin et al.,
2003). However, the popular assumption that this is the norm is the very notion that
we challenge in this research. We hold that in a population of SMEs, only a very
small proportion of cases are subject to true, potential performance advantages based
on scale, market share, FMA or network externalities that are unrelated to RBV-type
resource advantages and which require expansion at the expense of profitability in
order to be realized.
METHOD
Data Sources
We use two separate data sources to examine our research questions. The data
were originally collected by government statistical agencies in Australia and Sweden,
over different four year periods. Both data sets contain a random sample of SMEs
across many industries, though they stratify the population differently. In particular,
the Australian sample contains a much larger number of firms in the smallest size
class.
The Australian data is sourced from the Business Longitudinal Survey (BLS)
conducted by the Australian Bureau of Statistics (ABS) over the period 1995 to 19981.
The sampling frame was all businesses on the ABS business register employing fewer
than 200 employees, excluding primary industries other than mining, government
enterprises, utilities and public services. A panel of 5,031 businesses was established
in the 1994-95 financial year. Each subsequent year, the panel consists of those
businesses remaining alive, supplemented by a sample of new businesses added to the
ABS business register in that year. Completed responses were collected from between
1 Refers to financial years ending in July of nominated year.
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84% and 90% of the panel for the surveys in 1995-96 to 1997-98. We use all cases
that have complete data in any two subsequent years, or have complete data in the
first year and cease business during the second. As a result, between 3,488 and 3,717
businesses are included in any one analysis.
The Swedish data originates from a longitudinal survey study undertaken in
the years 1997-2000. The sample was drawn from Statistics Sweden’s complete
records of private limited liability companies with 10-250 employees, excluding
agriculture, forestry and fishing as well as government enterprises, utilities and public
services. The sampling frame was stratified as follows: two size groups of 10-49 and
50-250 employees; four industry sectors of manufacturing, retail/wholesale,
professional services and other services; and the three corporate governance
categories independent firms; member of company group of less than 250 employees,
and member of company group larger than 250 employees. From each of the 24 strata
110 firms were randomly selected, except where the sub-population was less than that
number, resulting in a sample of 2,455 firms.
Rather than representing items from the survey, the growth and profitability
data we use are likewise data from Statistics Sweden’s records. These data were
originally collected as part of the statutory reporting required of businesses in
Sweden, and were appended to the survey data set. Growth and profitability data was
requested from Statistics Sweden only for firms that participated in at least the first
survey round and for whom phone contact information could be obtained in 2000.
This reduces the sample to 1,917 cases. Missing data on growth and/or profitability in
Statistics Sweden’s files in addition to eliminating firms that merged or reorganized as
part of a parent company further reduced the analyzable sample for this study to 1,482
20
firms. As a result, our analysis of Swedish firms includes uses a minimum of 1,470
businesses in any one analysis.
Measures
Sales growth was preferred over employment growth based on emerging
consensus in the literature that for most purposes sales is the more relevant growth
indicator (Davidsson and Wiklund, 2000; Delmar, 1997; Hoy et al., 1992;
Weinzimmer et al., 1998). The specific formula used was the change in sales from
Year 1 to Year N as a percentage of the sales in Year 1. For the Australian data, sales
growth could be calculated in the first year (1995). For the Swedish data only current
year sales are reported. Hence, growth can only be calculated from the second year
(1998).
In line with Arend’s (2006: 410) recommendation we used return on assets
(ROA) as our measure of profitability. Slightly different measures were used due to
data availability. For the Australian sample, data on pre-tax ROA was available,
calculated as the net profit (operating profit or loss before tax and extraordinary
items) as a percentage of total assets in each year. After tax ROA was available
for the Swedish sample.
Since our theoretical foundation, RBV, is concerned with performance relative
to competitors (Peteraf and Barney, 2003), both growth and profitability were
calculated relative to other firms in the industry. Specifically, we divided by the
industry median rather than the mean to reduce the impact of outliers.
21
Primary Analysis
Our research is concerned with the dual growth-profitability performance of
firms over time. While the analysis problem entails aspects reminiscent of lagged- and
interaction effects in regression analysis (e.g., Cowling, 2004), this approach is not
appropriate for our problem of predicting a multivariate outcome. Instead, we adopt a
simple, intuitively appealing schema that allows us to follow a firm’s trajectory in a
two-dimensional growth-profitability performance space. We classify firms into five
performance groups in any time period as shown in Figure 1. Firms are first separated
into a 4x4 classification based on the two performance dimensions; sales growth and
profitability. Specifically, firms are classified into quartiles for both sales growth and
profitability. Both measures were calculated relative to other firms in their industry.
They were then divided into the following five performance groups as displayed in
Figure 1 above2:
Poor: low performance on both dimensions (below median on both and lowest
quartile on at least one). This is the final state for hypothesis H2.
Middle: mid performance (2nd or 3rd quartile) on both dimensions. This
category is included to reduce the risk that miniscule movements have a large
effect on results.
Growth: high growth performance, but low profit performance (above median
on the former and below on the latter, but not qualifying as Middle). This is
the initial state presumed to lead to poorer outcomes for H1 and H2.
2 We also used several other methods of categorising firms to ensure our results were not an artefact of
the categorisation schema. We categorised firms into four groups (no middle category), each group
representing a quarter of Figure 1. We also repeated the analysis for quartiles defined over the entire
population, rather than relative to industry. For each categorisation schema, the substantive results
presented in the paper were supported.
22
Profit: high profit performance, but low growth performance (above median
on the former and below on the latter, but not qualifying as Middle). This is
the initial state presumed to lead to better outcomes in hypotheses H1 and H2.
Star: high performance on both dimensions (above median on both and
highest quartile on at least one). This is the final state for hypothesis H1.
Our interest is in how firms move in this growth-profit performance space
over time. Similar to Markov chain analysis used in population dynamics we use state
transition matrices as the starting point of our analysis. That is, for each performance
group in one year, we calculate the proportion that moved to each group (or ceased
business). As displayed in Figure 1, we are interested in comparing Growth to Star
transitions with transitions from Profit to Star (H1). We are also interested in
comparing Growth to Poor with Profit to Poor (H2). We test the differences between
these specific transition proportions using standard z-tests.
In the transition matrices we also include transitions to ‘Exit’ as a separate
category. This is an ambiguous category including not only financial failures but also
voluntary closures and lucrative outright sales of firms to new owners (Gimeno et al.,
1997; Headd, 2003). Consequently Exit should not be merged with the Poor category
or be interpreted as a pure failure category. Also, this category is not directly
comparable for Australia and Sweden as many of the Swedish exiting firms are not
included in the available sample3. In addition to the separate analyses of the
Australian and Swedish samples we will also examine the robustness of our findings
3 Differences are due to several factors. The Swedish sample does not include firms with less than ten
employees (the size category most likely to exit). Further, the richer survey data allowed firms who
continued trading but changed registration number (and would otherwise have been considered to have
exited) to be included and those who have not exited but trading abnormally (in process of liquidation,
merger or reorganization) to be excluded.
23
by sub-categories based on industry, firm size, and firm age within each country. Thus
we control for each of these variables one at a time.
We perform our growth and profitability calculations based on annual data.
The theory on which our hypotheses are based does not suggest the ideal time period
for which the transitions should be tested. Hence, we test our hypotheses over both a
short time horizon (1-year transitions) and longest time horizon permitted by out data
(three-year two-year transitions for Australia and Sweden respectively).
Supplementary Analysis
We did not use logistic regression as our primary method since the purpose of
our research is not to predict which firms become Star or Poor but rather to compare
whether Profit or Growth firms are more likely to end up in the Star or Poor
categories. However, we supplement our primary analysis with a logistic regression
approach to examine multivariate effects. In addition, since our analyses are based on
variations in performance over time, we separately assess the possible influence of
regression to the mean (r-t-m) effects (Allen, et al., 1979) effects.
There is a risk that the longest time period we use for our main analysis is still
on the short side if there is a strong tendency for ‘investments in growth’ to lower
concurrent profitability while paying off in the long run. We therefore provide
supplementary analysis using the survey-based part of the Swedish study. These data
that can address the same issues over longer time periods, both as regards the time
period over which the initial and end states are assessed, and the spacing between
them.
24
RESULTS
Analysis of Entire Samples
The 1-year transition matrices as well a complete transition matrix over the
longest available period in each country are reported in Tables A1a-A1b in the
Appendix. In these analyses we have aggregated all the 1-year transitions provided by
the data (three transitions for Australia and two for Sweden). These tables show that
although a tendency to remain in one’s category of origin is a major source of
deviation from randomness, there are also many other deviations from statistical
expectation in the tables that are of a large absolute magnitude. In what category a
particular firm is found in a particular year is clearly not random. The results indicate
strong path dependence. As should be expected, this dependence is stronger for
shorter-term transitions.
The transitions relating to our hypotheses are summarized in Table 1. The left
half of this table provides very strong support for the hypothesis that Profit is more
likely than Growth to transition to Star (H1). In the 1-year transitions the Profit firms
are two to three times more likely to end up in the Star category. Although the
tendency is even stronger in the 2-year transition based on Swedish data, the size of
the category differences diminishes for the longer transitions in the Australian results.
However, the difference is still substantial an ‘over representation’ by 62%
(16.5/10.2) – and statistically significant in the three-year Australian analysis.
______________________________
Insert table 1 about here!
_______________________________
25
Strong support is also provided, in the right hand side of the table, that firms in
the Profit category are less likely than those originally being Growth firms to
transition to Poor (H2). This result comes through relatively stronger in the Australian
case, where Growth firms are two to three times more likely to end up among the
firms that perform below average on both dimensions. Although not as strong, the
difference is substantial and statistically significant also in the Swedish data, with a
minimum ‘over representation’ of 37% (26.1/19.0) for Growth firms making this
transition, relative to firms originating in the Profit category. Thus, both hypotheses
get strong support in the full sample analysis for both countries.
Analysis of Sub-samples
Tables 2a and 2b report the subgroup analyses that we perform in order to
explore the robustness of our findings with variation in industry, firm size and firm
age. These tests involve smaller sample sizes, and consequently lower power of the
statistical tests, with average cell sizes ranging from 12 to 844. Hence, differences of
the same magnitude as reported for the full samples will not be associated with the
same levels of statistical significance.
______________________________
Insert tables 2a and 2b about here!
_______________________________
Table 2a demonstrates that H1 is supported across all sub-categories tested.
Out of the 52 contrasts that could be made, 51 are in the expected direction and 41 are
statistically significant (at p = 0.05 or better). The support is somewhat weak for the
Retail industry, where the only reverse difference is found (for Australia in the three-
4 Sample size of entire sample / 5 sub-groups / 25 cells (5x5 transition matrix). 1-year results aggregate
multiple years to increase sample of transitions.
26
year analysis) and where the Swedish results include Wholesale businesses as well.
Similarly, Table 2b indicates that H2 holds up across sub-samples. Out of 52
contrasts, 51 are again in the expected direction and 30 reach statistical significance
(at p = 0.05 or better). While the Retail industry again achieves only one statistically
significant result out of four the reason seems to be lacking power; the estimated
magnitude of the percentage difference is substantial in all four analyses. The one
result that runs in the opposite direction concerns 1-year transitions for the 2-5 year
old firms in the Swedish. In isolation this result would seem to indicate possible FMA
effects. However, overall there is no obvious, general pattern across firm age groups
so the reversal for the 2-5 year category in Sweden appears to be an idiosyncratic
occurrence.
Within the boundaries of our empirical investigations, the effects hypothesized
in both H1 and H2 appear to be robust. Across a range of industries, firm sizes and
firm ages, firms that first achieve above average profitability at low growth (Profit)
are more likely to achieve the desirable state of high growth/high profitability (Star)
than are firms that first go for above average growth at low levels of profitability
(Growth). Conversely, the latter category of firm is more likely than the former to
transition to the low growth/low profitability category (Poor).
Additional Observations
Table 1 can also be read as showing that Growth firms are two to three times
more likely to transition to Poor than to Star. We note that if our results were entirely
driven by costly ‘investments in growth’ that will eventually pay off we would expect
to see this ratio diminish for longer transitions. Our results do not show any tendency
in this direction. A further inspection of tables A1a-b reveals that no other category is
27
as likely as the Growth firms to end up in the Poor group, apart from the firms that
were already in the latter category. Conversely, no other group is as likely as the
Profit firms to end up as Stars, except those that were Stars already in the first period.
Moreover, not only the Profit firms but also those in the Middle category ‘outperform’
the Growth firms in every analysis as judged by a higher frequency of transitions to
Star and a lower frequency of transitions to Poor.
All in all, these additional observations suggest a quite strong superiority for
‘profitability first’ over ‘growth first’ as a strategy to achieve high overall firm
performance. This conclusion would be moderated if there were a strong tendency for
Growth firms to transition to Profit, indicating that the firm now enjoys above average
profits based on a larger volume of business. Tables A1a-b show that such transitions
are unusual and about equally likely for firms originating in the Poor or Middle
categories. Hence, there is no support in this data for the general soundness of the idea
of ‘growing profitable’.
Supplementary Analysis
Our supplementary analyses using multiple logistic regressions uniformly
support the results and conclusions reported above. As an example, for the one year
Australian transition 1995-96 to Star group, the dummy variable for Profit coefficient,
B, was 0.93, significant at > 0.001. Profit firms were estimated as 2.6 times more
likely than Growth firms (exp B) to become Star. In all analyses our hypotheses were
supported at 0.01 level or better. The control variables showed little evidence of
significance.
We tested regression-to-the-mean effects by taking multiple measurements to
reduce random error as suggested by Barnett (2004; cf. Yudkin and Stratton, 1996).
Specifically, we averaged each firm’s growth and profitability in years 1 and 2 to
28
establish the initial performance groups, and similarly average years 3 and 4 to
determine final groups. The resulting transition percentages and patterns were
extremely close to the one year transitions. The average difference in the transition
matrix percentages was only 1.6%, and our hypotheses remained strongly supported.
Hence we are confident that our findings are not substantially confounded by r-t-m
effects.
To provide further confidence in our results over longer time periods we
conducted supplementary analyses using survey-based measures of net profitability
and sales growth relative to other firms in the industry over the last three years,
reported in both 1997 and 2000 in the Swedish data. These were self-reported on a
five point scale: much worse, worse, equal, better and much better. These data allow
us to perform similar analyses referring to an initial growth-profitability configuration
calculated over three years as related to a subsequent growth-profitability
configuration calculated over the following, non-overlapping three-year period. These
analyses also support our hypotheses (H1 and H2). This additional analysis
demonstrates that the most important aspects of our results hold up for longer periods
and for both self-report and accounting based performance measures.
DISCUSSION
Our results suggest that high profitability, low growth firms are more likely to
become high profitability, high growth firms compared with firms that start from a
position of high growth and low profitability. Firms that grow at low levels of
profitability are not very likely to achieve high profitability as a result of their
expansion. Instead, these firms are considerably more likely to transition to the sub-
sample of firms that is below average on both growth and profitability. That is, our
results suggest that attempting to ‘grow profitable’ is a dubious strategy that often
29
backfires. The scope of our empirical examination is restricted to small and medium
sized firms and we do not aspire to generalize beyond that context. As we have
pointed out repeatedly there may also be special cases within that general context
where our main results do not apply.
We argue that the results are consistent with an RBV-based interpretation.
Before going for significant growth, firms need to develop some kind of competitive
advantage based on the identification and successful exploitation of the uniqueness of
their resource bundles. We hold that in a population of SMEs, superior profitability is
likely to be indicative of having developed such an advantage. The underlying
advantage and the financial resources generated through high profitability make it
possible for firms in this situation to subsequently achieve sound and sustainable
growth without having to sacrifice profitability. By contrast, empirical evidence from
previous research suggests firms do not generally achieve high profitability merely as
a result of their growth. When firms pursue high growth starting from low
profitability it often indicates the growth must be achieved in head-to-head
competition with equally attractive alternatives, which would make profitability
deteriorate rather than improve. In addition, these low-profitability firms are unlikely
to be able to finance strategies towards building valuable and hard-to-copy advantages
while growing. Hence their growth would neither be sustainable nor lead to improved
profitability.
The resource-based mechanism underlying the configurative growth-
profitability relationships that we have uncovered has been assumed rather than
assessed in a more direct manner. We have not directly tested the existence or nature
of resource heterogeneity among the firms in our samples; nor have we examined if
and how such heterogeneity is transformed into differences in value creation in the
30
market place. This also means there may be other explanations for our results. In
support of a Porterian view of strategy (Porter, 1985) it can be noted that Capon et
al.’s (1990) meta-analysis indicates firms can enjoy a high growth/high profitability
position by being in the right industry’. However, while investors can freely move
from industry to industry, firms usually cannot, and this across-industry perspective is
not relevant to our within-industry analysis. A within-industry application of the
Porterian perspective reveals that our results are consistent with such a view as well:
firms have high profitability because of a favorable market position. This strong
position, further fueled by the lower cost of financing growth (because of high
retained earnings), allow them to grow successfully. To a considerable extent this is
the same explanation as what we have offered. As noted by Porter (1991), emphasis
on resources or market positions are (at least for within-industry analysis; our remark)
complementary rather than being each other’s substitutes. Porter (1991:108) argues
that “resources are only meaningful in the context of performing certain activities to
achieve certain competitive advantage.” Conversely, the advantage gained by a
favorable market position is usually contingent on possession and use of unique
resources.
The Porterian perspective emphasizes the environment more than does the
RBV but shares its belief in strategic choice. Evolutionary (Aldrich, 1999) and even
more so ecological perspectives (Hannan and Freeman, 1997) emphasize the role of
the environment even more and have less faith in deliberate strategic action. Applying
such perspectives, our results would be explained by firms being partly or totally
selected by the environment for certain performance configurations, with limited
ability to do much about it. As we have not investigated the strategic intent of our
firms our empirical analysis does not allow us to rule out that environmental forces
31
played a major role in their performance configurations and changes thereof over
time.
Importantly, however, we hold that most feasible interpretations of the
underlying mechanisms would lead to the same cautioning against SMEs in general
seeking growth when starting from a weak profitability position. We have not been
able to find or construe a compelling theoretical argument that is consistent with our
results as well as the literature we have reviewed and yet arrives at the conclusion that
going for growth before ascertaining high levels of profitability is usually a sound
route to enhanced value creation among SMEs. This gives us confidence in the
conclusion that in most situations it is advantageous to let profitability (and the
competitive advantage it reflects) be the horse that pulls the growth cart, rather than
the other way around.
Implications
Implications for academics. For positive theory the primary implication is that
it is descriptively wrong to portray SME growth as ‘success’. The exceptions are too
frequent to accept this proposition even as an approximation. Normative theory should
be more precise in specifying how and under which conditions (what type of) firm
growth contributes to more terminal outcomes like company value (or stakeholder
utility), either directly or via increased profits. For research design our results
strongly imply caution with the use and interpretation of growth as a measure of firm
performance. In the absence of direct measures of company value examining growth
and profitability jointly but as separate outcome dimensions appears to be a better
practice, allowing more detailed insights and sounder overall interpretation. When
non-availability of data forces a heavy reliance on growth as performance indicator,
32
increasing the time period assessed would be a step in the right direction, as unsound
growth is less likely to be sustained. More implications for researchers are integrated
in the ‘Research Agenda’ section below.
Implications for practitioners. Our interpretation of the results suggests that
rather than being very eager to expand, SME (owner-)managers should be eager to
build and identify the uniqueness of their resource endowments and transform them
into product/market offerings that enable them to generate sufficient profits. When
they have proven an above-average ability to create and appropriate value in the small
scale they have the basis for attaining sound, profitable growth that will be easier to
manage and less of a threat to the long term well-being of the firm and its owners.
Managers who believe that in their particular context growth is necessary to become
profitable should develop precise ideas concerning how growth can enhance
profitability of their particular firm, rather than relying on a belief that growth more or
less automatically improves profitability.
For external investors, our results imply that high growth in a low profitability
situation is a warning signal rather than an unambiguous sign of positive
development. However, we must caution that our results do not necessarily apply to
the much more select group of high-potential firms that VCs invest in. First-mover-
advantage (FMA) reasoning suggests radical innovators who create entirely new
markets play under different rules to the average SMEs. This said, the lack of proof
that size leads to eventual profitability is something that has concerned the very
researchers who coined the FMA concept: (Lieberman and Montgomery, 1998:1122).
Similarly, in the specific context of disruptive innovation, Christensen and Raynor
(2003) have argued forcefully for patience for growth but impatience for profit, a
notion directly in line with our ‘profits first’ arguments and findings for SMEs more
33
generally. In combination with our results, this provides sound reason for external
investors to put more emphasis on establishing profitability through VRIO resources
within their portfolio of firms, and having more patience for the growth that can
eventually realize the full value of opportunities developed and pursued by these
firms.
For policy-makers the main implication is that rather than pushing firms to
grow, policies should be geared toward helping firms become more profitable. Our
results demonstrate that firms that show high profitability often become growing
firms that still enjoy high profitability. Therefore, if policies can help more firms
become highly profitable arguably an objective better aligned with the small firm
owner-managers’ own goals (Sapienza et al., 2003; Wiklund et al., 2003) – the
problem of growth will take care of itself.
A Research Agenda
In this section we use Whetten's (1989) well-known discussion of the ‘What?
How? Why? Who? Where? and When?’ of theoretical contributions as a device to
organize our suggestions regarding how future research can reach further –
conceptually and empirically – employing the same general approach that we have
used in this paper. Regarding the What, our contribution was to focus on the interplay
between two dimensions of performance; growth and profitability, rather than trying
to maximize explained variance in one of them. According to Whetten (1989) the
main consideration regarding what factors to include in a theoretical model is
comprehensiveness vs. parsimony. Our argument has tended towards the latter, so
inclusion of additional factors may be advisable. While empirically hard to obtain, we
would advise the explicit inclusion of company value in future work, as this is
34
arguably a more terminal goal than either growth or profitability. Cho and Pucic
(2005) illustrate the value of making this extension.
Further, future work might benefit from acknowledging that ‘growth’ is a
complex phenomenon (Davidsson et al., 2006). For example, recent work by Lockett,
Wiklund and Davidsson (2007) suggests that previous organic growth acts as a
constraint while acquisitive growth acts as a catalyst for future organic growth.
Similarly, Mishina et al. (2004) find some support for differential hypotheses
regarding product- vs. market expansion with regard to the speed of growth. Thus,
conceptually and empirically incorporating distinctions by type of growth in these
terms may be important.
Refinement of the theoretical and empirical notion of ‘profitability’ may also
be an important route for further development. In particular, we suggest future
research examine whether – after controlling for the cost-of-capital effect – the effect
of having retained earnings is different from the effect of externally infused capital in
ways that accord with our hypotheses. If so our RBV-based interpretation would gain
currency.
As regards the How our contribution was the suggestion and empirical
substantiation of a contingent relationship between the two performance dimensions
‘growth’ and ‘profitability’ over time, essentially suggesting that a ‘profit first’
approach is usually superior to a ‘growth first’ strategy. The most important extension
we can see here is empirical in the first instance, namely to test our hypotheses over
longer periods of time in order to rule out that the main patterns are reversed. The
latter result, suggesting that in a majority of cases high growth starting from low
profitability represents sound investments in future value creation, would have
profound repercussions on our theoretical argument.
35
A theoretical refinement regarding the nature of the relationships would be to
consider the possibility of non-linear effects by speed of growth, as implied by
Dierickx & Cool’s (1989) notion of ‘time compression economies’. Differences in
curvature depending on initial performance configuration would then be of particular
interest. Our argument under How above suggests moderation by type of growth is
also likely. For empirical testing this development would require the identification of
an analysis technique – preferably allowing also for multivariate modeling including
control variables – that is more ideally suited to the task than either of the approaches
(transition matrices and logistic regression) that we have applied.
Our contribution in terms of the important Why dimension is the provision of a
resource-based rationale for the empirical patterns we observe. We have mentioned
already that further refinement of this theoretical explanation may include
consideration of differential effects by type of growth as well as contingent non-
linearity by starting configuration as well as by type and speed of growth. However,
the most important development regarding the suggested resource-based mechanism
would be to move it to the What domain; that is, to explicitly include it in the
empirical design. Our study shares with most published research referring to RBV a
lack of explicit assessment of key variables (Arend, 2006) and in this regard future
studies must aim to reach further.
This is challenging because mere quantification of generic resource stocks
clearly does not suffice for adequate testing of RBV-based hypotheses. We agree with
Arend (2006) that a promising way forward would be longitudinal survey studies
designed specifically for the purpose. A longitudinal design is essential for assessing
the dependent variable and establishing whether observed competitive advantages are
sustained. A survey approach is the only conceivable way in which the VRIO
36
qualities of resources could be directly assessed and meaningfully compared. Because
of the breadth of the notion of ‘resource’ in RBV and the innumerable ways in which
resources can provide advantages on their own or in combination the assessment of
resources and their VRIO qualities can never be complete. However, a focus on
narrowly defined empirical contexts may make the task somewhat manageable. A
narrow empirical context restricts the range of relevant resources to assess and makes
it feasible for the investigators to attain deep enough knowledge for developing and
applying high-quality measures adapted to the specific context. This would make for a
much stronger test of theory than the use of diluted, ‘one-size-fits-all measures’
applied to a heterogeneous population of firms.
Whetten’s (1989) discussion of the Who, Where and When concerns the
boundary conditions of the theory. We have argued that our resource-based rationale
may be more applicable to SMEs, but empirical testing in a large firm context might
suggest it can be generalized also to that domain. Our results showed considerable
stability across broad industry groupings; however our theorizing suggests the main
results should not hold up in contexts where economies of scale; experience effects;
FMAs or network externalities are pronounced. This may vary by country as well as
by industry. For example, one might theorize that trading off current profit for growth
may have a higher potential payoff in the dynamic context of ‘transition economies’
or where the domestic market is larger and the venture capital industry better
developed (such as in the US) compared to the empirical contexts we have
investigated.
Further, we have in this paper not discussed or tested the accuracy of our
hypotheses under differing business cycle conditions. It is conceivable that the
relative soundness of going for ‘profit first’ or ‘growth first’ varies with business
37
cycle dynamics, especially in combination with consideration of type of growth. For
example, Davidsson and Delmar (2000) found that ‘high growth firms’ change the
composition of their growth in such a way that acquisitions make up a larger share in
downturns while organic growth comes more to the fore in upturns.
In conclusion, as regards the Who, When and Where we would advise that
future studies a) develop precise theoretical ideas concerning how the growth-
profitability dynamics might vary by context, and b) carefully select empirical settings
– industries, countries and time periods – that clearly represent the theoretically
defined contextual conditions. To the extent such an approach led to theoretically
expected differential results our theoretical understanding would gain refinement and
the boundary conditions of our argument would be better defined. To the extent the
results are more or less uniform across contexts and in line with the original findings
we have presented our theoretical explanation would gain generalisability.
CONCLUSION
Growth is often portrayed as evidence of business success. This tendency is
particularly pronounced in the entrepreneurship research literature. Our findings are a
strong reason for practitioners and researchers alike to question a universal and
uncritical growth ideology. Our results show that firms in the desirable state of high
growth/high profitability are much more likely to originate from profitable firms with
low growth than from growing firms with low profitability. Firms in the latter
category are instead more likely to retreat to a low growth/low profitability state.
Hence, seeing profitability as the horse that pulls the growth cart seems in most cases
to be a sounder worldview than the opposite. Obviously, not all will be prepared to
accept this conclusion based on the theoretical rationales and empirical evidence we
have provided. We see our results as an invitation and hopefully an inspiration for
38
other researchers to verify or challenge them, and to provide additional input into how
they should be interpreted.
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