The corporate life cycle is a concept that has been talked and written about for decades in management and strategy circles. Ichak Adizes, a management expert, developed a ten-stage model to describe the corporate life cycle and used it as the basis for an institute founded to advance his ideas, as well as a book on the concept.
The focus in the Adizes life cycle was more on management and the strategic choices that companies must make at each stage. The financial questions were posed with the view that ageing was not easily reversible but that, with superior management, it could be done. Even within management research, there seems to be no consensus on the number of stages in the corporate life cycle and the process by which companies age. In a 1984 paper, Danny Miller and Peter H. Friesen present the corporate life cycle as comprising five common stages: birth, growth, maturity, revival, and decline. This assessment is based on a small sample population of 36 firms that they studied through 161 time periods. They concluded that the path and timing of the life cycle vary widely across companies.
In finance, the corporate life cycle has been used more sparingly, often to explain an aspect of corporate or investor decision-making. Accounting researchers, for instance, have used the corporate life cycle to explain how accounting ratios measuring leverage and profitability change over time. They have used that evidence to provide metrics that determine where a company is in its life cycle. Corporate governance researchers have found evidence that corporate governance challenges are greater for young firms and that governance practices improve as they mature.
In valuation, I have used the corporate life cycle construct to examine why the challenges of valuation can be different for companies at different stages, and how to adapt valuation models to meet these challenges. In finance, the research is scant and has primarily been focused on how corporate financial decisions regarding investing, financing, and paying dividends vary across the life cycle.
Given the prior work across disciplines on the corporate life cycle, you may wonder what is new that I will be bringing into this book. I will draw on the research and existing literature to get started, but as I hope to show, I will use these ideas not only to dig deeper into corporate financial decisions across the life cycle but also to examine how the challenges in valuing a company can vary across its life cycle and how different investment philosophies (value investing, growth investing, information trading) can be tied to corporate life cycles. Note that the six-phase breakdown depicted on page x is intended more to provide a common structure than it is to make assertions about the number of phases in the life cycle.
You may very well decide that there are five, eight, or ten stages to the life cycle instead. In fact, assigning more or fewer phases to the life cycle will have almost no effect on the conclusions that I will draw in subsequent chapters.
Here is a short summary of the core focus of each life cycle phase. In the start-up phase, a founder or founders have an idea for a product that they believe will meet a need in the market and attempt to turn that idea into a product. Assuming they succeed in that attempt – and many start-ups will not – the young-growth phase requires the creation of a business model that converts the product or service into a business, one that generates revenues and offers at least a pathway to profits in the future. For the subset of nascent companies that manage to create business models, the scaling-up or high-growth phase is when they try to take their small business and make it larger, within the bounds of founder ambition, capital constraints, and the size of the market that their product serves. Once a company has scaled up, maintaining growth rates becomes more difficult, but companies in mature growth can still find ways to grow by identifying new markets for existing products or creating new products. Eventually, though, growth will fade as companies enter the mature stable phase, and their focus must change to playing defense as competitors and disruptors come after their established products, especially if they are very profitable. The final phase of the life cycle is decline, wherein companies find revenues and margins shrinking under pressure, as their once-lucrative markets decline.
As you read this section, I am sure that you will have questions about or quibbles with this framework. For instance, how do you deal with firms that find ways (or seem to find ways) to reverse aging, allowing them to go back to being growth firms, as was the case with Apple in 2000 or Microsoft in 2013? Why do some firms (GE, GM) take decades to grow from start-up to mature, whereas others (Facebook, Google) make the transition at hyper-speed? How do you explain family-owned businesses that have lasted for not just decades but centuries, generating steady growth and profits? I will also look at the factors that determine how quickly the life cycle unfolds for companies, how long they endure as mature companies, and how quickly they decline.
Since each phase often brings very different challenges to businesses, and there are transitions that companies must make successfully to deal with these differences, I will be talking about transitions from one phase of the life cycle to the next, looking at both operating and financial transitions. As part of the latter, I will look at venture capital financing, often the pathway that start-ups use to become young-growth companies; initial public offerings, an exit choice available to some of the more successful young-growth companies; and changes in the structure and practices in both, especially in the last few decades. I will also look at buyouts – the means by which some public companies, usually later in the life cycle, are targeted by private equity investors to go private – and the motivations behind them.
The corporate life cycle is fascinating on its own, but it becomes even more so when used to explain how companies behave at different stages of the life cycle (corporate finance), how value drivers and valuation challenges vary across the life cycle (valuation), and how different investment philosophies can each claim the mantle of maximizing returns for investors despite their divergent approaches.
Corporate finance lays out the financial first principles that govern how to run a business and every decision that a business makes falls under its purview. I break down these business decisions into three groups: investment decisions, which determine the assets or projects that a business chooses to invest in; financing decisions, which cover how a business raises funds (the mix of debt and equity and the type of financing used) to finance these investments; and dividend decisions, which determine how much cash a business returns to owners and in what form. If you are unfamiliar with corporate finance, another chapter provides an introduction, laying out the first principles of investing, financing, and dividends, as well as the core tools and processes I use to put them into practice.
In another one, I look at investment decisions in more detail across the life cycle, examining how investment types and investment challenges vary as companies age and, as they vary, how businesses must adapt their investment techniques and decision-making rules. I begin by looking at the trade-off that determines how much a business should borrow and then use that trade-off to make judgments on how the mix and type of financing changes (or should change) as companies go from growth to mature status. I describe the process that can be used to determine how much cash a business can return, and then apply it to evaluate how much cash (if any) a business should return, given its place in the life cycle. In each of these chapters, I will also examine the consequences for businesses that choose to adopt corporate financial policies that are at odds with their age.
Excerpted with permission from The Corporate Life Cycle: Business, Investment, and Management Implications, Aswath Damodaran, Penguin Business.
