Schafer: A rocket to the moon? No, more of an elevator

Mike Harvath named the company he founded to help information technology services companies grow Revenue Rocket Consulting Group. He could easily have called it Sensible Growth Consulting instead.

Sure, that would be a far less memorable brand. But it would reflect what he teaches.

A revenue rocket ride, it seems, can be financially dangerous for owners of services companies.

Harvath postulates that in the IT consulting business, the only industry he serves, it's simply not possible to have the annual revenue growth rate plus the cash profit margin exceed 45 over a three-year period. He didn't say so, but his principle would seem to be applicable to just about any services company. Growing faster just means losing money.

It's a refreshing bit of realism in the area of growth and strategy. When scanning the top of "fastest growing" lists you can't help but suspect that the many of the ones now rocketing at triple-digit growth rates, particularly the services companies, will end up falling back to earth.

For those wondering how many IT services firms actually have the potential to grow at well into double-digit rates, Harvath said there are more than 17,000 IT consulting firms in the United States from $5 million to $50 million in annual revenue, and eye-popping growth is not that rare. These are firms like the Nerdery, last year placing 1,041 on the Inc. 5000 list of fastest-growing U.S. private companies, with 305 percent growth over three years and 2011 revenue of $26.2 million.

Harvath's principle isn't a particularly elegant or complex theorem, to take the sum of a growth rate and a profit margin. But it is grounded in data. His firm has had more than 300 consulting and acquisition advisory clients, and he has dug deeply into the financial records of more than a hundred companies.

The principle holds for firms that don't extensively use offshore labor and have at least $5 million in annual revenue.

Fast growth kills profitability for a number of reasons, from the lagging productivity of new hires to the complexity of managing a firm with more people, clients, departments and products and the opportunity that creates for inefficiency.

Then there is the very structure of these businesses. IT services companies develop websites and software applications, host applications, hire and provide skilled staff to work in the facilities of clients and sell a variety of other services. But they are all services, not products.

A software developer spends a lot to create and sell one copy of its software, but as the number of copies sold climbs, so does the profitability. It doesn't take double the people to double revenue. In the business of having people deliver professional services to clients, it just may.

Owners of fast-growing IT services companies see the daunting workload of new projects and new clients and staff up, not hiring just software developers but project managers and human resources managers and other staff. Harvath called that "managing the labor curve," and it's all but impossible to get right when quickly growing.

With additional costs for office space and equipment along with exploding staff costs in rapidly growing firms, even a 90-day delay on a big new client assignment can mean a quarter's worth of operating income evaporates. If it happens two quarters in a row there may be a layoff.

Harvath helps IT consultants avoid those setbacks and grow more slowly and profitably, as sustainable and growing cash profits are what create wealth for the owners of the business. When he first mentions his growth principle to clients, he said, one common reaction is "Aha, I get that. I was wondering why we couldn't make money at this growth rate."

Former Revenue Rocket client Jim Erickson, the president and chief operating officer of McKinley Consulting of St. Louis Park, said simply that "the theory is correct," and appreciates that Harvath has data to support it.

McKinley more than doubled in 2012, to $12.5 million in revenue, and while profits grew the profit margin declined, as Erickson knew it would. McKinley is on pace for 2013 revenue of $15 million with a five-year plan to get to $30 million.

"We could acquire a whole bunch of companies and roll them up and say 'Look, we are $30 million company,' " Erickson said. "But we wouldn't be. We'd be a group of companies that combined come to $30 million. Integration is going to be a problem. Cannibalization would be a problem. There are a lot of issues there, not least of which is profitability."

The Nerdery would seem to be a perfect case study for Harvath's growth principle. It's an IT consulting firm in Bloomington well-known for such practices as donating services to nonprofits and giving everyone the job title co-president. Growing rapidly, late last fall it launched a public hiring campaign called 100 Nerds in 100 Days.

In January of this year, within the hundred days, it eliminated 24 positions, or about 5 percent of its staff. As the CEO explained in a blog, "our recently slumping profitability had much to do with today's changes," and of course there wasn't much point to further discussing the 100 Days campaign.

When I ran Harvath's growth principle by the Nerdery, Chief Financial Officer Bill Stephenson responded this way:

"Growing a profitable technology company is a challenge at any scale, but the challenge increases as you increase the rate of growth. At the Nerdery, we've been able to take advantage of several trends and opportunities in the interactive market and maintain profitability despite 50-plus percent year-over-year growth."

Harvath, puzzling over this e-mail, allowed that the Nerdery making money at a 50 percent revenue growth rate was "a little surprising."

Has he seen it before?

"Not in the hundred companies I have looked at."

lee.schafer@startribune.com • 612-673-4302