Reid Hoffman, one of the Paypal Mafia, is considered as the legend in the world of entrepreneurship and startups. In his recent book, Blitzscaling, he provides insight on when and why should companies ‘grow at any cost’. The coined name, Blitzscaling is described as:
Prioritization of speed over efficiency in the zone of uncertainty.
In Blitzscaling, Hoffman covers the core factors a business should consider when going for the “hyper-growth”. He explores & explains the tactics implemented by companies in their quest for world domination. Examples like Amazon, Facebook, Apple, Airbnb, Tencent, Oracle, (any billion-dollar unicorn you could think of) etc.
The book help founders contextualize ‘scale’. What it really means & how it varies as compared to different business models.
Scaling is Sexy! Period.
Admit it. Scaling up is the desire and it is a buzz-word which is thrown a lot around by founders. Even I’m guilty of it.
The only problem is that leaders never contextualize what ‘scale’ actually means for their business. In addition, there are many businesses which are not meant to be scaled, for eg, a customized art shop operated single-handedly by an artist.
Today, we’ll be overviewing on why your business is really hard to scale, purely from an operational finance lens. We’ll be referring to various concepts from the Hoffman’s Blitzscaling book, and at times dive into the unit economics (I’m new, so would not use the PRO list of jargons! :D)
The Concept: BLITZ scaling
There are 4 overarching categories of growth that generally every company has, and could be possibly explained as follows,
Classic Startup Growth
A phase where the founders have just jumped off from a cliff and are ‘building out their airplane”. This stage covers the hard-core hustling and every aspect is craving growth potential. Most Founders in this stage are grinding hard in search of that ‘product-market fit’ and need to survive. Here, If you put $X, you’re unsure on even getting that ‘$X’ back as an ROI as this stage is at times the riskiest!
Classic Scale-Up Growth
A quite practical stage where the company knows what they’re into and carries a solid foundation of each process, including the distribution channels and accounts for measured calculations toward efficient growth path. As a founder of multiple startups, I’d say I’m pretty biased towards this form of growth as it accounts efficient capital allocation — which means that if you invest in the project, the ROI is way more than your investment. Here, if you put $X, you’ll surely get $Y (definitely higher) and your pure profit is $(Y-X)
In the layman terms, it means that you’re willing to sacrifice quality/efficiency for the sake of growth. FastScaling is at times contagious and is applicable to companies who forget the ‘ROI’ and focus on strategic objectives like taking market share or hitting revenue milestones just to meet investor hurdles and win on the Founder war-of-egos. Here, if you put in $X, I don’t care about the yield, it should get more revenue, that’s all that matters!
A special form of ‘all or nothing’ growth mindset. You tend to forget about efficiency and numbers; instead choose decisions on the basis of your gut, speed, uncertainties in order to design the pathway towards world domination. In simpler words, I don’t care if I’m spending more money, because if we don’t burn money, we’ll lose the game. All that matters now is winning.
BlitzScaling Business Model Characteristics
The above-mentioned ‘4 Growth Factors’ are critical to almost any business model, but how do you characterize a business model in itself? Here’s the answer.
The Market Size
Yes, I know. This sounds like an obvious answer. But you need to know one thing, to build a massive company, you need to have a massive market to cover.
As we’ve all heard, “a good product with a great distribution will almost always beat a great product with a poor distribution” Generally, there are two categories of Blitzscaling, companies could use
Leveraging Existing Networks
Simply Tap into existing networks to distribute your owned products/services. Eg, Airbnb in its early days leveraged online classified service Craiglist to gain traction towards its service.
Virality (also referred to as the ‘Viral’ Factor)
Virality occurs when the users of a product bring more users with them, and those users bring more users, creating a pyramid of users to the platform. If achieved, this category makes user acquisition very simple and effective, allowing you to just focus on your operations.
High Grossing Margins
Possessing high gross margins in any market is powerful as it allows you to make more profit which further can easily be reinvested to gain growth and expansion. Most technology businesses have enviable, high-gross profit margins, upwards of 75% to 80%. What’s also important to note is that the cost of duplicating a piece of software is almost zero which is pretty amazing, right?
Network Effects is a phenomenon where the value of a product or service increases in additional value as more people start using it. For eg, Facebook, the humongous social network is nothing, if it’s just you posting actively there. Network effects are powerful for any company because the platform becomes more powerful and useful as more people start using it. In simpler words, the greater the number of people, the higher the revenue.
The Two Growth Limiters
To get on your pathway to scale & grow, you must overcome the growth limiters. Generally, they are classified as the following,
- Lack of Product-Market fit: (if you don’t have it you don’t have a business.)
- Operational Scalability
Possessing a scalable business model is a critical aspect of Blitzscaling. Having an in-demand product is one thing, but getting the product available to the end-user is different altogether. For eg, Tesla Motors is a company which is seeing growth way beyond the infrastructure limitations.
Further, If we account these characteristics altogether, we could categorize them into the following buckets.
The Economics of Growth
As mentioned above, high gross profit margins are critical for scaling companies. If you somehow don’t manage to get this right, there’s a good chance that you’ll ‘grow broke’.
By growing broke, I refer to the fact that costs of growth will eventually ‘break’ the viability of the business model. Modelling the financial, as well as operational scalability, are key to avoid that from happening. Just a recap, Gross profit is the profit you make at the level of an individual product. That is, when you make a sale, what’s the profit after all the direct costs are deducted (in short, the leftovers).
What makes measuring gross profit so important is the fact that you want to ensure that you have enough remaining profit to reinvest back in your business in order to make it scalable. Simply, put in a formula,
GROSS PROFIT = Sales — Direct Costs
How to Bring Direct Costs Down?
Direct Costs (also referred to as Cost of Goods Sold or Cost of Sales ) are all the expenses that are attributed to the production of your products and services. You need to account the costs of the materials, labour costs, software hosting, management cost, and shipping.
Direct costs can be further split into Variable and Fixed Costs. Variable costs are all the expenses that increase in direct relation to your sales volume.
Fixed costs, on the other hand, are all the expenses that will stay the same, irrespective of your volume. Fixed costs include the direct labour costs (in a service-based business), software hosting (for a software business), etc.
It’s important to get granular with the nature of your fixed and variable costs because it is important to understand each to their foundation level for planning the growth of your company.
Why Software Businesses Scale So Easily
The business which runs on software model does have high gross profit margins, ranging an easy from 75%-85%. As they have a zero incremental cost, they are so damn easy to scale from the perspective of unit economics. This means that it almost zero money from a Direct Costs perspective to gain more customers. For eg, selling 1 software subscription v/s selling 2000 subscriptions carry a little impact on the hosting bill that you’ll get at the end of the month.
The result, revenue grows, but the fixed direct costs (being the hosting fee for now) doesn’t grow. Many people also call it ‘ hockey stick growth’ because the direct costs of software businesses are fixed and carry a very little incremental cost, Gross Profit improves as you scale your user base.
Software businesses can scale so beautifully from an operational end of the business because the product is a digital asset. You get to design businesses which are not entirely dependent on human capital, as your customers are dependent on the product functionality itself.
As an outcome, companies have low amounts of employees relative to revenue and gross profit made at the end of the day. It’s one reason why investors are more inclined towards investing in a software business.
Scale for ‘Traditional’ Businesses
Time to compare the scale definition of software business model to that of more ‘traditional’ business models. Generally, when we talk about traditional business models, it classifies into the following,
- Inventory-Based Businesses (Retail/E-commerce)
- Professional Services/Consultation
These are the businesses which sell physical products, as opposed to an intangible good or service. You may account an eCommerce business, fashion retailer, health supplements, or even a grocery store etc as an example of this form of business.
Gross profit margins for these businesses range typically from 40% to as high as 60%. A major fluctuation in their margins is seen primarily due to production costs, delivery and warehousing costs.
Here, there is a highly variable fixed cost as compared to fixed direct costs, this means direct costs will grow in relative proportion to revenue. With scale, the products will become cheaper to produce. In other words, they can benefit from economies of scale to generate higher revenue.
These type of businesses can also scale well as fulfilment can be outsourced to 3PL (Third Party Logistics) providers. This way, a low fixed overhead with scalable operations can be achieved resulting in a high-leverage on the revenue front.
Professional Services or Consultation Based Businesses
The key difference between a software-based business and a professional service based one is that here, the product is people. This means that you’ll be trading a human intelligence for some $X amount.
In this type of business, the gross profit margins range from 50% to 65%, if you’re lucky, you can get to as high as 70%. Wages are fixed costs (as they don’t scale up or down with revenue) but may act as a variable cost because you need to have more staff if you plan to make more revenue. Accordingly, the incremental cost of growth is high. To be simpler, the Gross Profit margins will grow in the same proportion as revenue will, irrespective of whether you’re a 10 people company, or 1000.
The Moral, Humans don’t scale as the Software does.
Further, the firm’s ability to grow is limited by the capacity (often measured in billable hours) of employees who are serving customers (the ‘asset’ to the company). This form of business also finds it difficult to grow as you’re in a continuous rush to onboard new ‘people’ in order to scale.
It requires discipline & focus to become good at capacity management, which is crucial towards the growth of any professional service-based business. Capacity Management is the art of knowing the match of human capital to workload.
Capacity Management & It’s Impact
Capacity management is so crucial in your service-based business that it could make-or-break it — particularly if you’re trying to scale the business.
If you carry excess capacity, your gross profit margins are eroded because of higher direct costs relative to revenue — you have people sitting idle with no work to do. If you don’t have enough capacity, you risk churning revenue because your customers are not being serviced. YES! It sounds vicious… I know it, I’ve been there.
Overall, it’s a balancing act and requires strict attention to knowing your hiring economics (repeatable process to hire employees), as well as growth economics (repeatable process to generate sales).
The impact on Gross Profit Margins:
As team sizes grow, layers of management are required, whom of which are often directly ‘non-revenue generating’. Seemingly, operational scalability becomes highly challenging for the founders of such a company.
Revenue per employee needs to be measured as total sales divided by headcount and can decline as you employ non-revenue generating staff for your operational infrastructure, which directly correlates to lesser end profit margin.
You would need teams of middle management to manage capacity and workflow of the team, for eg, HR personnel. All of which is employed to service the internal needs of the businesses so the revenue-generating staff can do their job efficiently.
Overall, one can arguably say that there is little to no ‘economies of scale’ to be gained with operating a service-based business model. A rational founder would say, “Why even bother to scale a traditional service business?”
Simply, There’s not a lot to be gained with ‘scale’. I’d like to add on this with a point that, “Yes, service-based businesses are hard to scale and the scope of growth is very small, but if managed well, you can gain a “sweet spot” where your business earns a fixed income at the end of the month (at times, without your interference)
‘Scale’ is a term often used by many entrepreneurs & founders. What I don’t often see is founders contextualizing what ‘scale’ means for their business. Is it to be the next Amazon? Or is it to be best at what you do in your geographical area? or maybe reaching a number X in the user base? Yes, you need to have a clear mindset on where you want to proceed.
Whatever be your goal, it’s critical to align it to a vision, understand the unit economics of your business model and plan things accordingly so that you don’t risk ‘growing broke’. Good luck with your business!