Dimensions of a Scalable Business Model
Finding and implementing a scalable business model is a goal many entrepreneurs pursue. In these models expenses are loosely coupled to revenue, meaning that every additional customer drives down cost, leading to higher margins. This results in companies that are highly investable and subject to a compounding effect, making them immensely profitable in the long run. Software and digital media businesses are often touted as prime examples.
But it doesn’t stop there. The notion of scalability is actually quite nuanced. Imagine a company selling software on a subscription basis. It would still require hiring a support agent for every x additional users in order to grow. Does this mean this business falls short of the definition? Palantir, a large software company that recently IPOd, only serves about 150 customers, but each client brings in millions in revenue each year. This company sells software specifically targeted at the public sector and Fortune 500 companies. Does this make for a scalable business model?
When looking at business models from this narrow perspective you realize that very few actually check the scalable business model box. Rather than looking at scalability in binary terms it should be considered a spectrum. Some business models are more scalable than others. The time it takes and the types of bottlenecks a business encounters while scaling ultimately determines the quality of its scalability.
There certainly are businesses that do not scale: an artist or high-end craftsperson produces work that is so specific to its creator that it is not likely nor desirable to hire employees to scale up production. Some do not want to scale, such as independent contractors that love the flexibility offered by this alternative form of employment.
Factors for scale
There are many factors that affect the ability and the speed to scale a business. There are at least as many measures to offset the negative impact of these factors. Having access to capital in order to fuel growth is one, as it will allow you to make larger investments or make them earlier in order to respond to demand. But the limiting factors will always impact scalability unless managed well.
When dealing with a physical service or selling physical products, location is the most limiting factor. Only businesses targeting the upper part of the market will be able to serve clients in a large area as transportation is costly. Being closer to customers can be a competitive advantage as it drives down on transportation costs, but requires additional overhead in terms of managing additional locations.
Some businesses require high concentration of traffic in order to sustain (think bars and restaurants), which are often in short supply. If a business has high or unique location requirements it will take longer to find appropriate areas to expand in, reducing the speed at which it can expand.
Small businesses often have a hard time hiring talent and it gets progressively worse when skill/education requirements get higher. This can be partly offset by higher wages, but this quickly leads to collapsing margins. Unskilled labor can be easier to find, but not in all areas and is highly depending on the local market. The more labor intensive and knowledge intensive your business model is, the harder it is to scale.
A business model that requires a relative homogeneous workforce has the edge when growing. This means hiring primarily for one of two roles, rather than hiring for a plethora of roles. Sourcing, evaluating and training gets a lot easier when looking to fill positions which were previously hired for.
Onboarding new employees correctly is paramount in building a great team, ensuring quality and maintaining culture. It is also incredibly expensive as employees are paid without them generating revenue. Striking a balance between sufficient job-specific training and generating revenue is incredibly important. Longer onboarding times will make a business model harder to scale.
For this reason businesses should be incredibly weary of Not Invented Here syndrome. Instead of making things up internally, find standards that are defined and maintained outside an organization that fit 90% of the requirements. This means new hires are more likely to encounter familiar practices (requiring less onboarding) and reducing costs by not spending time on setting up systems that offer little added value.
Marketing and sales
If the marketing and sales process isn’t scalable, there is little need to have the other parts of a business scale. Mass-marketing (either online or through traditional media) requires relatively little manpower and some models won’t even need a sales team. This is only possible for standardized products and services that allow customers to onboard themselves.
On the other hand, expensive and client-specific products or services are high-touch and require experienced staff and more elaborate sales pipelines. This can range from taking prospects out for dinner or sitting down for hours to spec out a car.
The size of the addressable market is another concern. If a business model is tied to a location, expanding requires opening a new location. Some models serve such a small niche that there is simply no sufficient demand to grow.
Service and product portfolio
Reducing the number of products or services offered, and reducing complexity of every single service is key when trying to scale. If either of these two numbers are high, the requirements in terms of talent recruitment and job-specific training will skyrocket, or it will require multiple employees in different roles to offer this product or service at a high level of quality.
Capital intensive businesses require a relatively large investment for each additional unit of revenue. This in itself does not make it hard to scale, but the time delay effect will influence the speed at which a business can expand. Some of this can be negated by attracting external capital to accelerate growth, as it allows for making earlier and larger investments to satisfy future demand.
Expanding a production facility requires a large investment, but also has additional requirements in terms of real estate, inventory, transportation and employee training. Neither does expanding a production line happen over night. Business models that require multiple locations suffer from the delay caused by finding and opening a new location, especially when self funded, again influencing its ability to scale.
Quality of revenue
Looking at revenue in terms of quality is about assessing how predictable, profitable and diversified a business’ revenue really is. High levels of predictability can be achieved by perpetual contracts to ensure recurring revenue (especially important for professional service businesses) or through continuous (mass) marketing efforts. Having a large number of customers across many client segments will ensure diversity and reduce impact of short-term headwinds.
Consistent revenue will lead to consistent future cash flows and allow for continued growth (at whatever pace), rather than stepped growth, which drastically impacts the speed at which a business can scale.
Truly scalable business models are far and few between, but there are many models that score well on some of the factors outlined above. Not all entrepreneurs require business models that are infinitely scalable; some may be quite happy to stick to a certain size. Running a business is often a continuous process of alleviating bottlenecks, only to find the next one. This often requires improvements in one of the areas outlined above.
If you never looked at a businesses model in terms of scalability you might find that your business does not score well in these factors. It is actually quite easy to get stuck in a place where a business does not seem to scale any further due to restrictions put in place by a business model. This simple framework allows you to pinpoint what is going on and potentially tune your business model and clear that hurdle.
Thanks to Alex Bridgeman for encouraging me to write up these thoughts.