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The Scalability Illusion

Even if an entrepreneur avoids all the pitfalls of how not to pitch a venture capitalist, there are still quite a few common mistakes that happen. One of the most common is something I call the scalability illusion.

It goes something like this:

Entrepreneur: I have got a great idea. I’ve built a [blog/game/social network/eCommerce site/product/etc] that has really taken off. Without any advertising, it has [100,000 users/articles/purchases/customers/etc]. All I need are a few million dollars and I can really blow this baby out of the water!

kcsw-t-front-expStop me if you’ve heard this one before…

The fundamental mistake that many new entrepreneurs make is that they assume that their ability to do well on a small scale with very little money necessarily translates into being able to do as well on a large scale … if only they had some money.

Occasionally, they are right. But, 9 times out of 10, they’re not. I have a theory of how these sorts of businesses grow:

  • Phase 1: Building something that works at all to get a small amount of recurring users/customers/etc.
  • Phase 2: Growing to a fairly large number of users/customers/etc.
  • Phase 3: billion dollar business.

Phase 1 tends to be extremely difficult. It takes a lot of work and skill and luck to build a product/service that is good enough to get people to actually use and stick with it. Phase 2, in my book, tends to be relatively easy (each step is hard, but this one is relatively easy compared to the other two phases) – because once you have a good product in place that a few people will use, it’s natural for there to be a few thousand or tens of thousands of users who are looking for a similar product or service.

Phase 3, however, is always the hardest part of the growth story. Once you get past your first few thousand/tens of thousands of users, you’ve gotten all the “low hanging fruit” – all the people who would naturally flock to your business have already jumped on board. To grow further, you need to:

  • develop a product team, not only because you’ll need new products and features to attract new customers and ward off competition, but because other companies will try to hire your best people
  • expand sales & marketing to win new customers and hold on to existing ones
  • build out a business development team to land the partnerships and deals you’ll need to stay ahead of the curve
  • invest in support/logistics to manage all the new people you need to hire and all the new customers you need to bring on
  • bring on a strong finance team and retain a good legal counsel, because the cost of success is taxes, red tape, lawsuits, and cash management
  • a general rule of thumb I’ve observed is that good strategies to bring in new customers always get copied, making the cost of getting a new customer go up over time (all other things held constant)

Or, in a nutshell: you are chasing an illusion if you think early stage successes easily scale to big home runs. If it were that easy, it’d happen a lot more often.

So, what does this mean if you’re a budding entrepreneur trying to raise money?

  • Be mature enough to accept that the toughest part of building your business is not the product, but getting it to scale. One of the biggest red flags on the quality of a management team, in my mind, is when they say “the tough part – building the technology/product — is over, now is the easy part – signing deals/landing customers.”
  • Expect one of the biggest questions on a potential investor’s mind to be how costly/difficult it will be to scale your business, and have a thoughtful, well-researched answer to it. This should include looking at how much other companies needed to spend to grow and the next bullet point…
  • Actively track the scalability of your business: have numbers like customer lifetime value and capital intensity readily available
  • Avoid business models/products which are obviously very hard to scale. On some level, all business models are hard to scale. But there are definitely some ideas which are notably harder to scale. For instance, selling a service where you have a complicated sales and development process that varies significantly for every customer? Probably not easily scalable (i.e. selling to K-12 schools; management consulting). Building a product which requires you to build an expensive factory every few years to achieve your growth goals? Probably not easily scalable (i.e. IDM semiconductor manufacturers). Selling a product that is extremely hit-driven and very long tail? Probably not easily scalable (i.e. movie studio, games, etc.) These aren’t the only ones — but they give you a flavor. The exception to this rule is if you have some underlying formula/secret which allows you to scale more easily — but rest assured, it is extremely rare for a startup to find this legendary holy grail

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