Scalable. The magic elixir for investment, growth and future wealth is captured in this one word. The business model of a successful startup must be scalable. What is required to achieve this quality? How will different methods of scaling affect the financial model for a growing business? What does it take to convince an investor that your startup is scalable?
Profitable paying customers
There are actually several different business model questions wrapped up in scalable. At one level, scale is simply about growth. Can you find enough customers who will pay a good price for your product or service. Scale is only achievable if there is a real market.
Closely related to growth is showing that your startup can generate profits and cash. The key figure here is gross margin, the amount of extra profit you make for every unit sold. One of the major attractions of software businesses is the high gross margin. Once the product is built, the cost per unit is low to negligible so a large proportion of income turns into profits and cash.
The challenge for software is to ensure that the design and build quality of your software are excellent. If either is poor then constant fixes and high maintenance costs will undermine your scalable business model. Increased volumes will just put an unbearable strain on bad software so a scalable business starts with a product that is high quality as well as high margin.
Sales and marketing are key costs
Generating strong revenues and gross profits is only part of being scalable. Getting to market costs money and selling to customers can rack up even more cost. Organic sales of digital products through the Internet are extremely cheap but few startups can achieve this. Most often the choice is between acquiring customers by advertising heavily on web and social media channels or the old fashioned method of knocking on doors.
Employing and rewarding a sales force can be costly. Once someone is on the payroll it is also much harder and slower to reduce costs. As a result, Internet based models, often with heavy advertising, seem a better fit with the scalable concept. This can be misleading. B2B ideas are often best suited to direct sales and these markets can also be less competitive than consumer markets. Business models based on customers acquired through advertising can also be vulnerable to poor customer loyalty. High churn means you need to keep advertising and this becomes almost a direct cost as growth can only be achieved through high marketing spend.
You will need to show you understand how your company can acquire customers and how much this will cost. Truly scalable business models will also address customer loyalty. The more you are able to retain your customers the lower the cost of acquisition will ultimately become.
Building an asset takes time and money
Another big element of scalability is the time and investment required to support high sales volumes. Software again seems very attractive on this measure. A small number of developers and minimal computer equipment are all that is required to build and constantly upgrade even quite sophisticated products. A physical product may require factories, tooling, a skilled workforce and delivery logistics which all cost money. Other types of business face regulatory or other barriers which consume both time and money. For example, new ideas in life sciences may have to pass a long series of laboratory and clinical tests in various territories before the product is approved for sale.
For software it is important to remember that low investment also means very low barriers to entry. In practice it is easy for both the next startup and giant tech companies with deep pockets to develop products which are more compelling or easier to use than yours. Sometimes this provides a good exit as a larger company may decide the easiest way to enter a new market is to acquire your clever startup.
However be aware that companies with a low asset base can also be blown away by new entrants very quickly. Your main defence is loyalty. Build a great product, acquire customers with a promise you can truly deliver and support your users with high quality service. To be a scalable business you need to beat your competition all over again every day.
Don't forget about service
One final aspect of scaling up a business is often overlooked. Attracting loyal customers is great but people stay loyal because of excellent service as well as a quality product. Most software is now launched on a SaaS basis and the last S stands for service. Your customers will expect great service as part of the experience. Your investors will want to know you have costed it into your business model. A good test is the 10X scenario. Imagine everything in your business is 10X greater in size than it is today - including the problems, bug lists and so on. How would you cope? What resources and processes would you need? This is your service model.
You need a great business to achieve scale
Investors love scalable businesses because they can grow fast from a small capital base. Software startups fit this criteria best - almost every other business model requires significant investment in capital, time or people to achieve growth. But scaling is not as easy as it sounds. You need to find a market, create a profit generating product or service, bring it to market effectively and use great design and quality service to build customer loyalty. Software offers great business models including SaaS but only great businesses succeed. Having the characteristics to scale is helpful but you need passion and determination to make it happen.
In the startup cauldron cash flow and burn rate can feel like the only financial measures that matter. You must keep focus on the kitty to survive but money in the bank is not how your business generates value. Many founders find it hard to pin down the measures that show progress in value creation. There are a number of ways to look at this but one common approach is to understand and measure customer lifetime value or CLV.
The fundamentals of CLV
Simply CLV is the total revenue you will receive from a customer over the whole time that individual or company is your customer (R) less the direct cost of sales to that customer (C) less the cost of acquiring that customer (A). R-C-A=CLV.
It should be obvious that this matters to any business but it is especially important to many startups.
For pretty much any business model, R-C needs to be greater than A. If not then the cost of acquiring a customer exceeds the benefit and you cannot hope to generate value. Note in this case that a customer and a user are not the same. Google for example has millions of users who contribute no revenue. This is fine so long as there is also a market of paying customers.
CLV can be a measure of value creation
Once you understand how much value each customer generates then you can start developing a long term model of business value and capital requirements. If 10,000 customers generate £10 million of CLV for example you can estimate the running costs and for a given amount of sales and marketing investment you can figure out how long it would take for your business to reach this number of customers. While this rule of thumb works for many businesses, it is especially useful for SaaS or other subscription based models.
CLV provides a window on operational metrics
CLV can also be a guide to understand which operational measures really matter. Every startup today has a bewildering variety of analytics at their fingertips. Which need to be monitored constantly and which are just interesting? In a fairly typical freemium SaaS business for example, A will be calculated by looking at the cost of sales and marketing divided by the number of customers that sign up and then multiplied by the rate of conversion into paying customers. Once the business has enough information to estimate the rate of churn, this can be used to estimate customer life. So if you lose 20% of your customers every year, typical life is 5 years. Multiply this by your average monthly revenue and hey presto you have a value for R.
Now your SaaS business can focus on number of sign ups, cost per sign up, conversion rate, average subscription and churn rate. Track direct costs every month and you have the complete model in 6 figures.
Of course each of the numbers in this kind of model is tough to estimate. When you start out you don't know how much your customers will pay or for how long. Figuring out how much it costs to sign up 100 customers might be quick but how many of those turn into loyal customers paying regular money? The risk increases if you need to employ a sales force to acquire customers.
Use seed funding to test CLV potential
These are all great questions. In my mind the purpose of raising seed funding is to answer them as robustly as possible. Test out how much it costs to acquire customers. Get feedback on what people will pay and how you can improve the design to make them more loyal - from a CLV point of view a year of extra usage may be worth more than a 10% increase in price for example. Demonstrate you can scale your product and your team to meet demand and that you know how much this costs.
Build a CLV model to demonstrate value
Once you have a robust proven model you have a basis on which you and other investors can make projections about future growth. You can show how you would spend that £5 million Series A round and calculate the value your business would create as a result. Your company will still be a high risk investment but you will have a model to work with at least.
Different companies require different approaches but CLV is a widely understood and applied concept. Build a model that demonstrates how your early progress creates CLV and you will have a great conversation with potential investors.
Remember you are selling a service....
Many of the companies I meet have a business to business sales model. It has become a cliche of the Startup world that large corporations are a slow and difficult sale. It goes double for major government departments like health or education. Having spent thirty years working in this environment delivering and selling professional services to some of the biggest companies in the world, I guess I should have some ideas to help manage this process.
Back to basics first. Almost without exception B2B Startups have adopted a SaaS model. This is absolutely correct but remember what that last S stands for. You are selling a service not a product.
This is really important because there are a lot sales methods and sales people out there which are built on product sales. The devotees of Huthwaite's SPIN selling and Miller- Heimann Strategic Selling spring to mind. Do not be tempted by these or similar approaches. SaaS is not just window dressing. Your customers will expect a service so make sure that is what you sell them and what you give them.
In B2B, know your competition....
Selling services start with one key secret - Whichever industry you target, whatever your software does, regardless of the country or business function you target, your top two competitors are always the same. SAP, IBM, Salesforce.com and Amazon also face the very same top two competitors. They are:
Do nothing; and
Do it yourself.
In that order.
Companies do not buy software (or anything else)
This may seem a radical departure from the traditional view of competitive markets but it is very important. If you do not beat Do Nothing and Do it Yourself, your large business customer will not buy. No amount of features and benefits and cost savings which are not offered by other software providers will help you.
The reason is simple. Businesses do not buy software. People buy software. In a large company a whole range of different people with different agendas and variable levels of influence are involved in the decision to buy. Do not make the mistake of believing these people are some amorphous corporate buyer. Treat them just like consumers. Identify their real world problems and find a way to help fix them.
Look at your two competitors in this light. Busy managers in big companies will always have the temptation to do nothing. Busy managers tend to be driven and successful people so they are also capable of getting a things done without any help that is doing things themselves. Your offering needs to get at something which is strong enough and urgent enough to overcome both of these.
Know your market....
The right time to address Do Nothing and Do it Yourself is in the product development phase. I get frustrated when I hear Startup pitches which say things like “According to IDC 75% of companies have problem X.” I would much rather hear about research which concerns managers and leaders i.e. real people. If you do this then your software will go at least part of the way to addressing one or more actual problems.
If you start with a well designed product then half the battle is won. The second part is in the sales process. This will be time consuming. The important thing is to keep reading the signals and steering the conversation in the right direction. You can’t avoid spending the time but you can avoid wasting it. Just getting the next meeting is not progress in itself. Often in fact it is a method of Do Nothing. I have passed you onto the next person so I have now avoided doing any work - success!
Learn to read the signals...
Reading and reacting to these signals is a big subject but there two big positive signs that you can watch out for. Number one is access to power. If the person you are meeting is prepared to take you to a major decision maker this is a great signal. This is not necessarily their boss so be careful. Not all big job titles carry real power or if they do it may not be the power you need to access. Do some research before jumping for joy at meeting the next guy.
The second sign works the other way. If someone in power sends you to their subordinates to plan for execution this is awesome. Again caution. You need to be sure you have actually been talking to power. You also need to be clear they have delegated action. Delegation for further review and investigation is just another Do Nothing.
I am conscious this all sounds pretty scary. Its not. Its an appeal to use the instincts and intelligence you already have. Talk to people, find out their problems, fix them. Don’t forget this because you are selling to a large company and don’t assume you are making progress just because they keep talking to you. Measure your progress and invest your time wisely. The process will not become short but it is much more likely to be successful.
Kenny Fraser is the Director of Sunstone Communication and a personal investor in startups.