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.
Kenny Fraser is the Director of Sunstone Communication and a personal investor in startups.