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Berkonomics

Premature scaling kills businesses.

Venture capitalists sometimes make an error in directing their portfolio company CEOs to push resources to the limit and scale the business to immense size quickly, all to seize market share.  The logic in this is simple: once a company has market share, other issues can be sorted out to monetize the market, make the company profitable, scoop up wavering competitors, or even sell the company to a larger firm looking for a large customer base.

This form of thinking has been unusually true during the rise of social media, where Up_rightmarket share became the primary goal of a company, with revenues and profitability to follow later.  It was true for Amazon and other visionary companies that grabbed market share during the early Internet era.  But beware. Many, many companies accepting venture capital lost it all following this instruction.  VCs have a goal of creating extraordinary value for their investors.  Incremental profits from companies that later sell for three to five times their original value at the time of their investment may be considered great successes for founders but relative failures for VCs, who must hit for the fences with every early stage investment.

[Email readers continue here.]   I’ve been involved as a board member of two such businesses, where venture investors came aboard and pushed management to immediately scale the business without regard for profitability, and without much regard for infrastructure.  Both businesses scaled beyond what their market could absorb, and revenues did not build at nearly the rate of audience increase.  The cost of each exercise was dramatic, far beyond what a founder-entrepreneur would order to be spent when using his or her capital or reinvesting cash flow from operations.  Venture investors need large scale to make large exit valuations, or in many cases are not interested in maintaining marginal companies.  To state it again, what might be a success to angel investors and to founders could be only of marginal interest to a typical VC.

Scaling a business is an art as well as a science.  By definition, scaling requires the addition of fixed overhead, sometimes the kind you cannot shed easily, including leases for expanded space.  Experienced CEOs often make it a habit to scale as a result of demand, reducing risk and mating cost to growth in revenues.  Angel investors are more tolerant of this than VCs.   Typically, when you bring a VC onboard, you increase the risk, the reward, and the definition of the size for a successful exit.  Adding to this is the extra risk undertaken by premature scaling.  It is important for you to realize that there is a fair tradeoff in valuation between a company with less outside investment and a lower endgame sales price, and one that shoots for a much higher valuation to justify a higher amount of outside investment.

  • Thanks, Dave. As someone who is now contracted as CTO for a fast-growth company, I’m facing this issue right now and appreciate any write-ups like this that can help map out the parameters that are going to drive our growth. My solution so far is to automate as many of our systems as possible and to minimize the use of pay-per-use resources, so we can scale without taking on massive personnel, physical plant or virtual resource commitments. Also, we’re building systems that should be able to add capacity quickly and painlessly, and designing today’s technology with an eye toward potentially supporting millions of users even though we currently have none. We’ll see how well that works in practice, but I’m definitely concerned about growing faster than a sane revenue model would allow. Thanks.

  • Nelson Paez

    Brilliant… I agree.

  • Dave,
    This is one of the reasons that I have steered clear of VC mentality for funding. Although my Fitlogic technology is a game changer for the fashion industry, everything we have done is innovation and cannot be put into a box. I can scale now with a business model that has never been available to the fashion industry, but it is only because there is so much pain around apparel fit. My methodical industry and consumer study has taken many many years. Angels let me do what I think we should do and although I would like to have a big chunk of money, I’m happy with the place we are, and I still control my company. I love your stories. Thanks! Cricket

  • Bob Kelley

    Hi Dave,
    & Hi Soham,

    Soham raises a very useful question for an early stage business: “When to scale?”

    Having successfully dealt with this question in three situations successfully, and at least five unsuccessfully (but failed fast), let me share a framework that will be useful… if your really ready to work it.

    So, Soham, this raises the question before the question of “Slug for the fence VC” versus “Get a solid single oriented Angel.” Actually, I oversimplify, because some angels do know when, and when not, to swing for the fence. And there are VC firms that are actually more like what Dave describes as angels, in that they “focus on profitability first”. (you have to ask, and then verify, to really know.)

    So, the question before the question is: “When to scale (fast), and when to grow incrementally?”

    And, in my humble opinion, that begets three other questions.
    – How big is the addressable market?
    – How much of a temporarily sustainable advantage can your value proposition provide against followers? – Can you really quickly gain a sufficient, temporary, dominant position in the market, and then use your market power to keep (Most) rivals out (until you get a big enough ROI) (Amazon, Uber, Homeaway, AirBnb)?
    – Is your business model either really profitable at scale, or will someone else pay enough to provide a grate exit (Skype, YouTube)?

    Soham, to help you get a good handle on these questions, let me suggest you consider really reading/reviewing, and understanding, the following four resources: “Business Model Generation” (Osterwalder & Pigneur 2010); their follow up “Value Proposition Design” (2014); their recommendation of understanding Trends (Dave, who authors this blog , is my highly regarded source for an “annual deep dive” in to technology trends; and another recommendation in “Value Proposition Design” to understanding the “Five Forces” (Detailed in Porter’s “Competitive Advantage”); to the point of really understanding these books and presentations, you’ll have the granular level of understanding you need to most likely make a very good decision. Alternatively, Soham, find someone, or some group, who can take you through the right questions, within the above framework, to get a good answer. In any event, Soham, best of luck with your quest!

  • Hi David,

    Thanks for this; very useful. There is also another side to this question: When to scale?

    We have been fortunate enough to get off the ground without any outside investment. But this question is gnawing on me quite a bit: when is a good time to scale? How to anticipate demand? Especially in a market where there is no clear prior comparison? It’s obviously a chicken and egg problem. ie. I can reach a wider audience asking for “interest”, but who knows if the conversion is going to remain the same? And like you said, fixed costs is a step-function (not linear) even if you decide to go even a bit bigger.

    I’m a first-time founder, so it’s hard for me to make that call. Any advice?

    -Soham

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