Past Midway Ramblings on Business & Life

Scalable Businesses

Some businesses are easily scalable. Others are not. Any business that requires a linear (or near-linear) relationship between revenue-and-effort or revenue-and-capital expenditure (equipment) is not easily scalable.

Low-Scalable Businesses

With low-scalable businesses, you are effectively trading time for money. A sole proprietor consulting on an hourly basis can only scale by:

  • Adding more billable hours – but this has an obvious ceiling. Namely, 168 hours per week, assuming one does not sleep at all.
  • Increasing the hourly rate – charging a higher rate is fine, but at some point, capitalism imposes an upper limit where the market simply won’t bear the price for the work performed because others may do it more cost effectively. At the upper end of pricing, consultants are forced to compete on speed and quality. In other words, they must sell to the client that they are a complete rock star compared to the competition. There is certainly a limit to rock-star-ness.
  • Hiring additional employees – Hiring is ultimately still trading time for money, with the benefit that it is other people’s time. But you are still paying employees a wholesale wage and charging customers a retail price for the employees’ time, thereby making a profit on the difference. This is only somewhat scalable. It scales, but not quickly… primarily because hiring consumes financial resources in advance of revenue generation from that employee.

Linear-Scaling Businesses

With linear-scaling businesses, growth is achievable, but slower.

In slow scaling businesses, revenue is subject to a certain gravitation force with a very high escape velocity. The only method to accelerate the growth of a linear-scaling business is with financial leverage (either debt or external funding). But in doing so, you introduce a non-zero risk that the company does not survive long-term (defaults on debt).

Geometrically Scalable Businesses

Internet businesses, software companies, intellectual property and information service companies currently provide the best examples of scalable businesses. They scale precisely because the increment cost to add an additional customer (and thus revenue) is nearly negligible. Therefore, growth does not consume as much cash nor time as a linear-scalable business. Once an information services company has sufficient sales to cover its base cost, all incremental sales above that fall almost entirely to profit. The challenge then becomes, “How quickly can we generate revenue in excess of the base cost?”.

All things being equal, you have a much better chance of a successful outcome with a business that scales geometrically than one that only scales linearly.1 Perhaps counter-intuitively, you also have a much greater chance at complete failure with a scalable business. Why? Because scalable businesses are so enticing, they become highly competitive very quickly, often maturing into winner-takes-all markets in short order, especially in the technology/internet space.

Highly scalable businesses are like using dynamite to dig a hole. It can be super-fast, but you can also blow yourself up or find yourself standing too close to the competitor’s dynamite.

In highly scalable businesses, the market will often bifurcate into two, perhaps three top players. Everyone else is an “also ran”. If you are not #1, #2 or maybe #3, you are likely pushed out of scalable market opportunities. It does not necessarily matter that you were first. If competitors come along behind you, copy you (at least in part) and are well-funded (potentially to the point that they are not as concerned about turning a profit and generating sustainable free cash flow), then they will, most definitely eat your lunch.

  1. Incidentally, while some people talk about “exponential growth”, very few businesses scale exponentially. This is just a word thrown around by people who do not fully appreciate the exactness of mathematical definitions. Stick to “geometric growth” and you’ll likely be more precise.

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By Andy Jones
Past Midway Ramblings on Business & Life

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