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June 18, 2005

What is a "Scalable" Business?

For Venture Investors:  Scalability is King

While both scalable and non-scalable businesses can be “successful” and grow — only scalable businesses can achieve the high-growth characteristics required to command market multiples attractive to venture investors.

So what is a “scalable” business? 

In my mind, to be truly scalable, a business must satisfy two criteria  —

Scalability Criteria #1:

This is essentially a financial criteria and is what people usually mean by scalable — but in my mind this is a necessary, but insufficient, criteria to be a truly scalable business. 

Scalablecosts1

For a business to be scalable, incremental costs must be decreasing — ideally approaching zero.

This means that the cost of each incremental dollar in revenue must be going down

Nothing is infinitely scalable. So scalability must be defined relative to market size and marketshare projections.  A company only needs to be scalable for anticipated revenue.  But any enterprise can grow to a point where it becomes non-scalable.  At any point in time, a company is only scalable to a certain revenue volume, beyond which each incremental revenue dollar begins to cost more.  Once a company reaches that point, the scalability of the enterprise must be addressed directly — through investment in operations, new technologies, new distribution, etc.

Relativescalability

Also, relative scalability is also a source of tremendous structural competitive market advantage.  A company which is more scalable relative to it’s competitors will continue to outperform it’s competitors until something alters their relative scalability.

Scalability Criteria #2:

To me, criteria #2 is the real key to understanding “scalability” — but, as with criteria #1, it is also a necessary, but insufficient, criteria. 

For a business to be scalable —

 the business must be able to grow — even if you throw mediocre resources at it

(both in terms of people and money — i.e.,  it must be able to flourish with dumb people and dumb money)

The importance to entrepreneurs is this corollary:

If your business requires smart talented hard-driving management or sophisticated investors or customers to grow, it is, by definition, NOT SCALABLE!!!

This is partially related to the Great Management Myth and the “1 x 10 >> 10 x 1” Rule.  While VCs always prefer a good management team, it is really a bonus.  

If a company’s long-term requirements includes any “super-humans” or “super-heroes” (management, customers, employees, investors, whatever) —– IT IS NOT SCALABLE!

If mere mortals can’t run it — IT DOES NOT SCALE!

So when you are on your road-show touting how great your management team is, remember — don’t over play your hand — you don’t want to create the impression that your business will go to “hell in a hand-basket” if anyone on the senior management team gets killed in a freak traffic accident.

My Personal Rule is “The bigger the key man insurance policy, the less scalable the business.”   In fact, I believe the mere existence of key-man insurance is a red flag that the business isn’t scalable.

All of this is ultimately related to the KISS principle (“Keep It Simple Stupid”) — or, as I like to say: “Complex businesses MUST become simple before they can scale.” 

If anyone in the chain of suppliers, employees, management, sales force, customers, and investors can’t explain simply what the company does for a living — IT DOES NOT SCALE!!!

The General von Moltke Management Value Matrix

Legend has it that Prussian General von Moltke had a very simple, but elegant, conceptual framework which underlied his approach to leadership and management.  He classified all individuals on only two dimensions — intelligence and drive — which he considered key independent variables.  According to General von Moltke, people are either smart or stupid and they are either active or lazy.

VonMoltkeMgtMatrix

What often surprises observers is the relative value General von Moltke assigned to these four categories of people. Although most people would reflexively assume that the “Smart Actives” would be the most prized — it was actually the “Smart Lazies” that are the most valuable. 

The von Moltke logic is as follows — 

“Smart Lazies” are your command center generals.  They are the most valuable because they are the most strategic minded — they figure out the easiest way to accomplish any objective.

“Smart Actives” are your battlefield generals.  They can think quick on their feet and recognise and exploit opportunities as they arise on the fields of battle.

“Stupid Lazies” are your rank and file troops.  They don’t second guess their commanders and just follow orders to the letter.

“Actively Stupid” are the most dangerous.  They must been kept out of all operations at all costs — their presence constantly undermines the mission.  They don’t follow orders to the letter and make many mistakes as they actively pursue their own agendas — which may be at cross-purposes to the mission.

If we adapt the General von Moltke Matrix to the life-cycle of companies, this means —

The “Smart Lazies” Discover Value — These are typically the founders of a company.

The “Smart Actives” Capture Value — These are typically the professional managers of the company during it’s growth phase.

The “Stupid Lazies” Maintain Value — These are the staff and administration which handle the day-to-day management chores of an operating entity.  Basically, the “Stupid Lazies” inherit the value created by the labors of the “Smart Actives”

The “Actively Stupid” Destroy Value — These are the elements that can spring up like cancer within an organisation and create a drag on company performance that can only be cured through radical excision from the organisation. 

Long-term sustainability is part of scalability: While Heroic Efforts are Heroic — if Heroic Efforts are Required, then the business is Not Sustainable and therefore Not Scalable.

This follows from our von Moltke Analysis —

The “Smart Actives” —

1) are brought in to “heroically” capture market share,

2) eventually get bored when the war is won and routine of governance sets in,

3) move on to lead new battles at other companies,

4) leave the “Stupid Lazies” behind to govern.

So, if the “Stupid Lazy” leave-behind management can’t govern what has been captured by the “Smart Actives” — then the business isn’t sustainable or scalable — and the market wasn’t worth capturing in the first place.

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Posted by cmayaud at 07:03 PM | Permalink| Comments (2)
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Comments

Great post... you could have broken it up into two it was that good. Good refresher and great info.

Posted by: John Furier at June 20, 2005 12:21 AM

Christian,

Excellent review of scalability factors and von Moltke's premises.

I generally agree with both areas of your comments. But, I also want to note that while not wanting to be dependent on execeptional leaders as part of an acquisition, there is an optimum case for 'scalable' businesses wtih top leadership. They are harder to find but of much greater potential value due to the inherent higher growth potential.

There are too many cases of average management ruining a perfectly scalable business!

Best Regards

Posted by: Stephen A. Burgess at June 22, 2005 06:31 PM

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