Why Your Service Business is Hard to Scale
And how founders should think about the unit economics of growth
Reid Hoffman is a legend in the world of entrepreneurship and startups. He was one of the Paypal Mafia. CoFounder of Linkedin, successful VC and advisor to many high-growth startups. He is an icon in the world of Silicon Valley and business.
In his recent book, Blitzscaling, Hoffman provides us with his assertion on when and why companies should ‘grow at all cost’. He coined the term Blitzscaling, described as:
‘prioritizing speed over efficiency in the face of uncertainty.
In Blitzscaling, Hoffman presents his assertion on the core factors a business should consider when going for ‘’hyper-growth’’. He explores the tactics that such companies implemented in their quest for world domination. Examples like Facebook, AirBnB, Amazon, Tencent, Oracle, Apple / [insert Billion dollar unicorn company here].
Blitzscaling is a fantastic book. Hoffman does a great job at distilling his wisdom into a set of principles a startup needs to adopt the mentality of ‘Blitzscale’.
My only issue with it is that the advice is only relevant for a certain type of business. Statistically, a rare type of business. This model is a scalable tech company, which *probably only comprises of .00000001% businesses globally. Perhaps even less.
In other words, if your business isn’t a hyper-growth, wannabe unicorn, ‘grow-at-all-costs’ software business, stereotypically found in the world of Silicon Valley; then the principles Hoffman offers in Blitzscaling is not applicable to you.
What it does do well is to help founders contextualise ‘scale’. What it means and how it varies for different business models.
Scale is sexy
There are a lot of bubbly connotations with the term ‘Scale’. It’s a buzz-word thrown around a lot by founders. I am also guilty of it.
My problem is that leaders don’t often contextualise what scale actually means for their business.
In addition, there are many that are operating business models that, in my opinion, should not be scaled.
In this blog, I’m going to explain why your business is really hard to scale, written from an operational finance lens. We’ll be looking at the different types of growth as presented by Hoffman, and dive into the unit economics relevant to your business model.
Brace yourself for lots of pretty graphs.
Blitzscaling as a concept
Hoffman describes the four overarching categories of growth that every company has, in one form or another.
The four types of growth are:
- Classic Startup growth – a controlled growth phase when your early stage business is hustling, and ‘building the aeroplane that has been thrown off the cliff’. Most founders in this phase are grinding it out to find the elusive ‘product-market fit’.
- Classic Scale-up Growth – this is the phase when a company has a solid understanding of its product, distribution channels and takes a measured approach to efficiently growing the business. As an accountant, I’m favourably biased towards this form of growth because it considers efficient capital allocation – which means investing in projects where the ROI exceeds the cost of capital. In other words, If I put $X dollars into this growth campaign, I know with a degree of confidence that it will yield $Y dollars in return. It’s the most common form of growth when trying to maximise value in a proven, stable market.
- Fastscaling – means you’re willing to sacrifice efficiency for the sake of growth. I like to call this ‘vanity growth’ (haha). Fastcaling is applicable to companies who forgo the ‘ROI’ and focus on strategic objectives like taking market share or hitting revenue milestones to meet investor hurdles and founder egos. Ie. If I put $X dollars into this growth campaign, I don’t care about the yield, as long as it means more revenue.
- Blitzscaling – this is a special form of ‘all or nothing’ growth which underpins Hoffman’s entire thesis. You forget about efficiency, the knowns and be comfortable with gut-wrenching aggressive speed, uncertainty and quest for world domination. In other words, I don’t care how much dollars we burn because if we don’t burn the money, we will lose. All that matters is winning.
Blitzscaling is reserved for a certain type of business model which we’ll explore shortly.
The characteristics of a Blitzscaling business model
Hoffman explores the ‘4 Growth Factors’ critical for a business model that is right for Blitzscaling.
1) A large market size
This sounds obvious. To build a massive company you need a massive market.
As the saying goes – ‘’a good product with great distribution will almost always beat a great product with poor distribution’’
There are two general categories Blitzscaling companies can achieve distribution at this scale;
- Leveraging existing networks – tapping into existing networks to distribute their products. An examples Hoffman uses is how AirBnb in its early days leveraged online classified service Craiglist.
- Virality – Virality occurs when the users of a product bring more users, and those users bring more users. And so on.
3) High Gross Margins
Having high gross margins are powerful it allows for more profit to be reinvested back into growth and expansion. Most technology businesses have enviable, high-gross profit margins, upwards of 70% to 80%. What’s also important to note is that the cost of duplicating software is almost zero. I will come back to this point.
3) Network Effects
In layman’s terms, network effects are a phenomenon where a product or service increases in gains additional value as more people use it. The classic example is social networks. Facebook isn’t very fun if it’s just you on the platform. Network effects are powerful because the platform becomes more powerful and useful as more people use it.
The Two Growth Limiters
Hoffman continues to talk about the 2 characteristics that limit growth. They are:
- Lack of product/market fit – if you don’t have this you don’t have a business.
- Operational Scalability
Having a scalable business model is critical for blitzscaling. Having an ‘in-demand’ product is one thing. Getting the product to your end users, easily and with little to no friction is different altogether. Tesla Motors is a great example of a company that has seen its growth held back by infrastructure limitations. This is the second theme I want to come back to.
Bringing these characteristics altogether, I’ve categorised them two 2 overarching buckets. They are, outward facing (product, sales, marketing owned challenges), verses inwards facing (operational finance and product owned challenges):
In this blog I will drill down into the inward facing characteristics of growth, being:
- High Gross Margins
- Operational Scalability
The Gross Profit Economics of Growth
As outlined above, High gross profit margins are critical for scaling companies. If you don’t get this crucial ingredient right, you have a high chance of ‘growing broke’.
When I refer to growing broke, I mean that the costs of growth ‘break’ the viability of your business model.
Modelling the financial and operational scalability are key to avoid that from happening.
As a quick recap, gross profit is a guide of the profit you make at the level of individual products. That is, when you make a sale, what’s the profit after all the direct costs are deducted.
It’s important to measure gross profit because you want to understand what profit margin you’re making on your products and services. You want to ensure you have enough remaining profit to reinvest back in your business.
The formula is simply stated as:
GROSS PROFIT = SALES – DIRECT COSTS
Breaking Down Direct Costs
Direct Costs—also referred to as Cost of Goods Sold or Cost of Sales—are all the expenses that are attributed to the production of your product and service. This includes the costs of the materials, direct labor costs, software hosting, and shipping.
Direct costs can be further split into Variable and Fixed Costs. Variable costs are all the expenses that increase in direct relation to your sales volume. Examples include the costs of your product and all the associated shipping and logistics expenses (assuming you’re an inventory-based business).
Fixed costs, on the other hand, are all the expenses that will stay the same, irrespective of your volume. Fixed costs include the direct labor costs (in a service-based business), software hosting (for a software business), and most other expenses.
It’s important to get granular with the nature of your fixed and variable costs because it’s an important factor when scaling up your company.
Why software businesses scale so well
Software businesses have high gross profit margins, ranging around 70%-80%. They also scale well from a unit economics perspective because they have close to zero incremental costs.
This means that it costs almost nothing from a Direct Costs perspective to service more customers. Selling 1 software subscription versus selling 200 subscriptions has little impact on the hosting bill you pay to AWS each month.
The financial result is that as your revenue grows, your fixed direct costs (being hosting fees) don’t grow.
Because the direct costs of software businesses are fixed and have little incremental costs, Gross Profit actually improves with scale.
There’s a reason why they call it ‘hockey stick growth’.
Software businesses can scale beautifully from an operational perspective. This is because the product is a digital asset. You can design a businesses which are not entirely reliant on human capital, as your customers are dependent on the product itself.
The outcome is that many valuable software companies have low amounts of employees relative to revenue and gross profit.
In an extreme example, Whatsapp, up until it’s sale to Facebook, had grown to 500 million monthly active users, with staff of just 43 employees. Pretty crazy.
These operational finance characteristics make software companies perfect for scaling. It’s why they are attractive operating business models to investors.
They get operational and financial benefits from scale.
So, if you don’t own and operate a software business, what does that mean for you?
Scale for ‘Traditional’ Businesses
Within the context of scale, let’s compare the software business model to a couple of more ‘traditional’ business models.
The two most common models being;
- Inventory based businesses (Retail/E-commerce)
- Professional Services/Consulting
Inventory based businesses sell physical products, opposed to an intangible good or service. Think of your typical Ecommerce business, fashion retailer, health supplements etc.
Gross profit margins for these businesses typically range from 40% to as high as 60%. They fluctuate primarily due to production costs, fulfilment and warehousing costs.
Inventory based businesses have a high level of Variable fixed costs in comparison on fixed direct costs. This means direct costs will grow in relative proportion to revenue. With scale, it’s not uncommon for cost per units to reduce as the products become cheaper to produce with scale. In other words, they can benefit from economies of scale.
Inventory based businesses can scale also well as fulfilment can be outsourced to 3PL (Third Party Logistics) providers. It’s common for Ecommerce businesses to only employ product and sales and marketing specialists, with the remaining functions of the business outsourced.
The result is a low fixed overhead with scalable operations. In other words, high-leveraged teams.
The key difference between professional services business models, compared to software or product based businesses, is that their product is the people. The thing they are selling is reliant on human capital.
Gross profit margins of service based businesses range between 50% to 70%. The Direct Costs of this model comprise of the ‘technicians’ servicing your customers. Wages are fixed costs (because they don’t scale up and down with revenue), but act like variable costs because you need more staff if you have more revenue.
Accordingly, the incremental cost of growth is high. In other words, Gross Profit margins will always grow in the same proportion as revenue, irrespective of whether you’re a 10 person company, or 100.
Humans don’t scale like software does.
Furthermore, the firm’s ability to grow is constrained by the capacity (often measured in billable hours) of employees servicing customers.
It is limited to the ability to find, train and onboard technicians to continue to service customers as revenue grows.
It requires disciplined attention to capacity management – the art of perfectly matching human capital to workload.
Capacity Management and the impact on Gross Profit
Capacity management will make or break you service-based business – particularly if you’re trying to exponentially scale.
If you carry excess capacity, your gross profit margins are eroded because of higher direct costs relative to revenue – you have people sitting idle with no work to do. If you don’t have enough capacity, you risk churning revenue because your customers are not being serviced.
Overall, it’s a balancing act and requires strict attention to knowing your hiring economics (repeatable process to hire employees), as well as growth economics (repeatable process to generate sales).
Gross Profit impact:
Operational scalability is challenging for service based business. As they are dependent on human capital, they need to hire a relatively large number of people. As team sizes grow, layers of management are required, whom of which are often directly ’non-revenue generating’. Think of the infrastructure you need to manage a team of 7 people versus 30.
You need teams of middle management to manage capacity and workflow, HR personnel; all of which are employed to service the internal needs of the business so the revenue generating staff can do their job.
Revenue per employee, measured as total sales divided by headcount, can decline as you employ non-revenue generating staff for operational infrastructure, which directly correlates to less profit.
Furthermore, you are forever dealing with a high percentage of fixed direct costs. If revenue tapers off, you’re left with payroll that directly impacts your profit and cash. There’s a reason why it’s not uncommon for consulting firms to expand and contract abruptly in response to market conditions.
Overall, there are arguably little to no ‘economies of scale’ to be gained with operating a service-based business model.
A rational fonder would ask themselves why even bother to scale a traditional service business.
There’s not a lot to be gained with ‘scale’.
To add to this point, there are ‘sweet spots’ of team size that traditional service-based business models can work with to optimize their revenue generating team members, coupled with non-revenue generating operational infrastructure. I’ll explore this in a separate post.
The term ‘Scale’ is a term used by many founders and entrepreneurs. What I don’t often see is founders contextualising what ‘scale’ means for their business. Is it to the next Amazon? Or is it to be best at what you do in your geographical area?
Whatever your goal, it’s critical to understand the unit economics of your business model so you don’t risk ‘growing broke’.
At SBO, we’ve seen under the hood of over 500+ business from an operational finance lens. After reviewing hundreds of business models through an analytical lens, we are able to spot patterns. We’ve learned to see what characteristics divide the efficient, high profitable growing businesses to the mediocre ones that struggle each month just to break-even.
What I can say is that the greatest businesses all have one thing in common. They translate their growth strategy into numbers, helping them contextualise how the decision to ”scale” impacts the fundamentals of profitability and cash flow.
A product we offer is to helping founders contextualise growth in their business and translate that into a financial model. If you’re serious about growing your business and don’t have visibility of how your strategy translates to numbers, request a call to set up a free 1-hour consultation with one of our financial advisors.
Don’t leave things to chance. Build a business that lasts.