Do you know how to determine if your business has exponential economic potential even if you are currently unprofitable or still growing? Here's how.
We met with an entrepreneur this week who is hoping to build what many young entrepreneurs hope to build--a highly scalable business. In this case the business connects restaurants to diners and is paid a commission for doing so. As we spoke about growing the business, we discussed the tradeoff of marketing spend aimed at growing the sales volume in a single city, versus investment in expansion to new cities. It became clear that although costs were fixed, the business required a large amount of sales in each city before it could become a "sizable" business, or one that could generate cash far in excess of the modest salaries for its owners. Every time the business expanded to a new city, it faced additional start-up costs, even though it was fairly scalable in the long-run.
This entrepreneur eventually ran into an issue--even after four or five new cities, it was profitable but not yet "sizable." In order to cover his fixed costs, the entrepreneur had to take the business nationwide, which would take lots of time and money. Even at its peak, the business was not projected to generate lots of cash, at least not enough to attract major venture capital investors.
The idea of scaling a business is simple--whether your fixed costs are high or low, if you can add significantly more customers without increasing your costs proportionally, the business is "scalable" and becomes more and more profitable as it grows. Web-based businesses like Facebook and Google's ad business are extremely scalable because the costs to operate the business are relatively fixed and more users do not significantly increase the costs.
It's important to understand your businesses scalability from the outset. Here are four steps to determine if the business is largely scalable:
1. Understand Your "Fixed Cost to Build"
What does it take to start-up the business, or until it begins to generate revenues that cover the operating cost?
2. Determine Your Ongoing Operating Costs
What will be the ongoing monthly or yearly operating costs to operate the business? How will they increase as your revenues and customer base expands?
3. Determine Your End State Economics
What will the economics look like once you reach your goal?
4. Determine What It Will Take to Get There
How many customers or how much revenue will it take to breakeven? How long will it take to generate significant cash flow? How will it change if you grow faster or slower? What level of investment will it take to sustain the business until it becomes profitable on its own?
This concept applies to businesses built by entrepreneurs as well as large, established companies. It is necessary to do the math up front to understand what it takes to make it to the promise land of scalability. Will you have the wherewithal to get there? Make sure you and your investors are willing to make the climb before you hit the trail.
KARL STARK AND BILL STEWART are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark