Understanding the Scale Stage
by Cedric Chin
This is part of a series on business fundamentals for data professionals.
Last week, we took a look at the business metrics that are most important during the first phase of a business — the product stage.
This week, we’re going to take a look at the business metrics that matter the most during the next stage of a business’s growth: that is, the stage after you’ve found product-market fit. In How Metrics Change When Your Company Grows, we called this stage the ‘scale’ stage.
The goal of this piece is to give you a solid understanding of the business during this stage, since the concerns of the scale stage are materially different from the concerns of early business, and different also from the more efficiency-minded challenges that emerge later.
After ‘Product-Market Fit’
For the sake of simplicity, let’s define ‘product-market fit’ in the following manner:
- You have found a group of customers (a ‘market’) who would happily hand over money for your product or service.
- You know you have achieved this when they are willing to hand over money repeatedly.
Some people would quibble over this definition, but we shouldn’t get distracted by definitional debates: for the context of this piece, the concept is more important than the exact words we use to describe it. What we’re trying to get at is the idea that before product-market fit, you’re trying to build something that people are willing to pay you for. After product-market fit, you’re trying to get as many people as possible to try or buy the product. This also means that the companies in the former situation are in a completely different plane of existence when compared to the companies in the latter situation.
In fact, this observation alone explains the many differences between the product stage and the scale stage. Companies at the scale stage measure very different things because their primary challenge has changed: they’re no longer looking for a thing to sell; they’re looking for growth.
The Nature of a Business is to Grow
Writer William S. Burroughs is credited with the saying “when you stop growing, you start dying.” Burroughs wasn’t talking about business, but he might as well have, for it is in the nature of businesses to grow. And nowhere else does growth play as large a role as during the scale stage.
What does this growth look like? It looks a little like this:
- Whole departments break. First, sales can’t handle the onslaught of new leads, then customer success breaks down under the weight of all the complaints, then product development stalls because it turns out your product wasn’t built for scale, and then management fails to keep track of employee happiness, and then people leave the company, and on and on.
- Headcount grows rapidly in response to growth. This has implications for the bottom line. To quote Rob Walling (who says this ruefully), “Fast growing companies are never profitable. Every dollar you make goes back into the business, because you know if you take it out to pay yourself, you’re just sabotaging the prospects of your company vs the competition. Every time we had extra money, we hired a new developer or product person or customer success rep. There was no space to do anything else.”
- You feel like something, somewhere in the company, is always on fire, and you go to work with some trepidation about what’s about to break next.
So: growth is great. But it comes with its fair share of challenges. As a data person, you’ll be asked to keep track of specific numbers that your businesspeople (and your investors, if you have any!) will use to determine if the growth you’re experiencing is any good.
These numbers are things like:
- Customer acquisition costs — how much does it take to acquire a new customer? If you’re an ecommerce company, you may be paying for Facebook ads to get new users to your site. If you’re a B2B SaaS company, you may be paying sales reps to sign on large deals with enterprises.
- The retention rate of customers using your service. This is important in a SaaS context because it defines the ‘payback period’ — that is, how long before you recoup the customer acquisition cost. (To read more about this topic, check out our post on developing an intuitive understanding of the SaaS quick ratio.)
- The percentage of customers who make repeat purchases, and the size of each transaction. This is important in an ecommerce context because it determines the kinds of marketing spend you can sustainably do. If customers buy regularly, you can spend more to acquire them; similarly, if they spend large amounts per cart checkout, you can invest more heavily into marketing.
- The ongoing costs necessary to serve your customers, and — more importantly! — the gross margins that you make from each customer. These costs could include infrastructure and sales costs if you are an enterprise software company; it could be cost of goods sold if you are a manufacturer like Tesla, or it could be the inventory spend and the marketing costs if you are an ecommerce company.
The scale stage contains as many possible metrics as there are industry types. Instead of going through all of them (a hopeless task!), an easier approach would be to walk through the fundamental economics of this stage. Again, the goal is to understand how business works; if you understand the fundamental principles, you may then work out the specific metrics for your particular domain.
Growth Can Be Bad, Too
The key to understanding this stage is to understand that growth can be bad as well.
Here are a couple of stories to demonstrate this fact:
Story One — Growth On Borrowed Money
Some entrepreneurs taste success on a smaller scale and become obsessed with growth, losing sight of the moneymaking basics along the way. Let’s say that you run a vending machine business, and you deploy soda fountains and dispensers to restaurants and to convenience shops. You pay $3000 per installation, but then you collect $200 a month from each location for the ingredients and sodas you supply.
This sounds like a SaaS business, doesn’t it? In this scenario, your payback period is 15 months (since it takes 15 months at $200 a month to pay back the total cost of your installation). This means that if you can get a handful of installations past the 15 month mark, you’ll be milking pure profit from those machines. The catch? You borrow money to make the installations, and the margins on the ingredients are so slim that you soon do not cover the interest payments on those loans. But you are so obsessed with growth that you keep borrowing to keep installing machines … and eventually, the company goes bankrupt under the debt load.
Story Two — Growth in a Crowded Market
Here’s a second story: you are a division head of an industrial tools company, and you are promoted to take charge of the drills division. You decide that you can gain significant market share by cutting prices. Growth is good, right? So you do so, and for awhile, it works. Sales grows for the next quarter, and you blow past your sales targets.
But a mature market is a dynamic ecosystem. You gain market share at the expense of your competitors, and they learn very quickly that you are slashing prices. They become desperate to cover their fixed costs. One of them sends an emissary to you — in the form of a sternly worded email: “Are you crazy? Do you want to start a price war?” You ignore this. You think they’re just complaining because they can’t keep up.
A month later, your competitors begin slashing prices on their products. The resulting price war wipes out all profits from your market for the next two years. It takes that long to undo the damage; you are fired unceremoniously before your first year is up.
Now, this isn’t to say that taking on debt or starting a price war are inherently bad ideas. The lesson here is that they must be done with business fundamentals in mind.
John Malone successfully used the ‘debt for growth’ strategy at TCI; he borrowed money to acquire subscription-earning cable companies. But he was careful to never let his debt load outstrip his capacity to service that debt; he made sure he always had enough cash flow to pay off the interest payments, and occasionally paused growth to reduce the total debt size whenever he saw fit. As a result TCI became the largest cable company in America.
Price wars can also be strategically used against competitors, but only if you have a business model that supports the permanently reduced margins. Amazon’s Jeff Bezos is famous for saying “your margin is my opportunity” — he used the insight that the Internet had fundamentally different distribution characteristics (which allowed for lower prices), and went after the margins of his competitors in the early years of Amazon.com.
So, this begs the question: what is good growth?
The Signs of Good Growth
The businesspeople in your company (and to a similar degree, your investors) are likely to watch out for signs of bad growth during the scale stage. The metrics that you produce during this stage will be used to paint a picture of growth in their heads. More concretely, they are looking for signs that your growth is:
- Efficient — Good growth has to be profitable, but more importantly, it has to be efficient in order to create good return on invested capital. If you’re spending ridiculous amounts on Facebook ads to generate a small return, this is not likely to lead to good sustained growth. (And — remember! — ROIC is what good businesspeople have in mind when they evaluate your business).
- Organic — The best growth flows naturally out of what the company is already doing. It’s a bit of a stretch to jump from one business activity (say, shipping product) to another (say, launching a new product); this is especially risky during the scale stage, when you have product-market fit but not proper distribution yet.
- Defensible — Think of the second story above, where competitors responded with reduced prices. They wouldn’t have been able to do so if you had a defensible position in the market. Defensible here means that you have pricing power of some sort, and whole books have been written about the search for pricing power. If you’re interested in this topic, you may read 7 Powers by Hamilton Helmer, but as a data professional, it is not important to know this deeply, only that the concept exists. What is more important is to understand that businesspeople and investors alike will be looking for signs of pricing power — they will want to see some level of stickiness even if you were to change your company’s pricing strategy. They would also want to know if competitors are able to flood your market and drive returns down (think: Grubhub and the army of competitors it faces) — but this is more a qualitative judgment in the early years, not a quantitative one.
- Sustainable — Good growth is sustainable — you’re not looking for a temporary spike in revenues. The goal is to have your growth continue year over year.
When you’re in the scale stage, pretty much every metric that is asked of you will tie in as an indicator of these four categories. To circle back to some of the metrics we talked about earlier:
- Customer acquisition costs will give business people an idea of the efficiency of your growth — this is by definition a combination of % conversion in your activation funnel, coupled with how much it costs to get a customer to the top of your activation funnel in the first place,
- The retention rate will tell you if your growth is sustainable, or if you’re merely chewing through a market with a subpar product (ironically, if you are at the scale stage, you should arguably already have product-market fit, which means high retention — but in fast-changing markets, product-market fit may be illusory and only last for a few years; dropping retention rates is how you tell).
- The costs and the gross margins will tell businesspeople how much pricing power you have — and therefore how defensible your market position really is.
This is part of a series of posts that explain business fundamentals to the data professional. For more updates, subscribe to our newsletter below:
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