Understand the Scale vs. Profitability Trade-Off

Written by Bernard Lunn / June 23, 2009 12:37 PM / 4 Comments

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This is possibly the most important strategic decision one can make for a Web tech venture. It is almost always a trade-off. There are those few magic ventures whose revenue scales from day one, without the need for external capital. We all want those, but they are almost as rare as hen's teeth. In most cases, you face a choice between scale and early profitability. You need total clarity on this decision, because it will determine your capital-raising strategy and all of your execution plans.

The Old Mantra: Get to Positive Cash Flow, Fast

Most traditional business people, when looking at a business plan, will ask, "How soon can the venture get to positive cash flow?" It is the critical business issue. It determines how much capital you will need and the overall risk of the business. You answer the question by looking at three factors very carefully:

How fast will revenue grow?
What are the gross margins?
How much operational overhead do you need to grow revenue at that level?

Any business can be reduced to these three fundamental factors.

Service-based businesses can get to positive cash flow very quickly, which is why they can be bootstrapped. Service-based businesses are also tough to scale because growth depends on people, and gross margins are usually not that good. So, the reason they usually have to be bootstrapped is that most venture investors won't touch them.

The VC Mantra: Scale First

At the other end of the extreme is a business like Facebook, which, at the time of this writing, has 300 million users but is still losing money. Twitter is another, with phenomenal growth and mind share but not a dime of revenue.

To a traditional business person, that sounds crazy. But when scale is your primary competitive advantage, it makes perfect sense. Think of Skype. You can replicate the technology relatively easily, but getting millions of Skype users to switch is hard. This is even truer for Twitter and Facebook, whose technology is very simple to replicate.

Scale Without a Revenue Model?

Scale first, monetize later is a reasonable strategy for certain types of Web ventures and for entrepreneurs who are well connected to sources of capital.

But to scale without even knowing what your revenue model will be? That is riskier. It might make sense in some cases. We will know that about Twitter once it finally reveals its revenue model.

For the vast majority of entrepreneurs and investors, though, scaling without a revenue model is too risky. It depends on being able to sell to an acquirer who will figure out a revenue model.

The Option That Gets You Financed

Practically speaking, most first-time entrepreneurs have little reason to conceive a venture that requires a lot of capital or a long ramp-up time to revenue and positive cash flow. There are exceptions to this rule, of course. But the normal route is for entrepreneurs to "earn their stripes" with a capital-efficient, low-risk venture that gets to positive cash flow quickly. If it works out well and they want to start another venture, they can shoot for something more ambitious then.

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Comments

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I think that it could not be a trade-off if you think in terms of sustainable growth. You may use differents revenue models like: ads, subscriptions for a services, affiliate programs to finance your growth. The important think to keep in mind is to mantain the quality, consistency, relevance and usability of your project.

The facebook business model is, with no doubt, to build a massive clients plataform and wait for a big acquirer, like youtube did. It´s for sure very risk.

Posted by: Pedro Souki | June 23, 2009 3:45 PM

A small (relatively) service that works on subscription could be profitable while its much more difficult for a large service that is based on ad revenue. But the scope for the small service is limited unless there is a path to scale. I am sure a theoretical path to scale would not make a VC fund you. Maybe there is a sweet spot in between where you can profitably grow with a subscription model and then have a free version that is ad powered.

Posted by: Ravikant | June 23, 2009 4:21 PM

There is a big difference between consumer business and B2B.
In consumer business or even social media large amounts need to be spend to gain traction or you need to get hyped like Twitter.

In B2B the marketing efforts are less: especially if you focus on a niche market.
In order to get a positive cash flow fast B2B is the way to go.
The challenges and rewards can be greater in B2C, but also the chance of total failure.

Posted by: Engago team | June 24, 2009 1:30 AM

I agree with Ravikant when he says "scope for the small service is limited unless there is a path to scale."

The scale is the objetive for the internet business, but you can do it in a sustainable manner. First you launch a free service based on ads, then you launch a recommend product sections and register yourself in affiliate programs for sales commission, the you launch a subscription paid version of you service.

In this brief plan you have already three sources of income. You can not depend in just one type of income, unless you have your back covered with CV money.

Posted by: Pedro Souki | June 24, 2009 7:39 AM