Addressing the VC Fondness for Scalability

As a high-potential startup talking to numerous investors across the board, how many times have you heard the following statements – how will you scale the business? We see scalability challenges in the business model. It’s good that you have established a strong presence in NCR; but, how will you scale up across other major metros? I agree that the auto sector has a real need for this software; but, can you scale this to other sectors?What is this fascination with “scalability” in the investor community? There are several startups out there that are innovative, disruptive, and have strong teams on board. Why then, do investors still consider many of them inherently “un-fundable”?

Let’s open up this black box a little. Venture Capital funds are institutional investors that manage some-one else’s (read: Limited Partners or LPs) money, with the objective of generating high returns within a LIMITED time period. Do note the stress on ‘limited’ – unlike individual retail investors in equity markets, VCs don’t have the luxury of a perpetual holding period for investments. Depending on the overall fund life and current vintage, their hold period could range from as low as 4-5 years, to up to 10 years. They need to GENERATE returns for their LPs within this time frame. Again, do note the stress on “generate” – this is not about notional or on-paper returns. For every $100 they raise, VCs need to give back 5 times, 10 times or in case of rock-star companies, even 50 times the money they raise, back to LPs. What this entails is building a large-enough business that is unique, has market leadership and which can then generate an exit for investors either by going IPO or getting acquired. This makes high scalability potential of startups a pre-requisite for investors.

It’s apparent that offering a unique, un-replicable and defendable value proposition that caters to a large and growing market is crucial for building large businesses. And most entrepreneurs appreciate this – as VCs, we see these points getting reflected in most business plan presentations. However, I would like to go one level deeper and explore ways in which entrepreneurs can significantly improve scalability of their businesses by tweaking their offerings, business model and go-to-market strategy.

Reduce customization and increase productization or templatization – Customization is one of the biggest banes of scalability. Especially in case of young companies, the cost of customization is rarely compensated for adequately by clients. This not only adversely impacts customer level economics for the company, but due to limited resources at the startup’s disposal, constrains overall growth of the company. As far as possible, ‘productize’ your offerings in a way that promotes adoption across customer sizes, across sectors, and preferably, across geographies, with minimal customization. Products are also easier to brand and sell. VCs love off-the-shelf offerings as what only needs to be done then to sell more, is to place them on as many shelves as possible.

Explore the potential of Channel Partners and other innovative means of collaboration – in general, direct enterprise selling is a time-consuming and pain-staking process. The sales cycles can range anywhere from a few weeks to 6 months. It also requires hiring a sales person who keeps knocking on doors of potential enterprise clients, and keeps setting up meetings in the hope of converting the lead. In case of complex offerings, this sales person also turns out to be an expensive proposition. Worse, as a young company trying to sell a relatively untested offering, the pricing power still lies in the hands of the customer.

An effective way of tackling this problem is the use of channel partners that are already entrenched in the target customer segments. For software companies, these could be the likes of Oracle and SAP; for medical device companies, it could be large national distributors of GE and Carl Zeiss equipment. By cracking one channel partner, a young company can potentially open access to multiple large clients in one go. Even if this means sharing a piece of the pie with the partner, the overall economics works out much better in most cases.

Minimize human touch points – human beings are expensive resources. The more times you need a human touch point in your business, the more expensive it becomes to sell. Try and explore ways of minimizing these touch points. Is there a way to give demos to clients on the web? Can customer complaints be resolved through webinars, online troubleshooting guides, and online chats or at worse, a call center? Is it possible to take your offering “on the cloud”, so that clients can use it through the web? Innovative ways of incorporating technology into the business model goes a long way in improving scalability.

Optimize pricing by tying it to value delivered – more often than not, young companies feel burdened by the weight of being a new entrant and therefore, end up using the wrong benchmarks to price their offerings. Irrespective of the size and experience of your company, majority of clients will be willing to pay in accordance with the value you are delivering to them. Several studies and surveys have repeatedly found that pricing inertia is more on the part of entrepreneurs, rather than customers. We have repeatedly seen this in portfolio companies, wherein investors have raised pricing by up to 3 times without even a slight impact on customer attrition.

Therefore, as far as possible, go for value pricing, rather than cost-plus or competitive. Talk to customers and understand the value and benefits that your offering is providing them. Try and then quantify this value to as much extent as possible, and triangulate on pricing based on this benefit.

As your clients scale, scale yourself too – Think about it – if your client is growing 100% y-o-y and has become a $100mn company, should it still be paying the same as what it was paying at $20mn topline? Explore ways of linking your pricing model and deployments with the client’s growth. Can your pricing be changed from annual license to license per user? Can the offering be transferred from a SBU level to a regional level? Should the pricing be changed from a flat pricing model to a slab-based model, with slabs varying according to metrics such as number of transactions on website? These models often lead to a better aligned risk-reward sharing between customers and vendors, and create more optimal outcomes for both sides.

In the end, it all boils down to the fundamental rule of classical economics – resources are finite and therefore, need to be allocated efficiently. VCs will invest in businesses that can become the largest while guzzling the minimum amount of resources. Entrepreneurs follow their passions, which might, or might not result in hugely scalable business models. However, by appreciating the importance of scalability and taking concerted steps to address it, young companies can create investable value propositions that will create tangible value and wealth for all stakeholders in the eco-system.

Disclaimer

The views and opinions expressed in this column are strictly personal, and not those of any organization/institution the author is or has been a part of, nor is made in any official capacity of such organization/institution, unless explicitly stated otherwise. None of the information, views and opinions in the column should be construed as business or legal advice. 

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We recommend you to read Soumitra's previous articles on YourStory.in