These models have always been around, but the challenge for entrepreneurs is to find new ways to achieve scalability. DORON BEN-MEIR
By Doron Ben-Meir
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If you’ve ever pitched a business to a venture capitalist, you will know that a typical requirement is that your business model is scalable.
In simple terms, this means that the business has the potential to grow its revenue base significantly faster than its cost base.
Businesses that are not generally scalable are in the services sector. A good example is a simple charge out rate business model – for example, in the professional services sector. While these are often very good businesses, they inherently rely on the personal output of staff to increase revenues, which means that there is a linear relationship between revenue and cost base.
By contrast, a successful product business can outsource its manufacturing and supply thousands of units with the same personnel overheads as it might supply hundreds of units. Of course the variable costs of manufacture and supply will scale linearly, but the contribution margin has the potential to increase exponentially relative to the fixed cost base and so deliver a more profitable business.
But what’s wrong with a successful legal practice, accounting firm etc?
Nothing… unless you are investing millions and want to see several multiples of your investment returned in a three to six year period.
Successful professional firms are totally reliant on the acquisition and retention of talented people who can deliver the service. This takes time. It takes even more time for a brand to form which transcends the individual founders – Ernst & Young, KPMG etc. High enterprise value is therefore difficult to crystallise as there is a fundamental reliance on key people.
Venture Capital firms don’t have the luxury of decades to build brands. They need businesses that can achieve a multiplication of enterprise value in a relatively short time frame.
Since the most difficult commodity to control in business is “people”, a scalable business model mitigates this risk by offering the potential to grow revenues without having to find large numbers of highly qualified staff.
Provided the core personnel have the capacity to execute the business plan by bringing together a productive ecosystem (product development, manufacture, supply chain, sales channels etc), then VCs can see the potential for sufficient success in a timeframe suitable for their investors.
A number of clever entrepreneurs have transitioned “old world” services into “new world” products through the utilisation of the internet – auctions, retail, stock broking, banking, publishing, recruitment etc. Franchising can also successfully scale a services business model – McDonald’s, Starbucks, Jim’s Mowing etc.
The principle of the scalable business will always be central to venture capital considerations – the challenge for entrepreneurs is to find new and exciting ways of achieving scalability.
Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology based businesses.