Qualities of a Scalable Business
- Every business owner would love to find a business that is able to replicate itself and hence, bring in large amounts of revenue
- Some businesses have models built around them to offer them this advantage while others do not
- How can we as investors find businesses that are easily duplicable
- There are four qualities to consider when identifying a company that is scalable
A start-up is a company designed to grow fast and scale quickly. Being newly founded does not in itself make a company a start-up. Nor is it necessary for a start-up to work on technology, raise funds from investors, or have an exit strategy planned out. What is essential, however, is the growth of the company.
In order for a business to grow rapidly, it requires that it has a large market to sell to. That is the key difference between family-owned restaurants as compared to a company like Facebook; family-owned restaurants are not easily scalable because of certain operational and financial constraints that arises from scaling a business.
While there are many different definitions of whether or not a company is scalable, here are four traits that can be observed in a business that has scale economies.
- Four Traits of a Scalable Business
1. A modest upfront and incremental (marginal) customer acquisition cost
Every business will need to get the word out that they have a product or service that is not only available but that it can add tremendous amounts of value to their customers. A positive word of mouth is important for a business because it enables it to lower its upfront customer acquisition cost. In other words, a scalable business generating organic growth does not require for it to throw money at advertise campaigns or burn through it cash hoard to market itself. After all, customers that are acquired organically are of higher quality than those that are acquire through marketing; they tend to be more satisfied, have a high retention rate and are more engaged in providing valuable insight for the business.
Consumers are willing to spend money on great products. If a business is able to keep its customer acquisition cost low, it can reinvest its resources into improving its existing products or develop a new line in order to better serve existing customers. Through this process, one can start to see that the business has the ability to scale over time.
- The average cost of creating products and services drops as volume of production increases (economies of scale)
This advantage is known as economies of scale and they exist when there are reductions in the average cost per unit associated with increasing the scale of production for a product or a service.
Some businesses that come to mind would be those that operate in the technology sector. For instance, businesses that provides Software as a Service (SaaS) subscription based model has this unique quality. If a company sells a machinery, it will not be able to sell it again because it does not have it. However, one can easily sign up for a movie streaming account without diminishing the quantity for the rest of the consumers. This non-rivalrous trait will enable a business to scale immensely because billions of people can possess the same software at close to zero additional cost. Combine this to the fact that the distribution cost of software is also close to zero. Microsoft is an example of a company that has this trait which allowed Bill Gates to be one of the world’s richest man today.
- The business does not require an increasing staff count as it gets larger
Think about a stock portfolio as compared to a real estate portfolio.
As a stock portfolio increases in value, its owner will continue to be able to manage it without getting much help. This is because the same amount of work is needed to buy a $1 million worth of shares and $1,000 worth of shares. The owner of the real estate portfolio will get busier managing his assets as the number of real estate in his portfolio increases. He will need to scout for tenants, scrutinise their background and credit reports, negotiate the deal and finalise the details of the agreement. The amount of work increased as the portfolio gets larger.
A classic example of a non-scalable business is a consulting company since in order for the business to grow it must hire more people the same skills and abilities. Bain & Co. is one of the greatest consulting firms and brands. However, it does not scale. The company is required to hire consultants, almost on a one-to-one basis, to grow its revenue. It is time consuming and expensive to create new consultants and they often leave to form their own consulting firms or join a company.
The nature of the business will be a key determinant in whether or not it requires more staff in order for it to expand.
- The business has a model that adds increasing value as the number of customers increase
Companies that have a network effect will be able to do this. I have written an article here on Value Investing Academy which addresses this particular trait and how it can be an economic moat for businesses as well.
The key takeaway is this: a business that has repeatability (provides a steady revenue) and cost-effectiveness (provides a steady profit due to high margins) is one that can scale. Investors should consider looking out for some of these traits in a potential investment before committing capital for the long haul.
Research Analyst, Mind Kinesis Value Investing Academy
Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.