Venture capital funded companies are far more present in the media than organically grown companies. This makes us erroneously assume that there is only one way to building a successful company: by raising VC. However, this is a typical availability bias. The truth is that only a tiny fraction of all small businesses obtains VC in the course of their life span. In fact, from all the companies aspiring to receive funding through VC, 99% will never achieve this objective.
According to Verne Harnish, a scaling expert, the engines of the economy are neither very small businesses, nor big corporations. The real growth, both in job opportunities and in innovation, mostly comes from the companies in between. For this reason, it is relevant that these companies — Harnish calls them “gazelles” — do not run out of cash, but successfully manage to keep growing.
However, a typical problem of VC funding is that amounts are too high and make companies lose their focus. Harnish even says that companies are more likely to die from indigestion than from starvation, in the same way as pouring too much water on a freshly planted seed will kill the plant rather than grow it. A recent example that large investments can destroy a growing company, is the nine-year-old coworking start-up WeWork. The venture had received in total $18.5 billion from its investor Softbank. In August 2019 WeWork planned their IPO and was the United States’ most valuable start-up with a private valuation of $47 billion. They filed their registration for an IPO, however, while doing so, they disclosed several conflicts of interest and mismanagement by the co-founder Adam Neumann. Investors, reporters and analysts lost their trust in the company and its valuation decreased immensely, leading nearly to the company’s bankruptcy. Analysts say that the biggest problem of WeWork was that it had too much money. It used its high funding to strengthen its commitment in unproven and money-losing business models. The venture capitalist Roger McNamee says that WeWork, but also Uber, who experienced a similar drop of valuation, have been run with the following conviction:
“The explicit assumption is if you get enough growth, it doesn’t matter how much you lose”.
Growth companies need cash in order to scale but raising and even receiving it can distract the company. Therefore, growth-oriented founders of software companies wonder whether it is possible for them to scale without investors and how they can approach to do so.
Scaling versus Growing
One of the most common misbeliefs around the term “scaling”, in the economical meaning, is that it is synonym to growing. However, there’s a differentiating factor to be aware of:
“Growth means adding revenue at the same pace you are adding resources; scaling means adding revenue at a much greater rate than cost.”
The consultant Jon Kandiah, who helped transform large-scale businesses such as EE, T-Mobile, Orange or Virgin Mobile adds in his definitions the lever that can make the difference between growing and scaling. He says that “Growth focuses on increasing revenue with the current business model” while “Scaling focuses on increasing revenue while adapting the business model to maximise profit”.
This concept of investing one unit of resources in the business but gaining more than one unit back, for instance augmenting production by 80% but increasing total costs only by 60%, is also known as “Economies of Scale”: the average production costs decrease or remain while the number of units produced increases.
Thanks to economies of scale, companies can recover fixed costs. But growing also brings a set of further benefits: bigger companies are taken more seriously from suppliers, channel partners and customers which helps them to negotiate better, for instance, volume discounts with suppliers.
In a McKinsey research, the life cycles of 3.000 software and online services companies had been analysed between 1980 and 2012. Their findings were that growth is indeed relevant because fast growing companies have higher returns and growth predicts long-term success. The right growth rate, however, also depends on the sector. While the investors and managers of a healthcare company would be happy about a yearly growth rate of 20%, software companies that are growing at that rate, have a 92% chance of going out of business within the next years, according to McKinsey’s research.
Challenges when scaling
The principal challenge that impedes companies to scale successfully is the increasing complexity. In fact, complexity increases exponentially with every new employee, not linearly. According to Harnish, this additional complexity cannot be managed if the following elements are missing:
- Leadership: There must be leaders who should always be a little bit ahead of the market, by predicting the competition and their employees, and with the ability to delegate effectively.
- Scalable infrastructure: A 10-employee team needs better phone systems and more structured space as smaller teams. Likewise, a 50-employee business needs more advanced accounting systems than smaller companies. Large companies need to have their information technology systems upgraded and integrated.
- Market dynamics: When scaling from $1 million to $10 million of revenue, the focus should be set internally to establish healthy organizational habits and a scalable infrastructure. After scaling to $10 million, however, the focus should be on the marketplace, talking to customers, because competitive pressure increases with that size. Customers might begin to demand lower prices, competitors might feel more threatened and internal complexities increase.
An equally challenging task for young companies is not to run out of cash, especially if they are scaling without investors.
Bootstrapping gives the founders the security that they will not one day be ousted from what used to be their company. Maintaining the autonomy to decide how fast to grow can also prevent the company from building a bigger team than the customer base requires.
The Swedish researchers Winborg and Landström identified six methods how small companies can use financial bootstrapping:
- Using personal savings and resources from friends and family
- Minimizing accounts receivables by speeding up invoicing or using interest on overdue payment
- Sharing and borrowing resources with other ventures, for instance office space and equipment, or even employees
- Negotiating with suppliers for later payments or using leased items rather than purchasing
- Negotiating with suppliers to minimize inventory
- Securing subsidies from government or research-granting programs
Most of these ideas are especially helpful at the very beginning of a new venture. But what methods can be used over the long term to permit a successful scaling with own resources?
Cash Flow: Keeping growth affordable
Verne Harnish gives an impressive example of the impact that a very simple initiative can have on cash flow: The IT consulting company Catapult Systems used to bill their clients every 30 days. Their employees, however, were paid twice a month. The cash-flow improving initiative that the company implemented, consisted of starting to bill customers twice per month instead of once, which more than 90% of customers were fine with. Cash flow was nearly doubled immediately.
According to the researchers Neil Churchill and John Mullins, there is an easy way to calculate the exact rate at which a company can afford to grow. This rate is directly interrelated with the cash-flow cycles. It is called the self-financeable growth (SFG) rate and can be calculated using the following three pillars, as figure 6 shows:
- The company’s operating cash cycle (OCC): How long is the company’s money tied up in inventory and current assets before it gets paid for its services and products?
- How much cash is needed to finance one euro of sales?
- How much cash is generated by each euro of sales?
Operating Cash Cycle (OCC): There are two key questions that help to determine the OCC:
- How many days after receiving the invoice do customers pay?
- How many days is inventory held before it is sold?
The sum of both these periods will determine for how many days the cash is tied up in working capital. For example, let’s have a look at the real numbers from a bootstrapped company. The customers of this Company X took in average 114 days to pay their invoices. Luckily, there is no inventory because products are resold directly without additional days of storage. This means that the operating cash cycle is 114 days long. However, Company X’ cash is not tied up for the entire OCC. There is a delay because suppliers are usually paid only after 67 days, so the cash is tied up only for 47 days, or 41% of the OCC.
Cash needed to finance each euro of sales: In our example, Company X has a yearly cost of sales (“the direct costs of producing the goods sold by a company” ) of 590K € which is generating 2.730K € of yearly revenue. This means that 1 € of sales has direct costs of 0,22 €. This money will be invested in working capital, and it will be tied up, as already determined, for 41% of the 114-day cycle. The average amount of cash needed for cost of sales over the entire cycle is thus 41% of 0,22 €, or 0,09 € per euro of sales.
Additional to the cost of sales, let’s assume there are operating expenses of 1.860K € that must be paid throughout the cycle; payroll, utilities, amortizations, financial costs and taxes. This cost is 0,68 € per euro of sales. Since the operating expenses are tied up for half of the OCC, on average, or 57 days, the amount of cash needed on average during the entire cycle is 0,34 € per euro of sales. In total, Company X must invest 0,34 € + 0,09 € = 0,43 € per euro of sales in each operating cash cycle.
Cash generated by each euro of sales: Fortunately, Company X is a profitable business: After investing 0,22 € of each sales euro back in the company to finance the cost of sales, and 0,68 € for operating expenses, the company gets one full euro back at the end of the cycle. In order to finance the next cycle with the same amount of sales, 0,90 € must be reinvested, 0,22 € for cost of sales and 0,68 € for operating costs. The remaining 0,10 €, which are produced by each euro of sales, can be used now to generate additional revenue in the next cycle by investing in additional working capital and operating expenses. The key question is: How much growth can be afforded exactly this way?
Maximum Self-Financeable Growth (SFG) rate: If this company would decide to use the whole 0,10 € to finance additional sales volume and provided that the necessary productive capacity and marketing capability is given, then adding the additional 0,10 € to the 0,43 € already invested each cycle would increase its investment by 23,26% each cycle and therefore lead directly to an increase of 23,26% in sales volume. If Company X can grow 23,26% each cycle, then: how fast could it grow every year? One year has 3,2 cycles of 114 days, so the maximum yearly growth rate that could be achieved from sales without running out of cash is 23,26% * 3,2 = 74%.
Revenue-Based Financing (RBF)
If a company plans to grow faster than what its self-financeable growth rate permits, and it cannot or does not want to consider VC funding, there is a relatively new alternative that is cheaper than bank loans and does not require to give away parts of the company: Revenue-based financing.
These loans are based on receiving a share of monthly recurring revenue until a certain limit, rather than receiving equity. RBF is an entrepreneur-friendly alternative to both, VC and to bank loans, with the following main advantages:
- RBF is less expensive than VC.
- Founders retain their ownership and control.
- Investors are interested in the company’s success. The higher the revenues, the faster they will get back their investment.
- Contrary to many bank loans, no personal guarantees from founders are required.
- Access to capital is easier compared to VC. Funding can be provided within weeks and the requirements are easy to meet, for example the company does not need to be highly disruptive, as it is often the case for VC.
- Founders maintain the optionality to do what they want after receiving funding: raising VC later, selling the company, or just keep it running long term without anyone pushing for an exit.
Nonetheless, there are also downsides of RFB which make it unattractive to certain types of businesses:
- Companies must have a monthly revenue.
- RBF lenders do not provide huge amounts of money. Usually they will not provide more than three to four times the monthly recurring revenue.
- In opposition to equity financing, monthly payments are required.
Sales Learning Curve
In contrast, if a company cannot grow as quickly as its self-financeable growth rate permits, it should firstly work on its traction in the market. After launching a new product into a new market, one of the most immediate temptations is to hire a full sales force in order to quickly acquire customers. However, it is dangerous to ramp up sales force capacity too fast, because doing so, before establishing an efficient sales process, will burn cash without the expected revenue. In the first place, it is critical to understand how customers will acquire and use the product — a process called the “Sales Learning Curve”, introduced by Mark Leslie and Charles A. Holloway. There are three phases in the sales learning curve: Initiation, Transition and Execution.
Initiation: This phase begins when the product has been beta tested and hits the market. In this time, few customers will be willing to purchase the product which is why large sales teams might be dysfunctional. Instead, a small salesforce of three to four people should be focused on learning as much as possible about how customers intend to use the product. This feedback should be transferred to engineering, product marketing and marketing communications in order to perfect the product and the go-to-market strategy. The skills that these “renaissance” sales people need in this first phase, differ from the skills needed when selling mature products: Communication among different parts of the organization, tolerance of ambiguity, a deep interest in the product technology, resourcefulness to develop own sales models and collateral material. When the small sales team generates enough return to cover the fully loaded cost per sales person, the company is ready to move to the second phase.
Transition: In the transition phase, the focus should be on developing a repeatable sales model, refining market positioning and adding sales capacity, provided that each new salesperson can easily generate one fully loaded cost per representative. The people hired during this phase, Leslie calls them “enlightened” sales representatives, should still be comfortable contributing to a not fully evolved sales model, however, they do not need the same analytical and communication skills of the “renaissance” sales people. When the team generates enough return to cover twice the fully loaded cost per sales person, the company is ready to move to the last phase.
Execution: In this last phase, sales employees can be added as quickly as financial constraints and the management will allow, because sales have reached a sustainable and predictable level. In this phase, a well-understood sales training program should be put in place and the company has gained an exact understanding of how much additional revenue each sales person can generate. Only now, a traditional sales force should be hired, also known as “coin-operated” representatives, requiring nothing more than a territory, a sales plan, a price book and marketing materials in order to bring in orders.
Strategy and Vision
During the scaling phase, the most critical element is having enough cash, but nearly equally important is strategic planning, which becomes even more relevant as the organization continues to grow. Not only Churchill and Lewis found this to be true in their research nearly four decades ago, but also the founder of Mailchimp experienced negative consequences after neglecting this for too long. When one of his employees asked him at a large company meeting about the future plans of Mailchimp he said: “We don’t need no stinking strategy — we’ll cross that bridge when we get there!”, as he admits in an interview. Mailchimp had 300 employees at that time and the more recently hired team members felt anxious about the missing direction. One employee even approached Chestnut afterwards and suggested him to do a speaking and leadership training. Eventually, Chestnut realized that it was time to stop treating Mailchimp as the start-up it used to be and start treating it as the grown-up it had become.
But what is a strategy, after all? According to the Oxford dictionary it is a “plan of action […] designed to achieve a major or overall aim”, which entrains that, as a first step, it is necessary to define a goal. In order to reach a goal, a common recommendation is to firstly gain an understanding about the deeper reason, why it makes sense to strive for that goal by clarifying the purpose behind it. The often-quoted article from Jim Collins and Jerry Porras describes how an organization can do so by determining their vision. The two components that must be figured out are the company’s core ideology and its envisioned future.
Core ideology: As a first step, the company should define three to five guiding principles with intrinsic value and importance to those inside the organization, independent from the current environment or other external factors, such as competitive requirements. The company’s core values will persist, even when circumstances change, and the values turn out to be a competitive disadvantage. In this case, it is not the values that must be changed, but rather the market in which the company operates.
The second element of the core ideology is the core purpose. A purpose is not something that can ever be reached, it is rather a star in the horizon indicating the direction. One method that can help detect the purpose is by asking why it is important that the company does not cease to exist or by asking key employees what deeper sense of purpose would motivate them to keep working in the organization even though they were financially independent from it.
This core ideology isn’t something that can be created, it can only be discovered by looking inside. Its role is not to differentiate from competitors, but solely to guide and inspire employees and, as a positive side effect, to attract and retain outstanding people. In fact, a strong ideology will attract people with similar personal values, while it will repel those who do not share the same core values and purpose.
Envisioned Future: The first element of the envisioned future is what Collins and Porras call a “Big, hairy, audacious goal”. This BHAG should be clear and specific, so no explanation is needed, and the organization knows exactly when the goal is reached. This highly focused, energizing and powerful goal should have a time horizon of ten to thirty years to be reached. The goal should be high enough to appear challenging to reach, but realistic enough to make the organization believe that it is possible to reach it with extraordinary efforts and a little luck.
Once the goal is set, it is necessary to describe the envisioned future as detailed as possible to get a stimulating picture into people’s heads and get them going. For example, the BHAG of Henry Ford was to democratize the automobile. He described this goal vividly in the following way:
“When I’m through, everybody will be able to afford one, and everyone will have one. The horse will have disappeared from our highways, the automobile will be taken for granted… [and we will] give a large number of men employment and good wages”.
As examples of successfully bootstrapped companies show, it is not impossible to scale a company without investors. Mailchimp and Zoho are the most remarkable examples, having achieved yearly revenues of more than $500 million both, without any outside funding. It is relevant to notice, however, that all the bootstrapped companies I analyzed took their time to scale to their current size — between 13 years, such as the online forms company JotForm, and 23 years, such as Zoho. These companies might be even more successful and bigger in terms of revenue or employees today if they had raised VC, as also the CEO of Zoho recognizes. However, all of them rejected this possibility consciously for the sake of building a stable company, customer-centricity and a strong corporate culture, independent from outside influence.
Software companies usually can scale even easier than companies selling tangible goods or services: Firstly, they have insignificant marginal costs because new copies can be created without additional resources. Secondly, they typically have a low operating cash cycle because there is no inventory that must be stored before it is sold. Lastly, selling a product rather than selling services decouples time from revenue which is a requirement for scalability.
The economists Hall and Woodward concluded in their research about VC-backed companies, that entrepreneurship is risky, however they believe that VC is still the best solution to get people to commercialize their good ideas. As my investigation about this topic reveals, this is not necessarily the only, nor the best way: entrepreneurs should also consider to start and even to scale their company without the necessity of selling parts of it. Scaling a company without external funding can solve the problem of low availability of VC in certain countries and the high difficulty of raising VC. In start-up hubs, success is defined by convincing investors from business ideas and raising capital, round after round. However, young companies should remind themselves of the main elements that will help them persist and scale: Generating value by focusing on their customers and delivering great products.
The whole thesis that I dedicated to this topic is available on Amazon: https://www.amazon.de/-/en/Carolin-Nothof/dp/334619888X