How to know if your business will scale

Jun 01, 2011

Before you explain how your business will scale, you need to understand the question.

By Alex Taussig, contributor

(I originally published this at my blog Go check it out!)

Venture capitalists can ask a lot of dumb questions. Well, maybe “dumb” is the wrong word; “repetitive” is probably more accurate. How many times do you have to explain how you acquire users, how big your market is or what the competitive response will be to your product? It can get pretty frustrating, especially if you’re actually turning poop into gold.

I think conference panels exacerbate this frustration, especially those “lightning pitches” during which judges instantly critique a business plan they know almost nothing about. I’d estimate that 90% of the questions judges ask on these things are the same 10 questions. And, the one that is always included is:

How do you scale?

This question is almost never answered properly. I think it’s because “scale” is not well-defined in common discourse. So here’s my attempt to put a framework around it:

For me, scale has a very specific meaning. It has nothing to do with your back-end technology. Product scalability is an entirely different topic, and one best covered by other authors.

Businesses that scale are businesses with operating leverage. Put simply, if you add operating costs (sales, marketing, administrators, R&D, etc.) at the same rate you grow revenue, then your business does not scale. Alternatively, if additional revenue requires relatively smaller and smaller additions to operating costs, then congratulations… your business scales!

Let’s make one thing clear: Just because a business doesn’t scale, that doesn’t mean it’s not a wonderful business. McKinsey & Co. is one of the greatest consulting firms and brands in corporate America. But, it doesn’t scale. Ignoring its publishing business, McKinsey needs to add consultants, almost on a one-to-one basis, to grow its revenue. Its financials aren’t public, but they probably look something like this:

(Note that I’ve put gross margin in the above plot instead of revenue. You should actually be scaling gross margin, not just revenue, so we’ll stick with the former from here on.)

Technology businesses, on the other hand, tend to have a core set of assets that are developed early on, which can then be monetized at very low marginal cost going forward. Along with viral user acquisition or another low cost method of acquiring customers, scalable technology businesses tend to look like this:

While both companies exhibit linear operating cost growth, McKinsey’s top-line growth is linear, while our hypothetical tech company has an exponentially growing top-line. This is why VC firms prefer to invest in technology companies: We get a lot of bang for our buck, and can spend the difference between the blue and red lines to create a rocketship. Businesses like McKinsey, on the other hand, don’t need any capital to get started, and also don’t grow as fast.

The nice thing about exponential growth is that public markets reward it with big revenue multiples. Take OpenTable (open), for instance, which trades at an astounding 18x trailing revenues:

Real life is never quite as nice as theory, but I think you’ll agree directionally. In fact, it appears that the business was managed on a break-even basis until the IPO in mid-2009. That said, when management decided to “go for it,” OpenTable’s business model certainly supported significant operating leverage and top-line growth.

Google (goog) took this principle to the extreme after its IPO in 2004, as shown below:

It’s no coincidence that the best venture-backed companies in history did a great job scaling. It’s how you turn small amounts of invested capital into extremely valuable equity in a short period of time.

So next time a VC asks you a dumb question about how you scale your business, tell him how you make a chart that looks like one of these, and you’ll be all set!

Alex Taussig is a Principal with Highland Capital Partners and invests in early stage technology companies. You can find this blog post, as well as additional content on his blog You can also follow Alex on Twitter @ataussig.

All products and services featured are based solely on editorial selection. FORTUNE may receive compensation for some links to products and services on this website.

Quotes delayed at least 15 minutes. Market data provided by Interactive Data. ETF and Mutual Fund data provided by Morningstar, Inc. Dow Jones Terms & Conditions: S&P Index data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Terms & Conditions. Powered and implemented by Interactive Data Managed Solutions