This is one post/chapter in a serialized book called Startup 101. For the introduction and table of contents, please click here.
This is possibly the most important strategic decision one can make for a Web tech venture. It is almost always a trade-off. There are those few magic ventures whose revenue scales from day one, without the need for external capital. We all want those, but they are almost as rare as hen’s teeth. In most cases, you face a choice between scale and early profitability. You need total clarity on this decision, because it will determine your capital-raising strategy and all of your execution plans.
The Old Mantra: Get to Positive Cash Flow, Fast
Most traditional business people, when looking at a business plan, will ask, “How soon can the venture get to positive cash flow?” It is the critical business issue. It determines how much capital you will need and the overall risk of the business. You answer the question by looking at three factors very carefully:
- How fast will revenue grow?
- What are the gross margins?
- How much operational overhead do you need to grow revenue at that level?
Any business can be reduced to these three fundamental factors.
Service-based businesses can get to positive cash flow very quickly, which is why they can be bootstrapped. Service-based businesses are also tough to scale because growth depends on people, and gross margins are usually not that good. So, the reason they usually have to be bootstrapped is that most venture investors won’t touch them.
The VC Mantra: Scale First
At the other end of the extreme is a business like Facebook, which, at the time of this writing, has 300 million users but is still losing money. Twitter is another, with phenomenal growth and mind share but not a dime of revenue.
To a traditional business person, that sounds crazy. But when scale is your primary competitive advantage, it makes perfect sense. Think of Skype. You can replicate the technology relatively easily, but getting millions of Skype users to switch is hard. This is even truer for Twitter and Facebook, whose technology is very simple to replicate.
Scale Without a Revenue Model?
Scale first, monetize later is a reasonable strategy for certain types of Web ventures and for entrepreneurs who are well connected to sources of capital.
But to scale without even knowing what your revenue model will be? That is riskier. It might make sense in some cases. We will know that about Twitter once it finally reveals its revenue model.
For the vast majority of entrepreneurs and investors, though, scaling without a revenue model is too risky. It depends on being able to sell to an acquirer who will figure out a revenue model.
The Option That Gets You Financed
Practically speaking, most first-time entrepreneurs have little reason to conceive a venture that requires a lot of capital or a long ramp-up time to revenue and positive cash flow. There are exceptions to this rule, of course. But the normal route is for entrepreneurs to “earn their stripes” with a capital-efficient, low-risk venture that gets to positive cash flow quickly. If it works out well and they want to start another venture, they can shoot for something more ambitious then.