When it comes to startup success we all immediately think of companies like Facebook, Google, Amazon, Uber, Robinhood and so many others.
But not every startup succeeds or prospers to that extent.
That’s why a huge part of my job as a venture capitalist is to use my experience and diligence work to discern between startups that show the promise of big successes and those that don’t.
A significant factor in determining how big a startup can become is its scalability.
At the heart of every huge startup is a “scale advantage…” that something that helps the company scale its revenue and customer base even faster as it grows bigger so that the accompanying higher costs don’t destroy the business.
These scale advantages help sustain rapid growth. For example, Amazon Web Services is growing its business at 40% year-on-year despite the fact that it is on track to generate over $70 billion of revenue per year.
Searching for these scale advantages is important when assessing a startup’s potential. That’s why today I want to talk about three scale advantages you should keep your eyes out for…
Network Effects: More Breeds More
Network effects is a very powerful force that has driven the success of startups like Facebook, Snapchat, Twitter and others over the past two decades. It refers to the phenomenon where the value of a product or service increases the more people use it.
Let’s take the example of Amazon…
As the number of third-party sellers on Amazon grows, it becomes a more and more valuable service to customers looking to buy a range of items.
Similarly, as the number of shoppers on Amazon grows, the platform becomes more and more attractive to sellers. It’s where they want to be to efficiently sell to lots of customers.
That’s the network effects in action.
When analyzing a startup, look to see if this effect is at play or can be kickstarted in future?
Will this startup’s product or service get more valuable as more users join?
Are existing users referring tons of new users?
Does user retention improve over time as the network grows?
These are some of the questions to ask when conducting due diligence for an angel investing opportunity.
Only the lucky few startups have network effects built into their product and business. If you find a startup that does, you might just have struck gold!
Economies of Scale: The Original Scale Advantage
Economies of scale is one of the most widely recognized business phenomena and one of the most dependable.
It’s also the original “scale advantage,” where it gets cheaper to produce a good or service in larger quantities rather than in smaller ones.
Watches are a good example of this. Luxury Swiss watches – which are incredible pieces of engineering and design – are handmade and assembled by expert watchmakers in Switzerland. This kind of manufacturing is not super efficient and only produces small quantities annually. Because of that, Swiss watches sell for thousands or tens of thousands of dollars on average, depending on the brand.
On the other hand, the popular outdoor watch brand G-Shock manufactures their watches in factories with a high degree of automation. The company will sell around 12 million watches this year. G-Shocks retail for around $150 dollars instead of thousands of dollars.
Not every startup has economies of scale. And some startups, like software companies, don’t really benefit from this effect.
Instead, startups that produce physical goods or services typically are most likely to benefit from economies of scale. For these startups, economies of scale can help improve margins and profits and allow it to beat competitors on price.
Strong Unit Economics & Retention: Value Must Always Beat Cost
Unit economics are at the heart of a startup’s business model and I’ve written before about ways to assess it. However, unit economics are also an important scale advantage that can help differentiate startups that truly have huge potential.
At the heart of unit economics is the customer lifetime value (CLV) to customer acquisition cost ratio (CAC). For every startup you invest in you want CLV to be higher than CAC… ideally a lot higher.
Let’s walk through an example to understand this in more depth. Let’s assume it costs a company $1 to acquire a new customer and their lifetime value is $5 for one company and $10 for another. In this case you’ll have a CLV to CAC ratio of 5 for one company and of 10 for another. That means that one company will generate twice as much revenue from every customer they acquire over their lifetime. This additional revenue can be reinvested into acquiring even more customers and driving even more growth.
Unit economics is closely related to customer retention as well. If a startup loses 15% of its customers every year to churn that means it has to invest significant money to acquire new customers just to get back to even.
On the other hand, if a startup churns 5% of its customers every year then it has to invest a proportionally smaller amount to get back to even. Low retention fights directly against revenue and customer growth for a startup.
These scale advantages are some of the most common factors that help turn good startups into great ones.
And the scalability of a startup is one of the main determining factors of whether you get 10X your money back on an investment or 100X.
When assessing an angel investment opportunity, remember these scale advantages and see if you can find startups with these built into their model.