Scaling a Company: The 4 Growth Factors

How to Build the Next Trillion Dollar Business

This article is an excerpt from the Shortform book guide to "Blitzscaling" by Reid Hoffman and Chris Yeh. Shortform has the world's best summaries and analyses of books you should be reading.

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What are the four growth factors that are incorporated into most great business models? What business models are more suitable for scaling a company?

The four growth factors that affect scaling a company are market size, distribution, high gross margins, and network effects. There isn’t one business model that will work for every company but incorporating these growth factors will help you scale.

Continue reading for more information on scaling a company.

Business Models That Scale

Scaling a company isn’t easy, but there are some business models that are more suitable for blitzscaling (rapidly growing a company). Business models are how the company makes money by serving its customers. This article discusses aspects of successful business models in general, and business models that are especially suited to blitzscaling.

The Four Growth Factors

There isn’t a universal business model that works for every company, but most great business models overlap with these four growth factors.

1. Market Size

A big market has a large number of potential customers and efficient channels for reaching those customers. Ideally, the market is also growing quickly, meaning markets that seem small initially can grow to become massive.

Sometimes the market size for an innovative company is underestimated because the potential to grow the market and the potential for the company to scale are underestimated. Therefore, don’t fix your sense of market size to the size of the incumbent – this can drastically underestimate how large the market can grow.

Analogy: Don’t size the car industry off of how many horses there were in 1910.
Some analysts once found Uber’s valuation ridiculous since it represented a sizable percentage of the global taxi market. It turns out Uber’s superior customer experience grew the market beyond what taxis did, and ridesharing eventually eclipsed all of taxis.
Airbnb grew to carry more rooms than the entire hotel industry.
Amazon grew far beyond its early beachhead in books, which now accounts for less than 7% of company sales.

2. Distribution

Many startups focus on product but overlook the importance of distribution. Roughly speaking, there are two general categories: existing networks and word-of-mouth.

Existing Networks

Traditional web models include paid acquisition and SEO.
Companies also get exposure from existing platforms like Facebook, app stores.
Scrappy startups can find ways to co-opt existing networks.
- PayPal made it easy for eBay sellers to add a “Pay with PayPal” button to listings
- Airbnb sent requests to Craigslist posters to replicate their listings on Airbnb.

Word of Mouth/Virality

A virality strategy requires good retention, to better increase the number of referrals made.
Virality usually requires a free or freemium product. The authors of Blitzscaling can’t recall a company with a paid product that grew to a massive scale using virality.
Examples
- Linkedin built address book scrapers to invite contacts; added public profiles which users started integrating in their email signatures.
- For each referral, PayPal paid the referrer $10 and the new user $10. People obviously like free money.
- Dropbox gave perks (extra storage) for inviting friends.

3. High Gross Margins

Gross margins = Revenue – cost of goods sold. This is a good measure of long-term unit economics.

Software companies have high fixed costs and low marginal costs, often above 60%. In contrast, “old economy” businesses like restaurants have low gross margins. (note: Part of the reason is that the low upfront costs of “old economy” businesses like restaurants lower the barrier to entry, thus driving down prices. Further, “old economy” businesses often exist in the physical world rather than virtually, thus costing more to operate.)

High gross margins give big strategic benefits:

For a fixed amount of revenue, higher margins create more funds for companies to reinvest in R&D and growth to ward off competitors.
Operations scale with revenue or sales volume, moreso than with earnings. In other words, fixing profit, a company can have lower operational complexity with higher gross margins. It’s easier to service customers who generate $15MM in sales and $10MM in margins, than to service customers who generate $100MM sales with the same $10MM in margins.

4. Network Effects

Network effects apply when a user using the product makes the product more valuable for other users. This is also called “demand-side economies of scale” by economists.

The major types of network effects are:

Direct: Usage directly increases value
- Messaging apps like WeChat, social networks like Facebook
Indirect: Usage encourages consumption of complementary goods, which increases the value of the original product
- Tech platforms invite developers to build applications on the platform
  - Operating systems like Windows, iOS, Android
  - Gaming consoles like Playstation
Two-Sided Network Effects: Usage by one set of users increases value to a different set of users
- Marketplaces like eBay, Uber, Airbnb, Steam, Adwords
Local Network Effects: Usage by a small subset of users increases the value for a connected user
- Cell phone companies used to offer unlimited cell phone calls to “favorites”
Compatibility and Standards: Use of one technology encourages use of compatible products
- More people using the MS Word .doc made rivals like WordPerfect less useful

Network effects generate positive feedback loops: more users makes the product more valuable, which attract more users. Inversely, a network with relatively fewer users is useless relative to more popular alternatives.

The game is thus to be the first to gain a critical mass of users, thus kicking off the virtuous cycle. Companies like Uber are willing to subsidize users in the belief that they can capture more value once they become the winner in the space.

The Internet has enabled faster acceleration of network effects, because of low marginal cost of reaching more users. Building phone lines to connect people was one pace of growth; allowing a user to instantaneously invite 100 friends, who can join within minutes, is wholly another.

Scaling a Company: The 4 Growth Factors