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The annals of entrepreneurship are filled with promising start-ups that appeared ready to change their industries—but weren’t able to navigate the difficult path from exciting small business to big, well-functioning company. Chicago Booth’s Ram Shivakumar says that journey is fraught with big decisions and important changes, and founders need to be prepared for the obstacles they’ll encounter. In this video series, Shivakumar helps entrepreneurs identify the questions they should be asking and the steps they should be taking, from establishing key organizational attributes to identifying fundamental pivot points in the business model.
1. Creating a market
As founders take their companies to scale, many will find they need to pivot their business models along the way. Shivakumar says that entrepreneurs need to ask themselves foundational questions about their products and companies: What are we offering? Who are we targeting? What value do we bring? Determining precisely what the product is, who the right customers are, and which channels are right for reaching those customers is crucial to scaling successfully.
(swelling music) Ram Shivakumar: Most startups have had to pivot in small and big ways to find a winning business model. Among the questions that the startup must frequently answer is: What business should we be in? Who are our target customers, and what do they want? What is our product? What does the consumer pay for, and how do they pay? A one-time fee, a recurring fee? How are we creating economic value, and how are we capturing it?
The list of startups that have successfully pivoted is short in comparison to those that were unsuccessful. Twitter started as audio, a company devoted to podcasting, but pivoted to become a microblogging platform after observing that iTunes was bent on entering the podcasting space. Instagram started as Burbn, an app that combined gaming with photography, but simplified its business to focus on photography alone.
Creating a market requires a company to acquire several related skills. Changing customer needs, competencies, and competition force companies to iterate until they find a product offering that has a chance at success. The original owners of Starbucks wanted to be in the coffee-roasting business, but Howard Schultz, who acquired Starbucks in 1987, wanted to be in the coffee-bar business. Schultz’s dream was to recreate the experience of an Italian coffee bar in the United States at scale. After a great deal of iterations, Schultz and his team settled on the characteristics of the Starbucks product: high-quality coffee beans, strong aroma of coffee, fast service, a friendly barista, and a limited food menu.
Successful scalers often attribute their success to getting the right customer. The right customer views the problem that the company is trying to solve as vital to its own performance. The right customer is likely to positively influence the decisions of other customers. And importantly, the right customer enables the company to make a profit.
Conversely, a costly mistake is acquiring the wrong customer, someone who is unlikely to be a repeat customer, whose needs are incompatible with the product offering, or who is unlikely to influence the purchase decisions of other customers. Reflecting on the pivotal moments during his years as CEO of Fieldglass, an enterprise software company that was acquired by SAP in 2014, Jai Shekhawat told me that an important lesson from early failures was learning to distinguish the right customers from the wrong customers. As he said, you don’t wanna do a beta test with a customer that has no intention of being your customer. And you don’t wanna take on customers who force you far afield from your mission and competencies.
The right channel partners operate quickly, put the company’s products in the hands of the ideal customer, and help the product achieve greater name recognition—and importantly, help the company grows its reputation and bottom line.
In contrast, the wrong channel partners damage a company’s prospects. They dilute the brand value by mispositioning the product or, in many cases, waste valuable time by doing nothing. Startups in a range of industries from software to manufacturing often rely on bigger competitors to bring the product to market. Small biotech companies often enter into partnerships with large pharmaceutical companies to commercialize their products. Small retailers use the Amazon marketplace to sell their products. And small software companies often rely on large software and IT services companies to market and distribute their products.
However, reliance on a single channel partner is risky. A formal Booth student of mine, Jill James, who now runs a growth advisory company Sif Industries, describes the channel challenge for startups as follows: I think of early stage channel strategy as finding your frenemies. You’ll work together for now, but if things go well, you’ll directly compete or even put them out of business. You do want you need to do on the way up to build scale until you can have the means to control the channel. Now it’s time for you to create the right market.
2. Raising capital
As entrepreneurs scale their businesses, they're often going to face periods of illiquidity and unprofitability. As a result, they need to raise capital—but what kind of capital should they target? Shivakumar says that’s just the first question founders need to confront as they consider how to finance their attempts to scale. They also need to decide how much capital they need—do they want to risk “death by indigestion,” or hope to signal market dominance by raising as much capital as possible?
(swelling music) Ram Shivakumar: Going from prototype to scale, or niche segment to mass market requires capital. Often, the capital required is far greater than can be bootstrapped by the entrepreneur. Many entrepreneurs raised seed capital from family members, friends and angel investors, and debt capital from individuals, credit cards, banks, and alternative lending platforms such as a lending club.
For the entrepreneur contemplating a venture investment to support the scaling-up journey, it is important to answer a couple of questions. In his book Secrets of Sand Hill Road, Scott Kupor, the venture capitalist, says that one of the first questions the entrepreneurs must ask is whether venture capital is right for them.
As he says, just as with product market fit—where we care about how well your product satisfies a specific need—you need to determine whether your company’s appropriate for venture capital. No matter how interesting or stimulating your business, if the ultimate size of the opportunity isn’t big enough to create a stand-alone, self-sustaining business of scale, they may not be a candidate for venture financing.
Venture capital is a better source of capital than loans for most startups that are scaling up because they’re unlikely to generate positive cashflow, have a high probability of failure, and will likely experience prolonged periods of illiquidity. But venture capital comes with strings attached. Not only will the entrepreneur have to give up a portion for equity stake, the entrepreneur will have to share decision-making rights with the venture capitalist.
As Scott Kupor says, the answer is to raise as much as money as you can that enables you to safely achieve the key milestones you will need for the next fundraising. What the key milestones have in common is that risk is reduced. The startup has developed its products, acquired key customers, and met some financial and operational targets. Hitting these milestones mean that the next round of investors will reward you with a higher valuation.
One school of thought says that companies would do well to avoid raising too much capital. Reflecting on the $38 million that he raised for Fieldglass over six years, Jai Shekhawat told me, in hindsight: we probably raised about $8 million too much, which makes for expensive equity at the relatively modest valuations back then. As David Packard, the founder of Hewlett-Packard, famously observed, more companies die of indigestion than from starvation. What he was trying to say was that companies with a great deal of capital are forced to make the hard economic choices that serve as the catalyst for innovation.
Another school of thought is that companies should raise as much capital as they can when they can. Reid Hoffman and Chris Yeh articulate the logic for this view in their most recent book, Blitzscaling. Raising enormous amounts of capital, in their view, acts as a signal to the financial markets that the company has increased the probability of locking up its market and building a dominant position. The emphasis, they argue, should be in acquiring a strong user base, if necessary at the expense of profits.
The archetype company that has employed this model is Uber, which raised $24.3 billion over the 12 years prior to its 2019 IPO. Sidecar, the company that introduced the peer-to-peer taxi service model in 2000, raised a competitively puny $35.5 million, was unable to match the scale of Uber’s investments, and was forced to exit.
So here’s the decision for you. How much capital do you need, and what kind of capital will it be?
3. Molding the organization
Among the adjustments founders need to make as they attempt to scale their start-ups, many are internal. Shivakumar says that while start-ups tend to have informal cultures and flat structures, scaling up often requires formalizing various layers of authority and more rigorously assessing competencies. The organizational changes that take place during scaling can be difficult for early employees, who often cherish their memories of the start-up phase, so Shivakumar also says that reinforcing company values, telling stories, and celebrating personal milestones and accomplishments is important to maintaining a positive culture.
(swelling music) Ram Shivakumar: Startups tend to be informal organizations—and for a very good reason: they need to pivot when circumstances dictate. Consequently, their organization structures are flexible, management practices are not codified, employers wear many hats, and decision-making is concentrated in the hands of a few people.
Scaling up, however, requires an organizational reboot. Start with an audit of competencies, identifying those that the company possesses and those that it does not. Scaling up requires explorers who excel at discovering new things, but it also requires exploiters, those who are good at repeated tasks. The people hired to be explorers must be entrepreneurially inclined, while those hired to be exploiters must have operational competence.
Explorers should focus on innovation and growth, while exploiters focus on cost optimization and profit maximization. While most startups likely have many explorers among their employees, they often lack exploiters. Scaling up requires discipline, which in turn requires a company to formalize its organizational structure. You do this by explicitly assigning authority, responsibility and delegating decision-making.
The value of a formal organizational structure is greater in an ever more complex world in which the manufacturing of smartphones, automobiles, software and other products depends on global networks of competencies. Organizational structure enables cooperation, coordination and accountability as companies grow. Some collaborations are easier to foster than others. What makes for difficult collaborations is that knowledge and skill are often diffused and tacit. In his 2015 book Why Information Grows, MIT’s Cesar Hidalgo argues that the ability to combine tacit knowledge is a source of sustainable competitive advantage.
In his 2018 book Measure What Matters, John Doerr, chairman of Kleiner Perkins, the Silicon Valley VC firm, recalls his early investment in Google and his initial assessment of the company. Great product, high energy, big ambitions, and no business plan. Doerr recalls that what Google badly needed was a system to prioritize decisions and a way to track progress on initiatives. So Doerr proceeded to teach Google founders Sergey Brin and Larry Page the OKR model—O, objectives; KR being key results—that he had learned at Intel.
The OKR model helps companies articulate their objectives and spell out the set of actions that the company must take to achieve those objectives. Doerr argues that the OKR model works because everyone is aware of the company’s priorities as well as every team’s responsibilities and that each team is incentivized to coordinate its actions to solve the company’s most pressing problems.
The late Herb Kelleher, the founder and CEO of Southwest Airlines, considered the company’s culture to be what separated it from other airlines. As he said, it’s the intangibles that’s the hardest thing for a competitor to imitate. You can get airplanes. You can get ticket counter space. You can get tugs. You can get baggage conveyors. But the spirit of Southwest is the most difficult thing to emulate.
So my biggest concern is that somehow through maladroitness, through inattention, through misunderstanding, we lose the esprit de corps, the culture, the spirit. If we do ever lose that, we have lost our most competitive asset.
Many employees fondly recall their early days and nights in a startup: the camaraderie, the free-flowing exchange of ideas, the flat structure. But culture is threatened when the startup takes on new employees, introduces hierarchies, and restructures.
So reiterating a company’s mission and values is one step toward invigorating the culture. More important is the sharing of stories, celebrating personal and professional accomplishments, fostering opportunities for collaboration, and having honest and direct conversations on difficult issues. A company’s culture is like the plumbing system. If it isn’t maintained, it will deteriorate. So molding your organization is hard, but if you follow these steps, your company will be the better for it.
4. Learning how to learn
Entrepreneurs who hope to scale their start-ups need to also be adept learners, says Shivakumar. That means drawing lessons from experience, but also developing an experimental culture that accepts the possibility of failure. A company that learns quickly and effectively can better distinguish good opportunities from poor ones, and establish a lasting competitive advantage in its market.
Ram Shivakumar: What is underemphasized in most stories of scaling is the journey of learning. This includes learning the things that work as well as the things that do not, a process that prepares entrepreneurs to distinguish promising opportunities from less promising ones. Analyzing the lessons of each experience and modifying management practices accordingly can help companies become faster learners. Learning by doing, an educational philosophy championed by the philosopher John Dewey, posits that learning is most substantive and enduring when the learner is forced to interact with the real world.
The entrepreneur Mark Cuban argues that in business, knowledge and skill can only be obtained by actual experience. This is why the Nike slogan “Just Do It” is a simple as well as profound call to action. As Tim Harford, the Financial Times columnist, observes, when a problem reaches a certain level of complexity, familiarity won’t get nearly as far as an incredibly rapid process of trial and error. Successful scaling requires companies to conduct many experiments, observe processes and outcomes, and iterate.
Chicago Booth’s Harry Davis has championed a portfolio approach to innovation, running lots of carefully chosen, small-scale experiments. This requires asking and answering many questions. How many experiments should we run? When should we abandon an experiment? When should we continue with an experiment? And what criteria should we use to decide? Experimenting with different processes was what led the engineers at Ford Motors to conclude in 1916 that producing a car effectively and efficiently required 84 steps and not 78 or 89.
Learning how to deal with failure is a vital organizational trait. The cost of avoiding small failures is often big failure. As the entrepreneur Reid Hoffman observes, if you tune it so that you have zero chance of failure, you also have zero chance of success. A healthy organization acknowledges that the possibility of failure is a prerequisite for achieving its long-term goals and creates a culture that accepts failures and learns from them.
Arie de Geus, former head of Shell Oil’s strategic planning group, observed that the ability to learn faster than your competitors may be the only sustainable advantage. The bigger the potential prize, the more intense the competitive race is to scale up. (electronic jazz music)
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