Idea in Brief
Many start-ups and new corporate ventures that grow very fast never sustain profitability and hence scalability.
In an often-overlooked stage of growth—extrapolation—successful start-ups ensure that each new customer brings in additional revenue and incurs only marginal cost—the key to lasting, profitable growth. During this phase firms turn product-market fit into profit-market fit.
To keep scaling up, a start-up or a new enterprise initiative must have a host of resources in place—such as a proven monetization approach, a strategy to exploit network effects, and robust capital resources. It must also be managed as an “ambidextrous” organization—capable of exploring new businesses while exploiting its existing core business—and systematically remove internal business-model constraints on growth.
In 2012, King Digital Entertainment had established itself as a developer of popular free games on smartphones. Its user base was growing exponentially, driven by the hit game Candy Crush Saga. From mid-2012 to mid-2013 the company experienced a 12-fold increase in revenue but only a sixfold increase in costs. The result was a nearly 70-fold increase in operating income, from €10.5 million to €716 million.
SoundCloud was an online audio-sharing platform and a rival of Spotify and Apple Music. From 2012 to 2013 its user base grew 15-fold, from 10 million to 150 million registered users. However, its revenues increased less than 50%, from €8 million to €11 million, while its operating costs grew 75%, from €16.5 million to €28.5 million.
In 2017, WeWork, a celebrated coworking venture, had raised $10 billion in equity and debt. Its top-line revenues had doubled for five consecutive years, and its membership had grown 10-fold. But over the same period, operating costs rose from $400 million to almost $2 billion, leading to significant and deepening losses.
Of these three high-flying start-ups, only King Digital Entertainment became a stable, highly profitable business. What explains their diverging fortunes?
Drawing on an examination of dozens of rapidly growing ventures and our experience teaching courses on scaling up enterprises at our respective business schools, we’ve concluded that what made the difference was that King Digital Entertainment engaged in a developmental stage we call extrapolation, in which a company explores profitable growth options while exploiting economies of scale and scope. This stage isn’t part of traditional organization theory, which says that businesses are in either exploration mode or exploitation mode.
Exploration involves the search for product-market fit. The company’s hypothesis about how it will deliver value is tested to determine whether customers have a problem to be solved or a pain point to be addressed—and are willing to pay for the company’s solution.
Exploitation begins when the fast revenue and profit growth enjoyed in the start-up stage slows and reverts to market norms. In this phase the company aims to strengthen its competitive advantage by fine-tuning the business model and strives to achieve incremental long-term growth and stable profits.
These two stages are well-known—start-ups often begin with a bang, and a few seem to emerge as stable giants. But in our view extrapolation is the often-overlooked but critical phase between exploring many opportunities and exploiting one.
During this stage start-ups pursue two goals. The first is to confirm the extent to which product-market fit shows that there is demand for the company’s offering. The second is to achieve what we call profit-market fit—to demonstrate not only that the venture can ramp up revenue rapidly but that every new customer brings in additional revenue and incurs only marginal cost—the key to profitable growth.
The company must construct a business model that boosts revenue while reducing variable unit costs and containing fixed costs.
King Digital Entertainment, SoundCloud, and WeWork all proved the value of their offerings by achieving impressive growth in numbers of customers and theoretically were positioned for market dominance. But King alone was able to turn its top-line growth into comparable profit growth during the extrapolation phase. Each new smartphone user who downloaded the Candy Crush Saga app brought in revenue that went almost directly to the bottom line. SoundCloud, in contrast, never managed to develop a scalable and profitable way to monetize the enormous consumer audience it had built. WeWork’s problem, aside from the well-known controversies surrounding its ill-fated initial public offering, was failing to establish an increasingly profitable business model to support its global network of coworking spaces.
What is the key to successful extrapolation? It demands new ways of thinking about strategy, operations, financing, and speed. It also requires approaches to organizational structure, culture, and talent that are distinct from those of the other two phases. Start-up and enterprise leaders alike must consciously treat extrapolation as a specific stage in the development of any new venture or new-to-market offer.
Principles of Extrapolation
In the companies we studied the extrapolation phase spanned as little as a year and as much as three years. Eventually, competitive responses, market saturation, or shifts in the external business environment brought this phase of dramatic growth in revenue and operating income to an end.
Our research shows that ventures that succeed at extrapolation have three characteristics:
- They understand and leverage the conditions that are critical for success.
- They follow a rigorous extrapolation process.
- They have ambidextrous organizations that can manage strategic experimentation and disciplined execution simultaneously.
Let’s look at each of these in turn.
Extrapolation requires two types of conditions to be in effect: necessary conditions, which don’t by themselves create extrapolation but must be present for it to occur, and sufficient conditions, which can produce it.
There are two necessary conditions:
A robust market.
Extrapolation requires a large number of customers who have similar needs and will pay for a product that meets them. (It may seem obvious that the market must be big enough to support scale, but we are often struck by how many early-stage start-up teams miss this point or misconstrue the relevant data.)
Solution repeatability and distinctiveness.
The product the company offers must be the same for each customer but differentiated from competitors’. Homogeneity simplifies the business model and makes it easier to scale up.
In addition, we have identified five sufficient conditions. Not all are essential to success in every case, but several are always present when extrapolation works.
An effective go-to-market strategy.
The venture must have a clear plan to reach users through direct or indirect channels, turn them into loyal customers, and persuade them to promote the product. Consider the pre-owned-apparel business ThredUp, which appears to be in a successful extrapolation phase. To get there leadership had to scale up both sides of its platform, recruiting enough sellers of used clothing to attract buyers. By focusing on achieving high engagement and satisfaction among both buyers and sellers, it activated powerful word of mouth, which propelled the growth it needed to pull off its recent IPO and generate a 39% annual increase in profits.
A proven monetization approach.
The offer ultimately must generate revenue directly or indirectly through payments or advertising. Without healthy revenue sources, scale is hard to justify or support. That was one of the problems that dogged SoundCloud: It derived limited revenues from listeners and only modest revenues from the musicians whose songs it hosted. In comparison, Spotify, while still challenged in its profit model, derives huge revenues from a mass audience of paying listeners.
Network and density effects.
While network effects kick in when a platform or a product attracts enough users to make it more valuable to other users, density effects happen when the concentration of users in one geography or market segment intensifies substantially, leading to virality or word of mouth, or the average number of new-user referrals each existing user in the network makes is greater than one (a concept known as the viral coefficient). Effective extrapolation usually (but not always) requires strong network and density effects that enable economies of scale and limit defections to other offers.
The company must construct a business model that boosts revenue while reducing variable unit costs and containing fixed costs. Tech platforms (like Facebook, Nextdoor, and Slack) are famous for achieving extreme economies of scale, given that each incremental unit of service delivered often incurs zero variable cost. Such platforms also grow fixed costs more slowly than top-line revenue—often by a factor of three to five—an obvious formula for success.
Substantial capital resources.
Without question, there are founders and ventures that can bootstrap their way to scale. The direct-to-consumer home-goods retailer Resident was able to largely self-fund its early growth because it sold big-ticket, high-margin products (mattresses) from day one. But in reality, most successful ventures must raise significant outside capital in order to achieve the rapid growth in scale seen in extrapolation.
A Rigorous Process
Successful extrapolation requires a focused, systematic approach to identifying and removing internal business-model constraints on growth. The theory of constraints process, first codified by Eliyahu Goldratt in his classic book, The Goal, suggests that companies can do so by following these five steps:
- Articulate the growth goals (for example, “achieve a fivefold increase in revenues and a 10-fold increase in operating margin”) and examine whether the necessary and sufficient conditions for achieving them are present. The goals selected will be influenced in part by market and business-model realities and in part by the founding team’s level of ambition.
- Define the critical assumptions underpinning your business model. These should be based on an assessment of what factors must be in place to produce growth. In other words, ask “What needs to be true?” for you to realize your growth goals. For example, to increase revenue 10-fold, you might need five times as many customers who make purchases three times as frequently as your customers currently do.
- Identify the business model constraints—the barriers to achieving your growth goals—and the right sequence in which to tackle them. For example, managers may discover that the cost of a certain input is an enormous constraint or that the market is just too small. The theory of constraints tells us that no chain can be stronger than its weakest link, and that thinking applies to the business model. Every model will have one or more constraints that limit its output.
- Develop a way to remediate the most significant constraint. You may need to either examine how other companies have adapted their models to address the same type of constraint or develop an innovative new business model to find a work-around. The key is to apply what we call “strategic experimentation,” in which you validate adaptations or innovations on a small scale before applying them to the whole business.
- Once the first constraint is no longer a barrier to growth, select the next one and remediate it. Continue this iterative process until all significant constraints have been addressed.
To understand this process in action, we studied how Niraj Shah and Steve Conine, the founders of the home-goods retailer Wayfair, approached extrapolation. Initially known as CSN Stores, the venture began as a collection of niche e-commerce sites focused on narrow product categories, each accessed through a generic web address in the form of “product.com” (such as RacksAndStands.com or EveryGrandfatherClock.com). As revenues grew, CSN wound up with more than 200 such sites and encountered a first significant constraint: Few customers who bought from one site had any idea that the same company operated other similar sites. That meant CSN lost sales from satisfied customers who otherwise would have come back to buy again. Here the constraint was the dispersion of channels. There were too many channels and no network effects.
The retailer’s first remediation effort focused on increasing repeat purchases. The founders rebranded the business as Wayfair and then consolidated all the “product.com” sites under the new name, combining millions of SKUs on one platform. Once that integration was complete, cross-selling and repeat purchase rates took off.
The second remediation effort focused on increasing customers’ lifetime value by improving fulfillment. The business was drop-shipping more than 85% of orders, meaning they were sent directly from suppliers, which made it difficult to ensure that they were filled in an accurate and timely fashion. Customers who had bad experiences with orders were unlikely to return. To address that problem, Wayfair established a network of distribution centers to handle its fastest-moving SKUs. That way it could “forward position” inventory for vendors (without taking title to merchandise, sustaining its asset-light business model), enabling faster fulfillment and more-consistent service to consumers. That helped cement loyalty to the Wayfair brand.
The third remediation effort focused on lack of product differentiation and defensibility. Management realized that the business was constrained by its generic and commoditized offerings. As a result it had to compete on price. The goal was to start selling products that were exclusive to the site and more distinctive in the eyes of consumers. That was achieved by implementing several branding initiatives. Wayfair worked with suppliers to develop private label lines, capturing additional points of margin with an array of proprietary offerings. Shoppers could no longer directly compare Wayfair’s prices against competitors’. In addition, Wayfair created “lifestyle” brands, which presented otherwise unrelated SKUs (say, a sofa and a dining room table) in highly styled groupings. Because many of these were also private label, they boosted gross margins. Meanwhile the groupings increased average order value by encouraging shoppers to buy combinations of items. All those changes led to higher lifetime values.
An Ambidextrous Organization
In their 2004 Harvard Business Review article “The Ambidextrous Organization,” Charles O’Reilly and Michael Tushman described companies that could simultaneously explore new businesses while exploiting their existing core businesses. The ability to do that is crucial to extrapolation success.
Almost all growing ventures, after they move beyond the early start-up stage, routinely need to reinvent themselves and refine their core business. But such flexibility is especially important during extrapolation. “When we were growing the user base, we had to adjust and change our monetization mechanism several times,” King Digital Entertainment’s cofounder Riccardo Zacconi told us. “Initially it was geared toward advertising, but then it became almost entirely reliant on selling virtual goods.” In fact, the adaptation process at King went further than a pivot in monetization. Relentless experimentation brought about changes in the revenue model, management processes, staffing levels, and the organization of the company’s studios and teams.
King managed to scale up its infrastructure while reducing unit costs. It did that by rigorously analyzing the drivers of its customer acquisition cost and then lowering it through iterative in-market testing. That business model transformation was carried out at the same time that strong product-market fit unlocked rapid revenue growth. During the extrapolation phase, King’s leadership was able to simultaneously explore and exploit. Rather than canceling each other out, those seemingly opposed approaches came together to make the organization stronger.
In our research we have found that the following elements are crucial for rapidly growing start-ups and corporate ventures that aim to achieve ambidexterity:
Modular organizations and autonomous teams.
Ventures that successfully navigate the high-stakes transition from start-up to scaled-up keep their working units small. King, for example, doesn’t have one creative studio, as many entertainment companies do; it operates five studios, in parallel, that are part of creative clusters around the world. Voi Technology, a European app-based electric-scooter company, is organized into units for different metro markets. Such modular approaches allow ventures to expand without losing their agility. During extrapolation, businesses need to replicate the success of proven business models while maintaining the flexibility to invent new ones. Without modular forms of organization, pivots become challenging or nearly impossible to pull off.
Extrapolation is also most effective at companies where authority is distributed to teams rather than held within a tight management hierarchy. For example, at King’s successful competitor Supercell, Ilkka Paananen aspires to be the “least powerful CEO in the world,” which means that his teams can make all key decisions about game franchises without consulting him or others in top management.
Swift reallocation of talent.
When a business enters the extrapolation phase, management must begin assigning its most valuable human capital to its highest-potential opportunities. Both King and Supercell move game developers off unpromising or maturing game franchises with ruthless speed and discipline. Resident, the bed-in-a-box mattress company, laid the groundwork for rapid talent reallocation by launching itself as a virtual organization long before the pandemic. Because most of its staff works remotely, Resident can tap the best employees from anywhere around the world and continually reassign them to projects with the highest prospects.
Because workforces tend to expand dramatically during extrapolation, culture is an essential tool for maintaining a firm’s focus, mission, and direction. King invests in large-scale “infomarket” events, where it brings all its talent together to reinforce cultural norms and “create energy.” At Zoom, the teleconference software company, the founder and CEO, Eric Yuan, champions what he has called a “culture of happiness,” predicated on the idea that a happy organization is more likely to develop products that will delight users.
Expansion of opportunities.
Many of the successful ventures we examined didn’t regard their initial market opportunity as fixed. Rather, they pursued two goals simultaneously: first, increasing the total potential market, and second, unlocking higher-quality revenue growth (that is, revenues with higher margins). Chegg, for instance, started as an online marketplace where college and university students could rent or buy used textbooks. Under new leadership, it reframed its mission of serving students with a holistic offer—a web portal that the company originally called the Student Hub—which was designed to address an array of students’ needs (with course schedules, study guides, information on internships, and more). That change dramatically expanded the potential market while also shifting the model from a seasonal sales and rental business with narrow gross margins to a platform business with robust gross margins, higher and more-predictable revenue, and reduced seasonality. Chegg’s story demonstrates how extrapolation entails the creation of a better, more sustainable business model too.
The embrace of inorganic growth.
While early-stage start-ups are relentlessly focused on refining their offers in search of product-market fit, ventures in the extrapolation phase often consider acquisitions as a way to expand geographic footprints (and thus their markets), address talent gaps, add features or functionality, or augment reach in terms of audience, users, or customers. Chegg went on an acquisition spree (buying six companies in 15 months) in order to add features to its Student Hub portal. Though not all those purchases were successful, together they brought in critical capabilities during a period when time was of the essence.
. . .
Our research demonstrates the wisdom of approaching extrapolation as a distinct phase of business development with its own principles, processes, and management requirements. More than half the ventures we studied did so, and they appeared to have a higher likelihood of success.
Managing the dynamics of rapid growth is an enormous challenge for young businesses—start-ups and initiatives within enterprises alike. Once executives understand the fundamental differences between exploration, extrapolation, and exploitation—especially the requirement of not only product-market fit but also profit-market fit—they can confidently navigate the difficult transitions between the phases, make the necessary changes in focus, and adopt the right approach at the right time.
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