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by
Reid Hoffman
Read between
June 15 - June 23, 2020
GROWTH FACTOR #3: HIGH GROSS MARGINS
Software businesses have high gross margins because the cost of duplicating software is essentially zero. Software-as-a-service (SaaS) businesses have a slightly higher cost of goods sold because they need to operate a service, but thanks to cloud providers like Amazon, this cost is becoming smaller all the time.
Most of the valuable companies we’re focusing on in this book have gross margins of over 60, 70, or even 80 percent.
High gross margins are a powerful growth factor because, as noted below, not all revenue is created equal. The key insight here is that even though gross margins matter a great deal to the seller, they are irrelevant to the buyer. How often do you consider the gross margin involved when you make a purchase?
Typically, you focus solely on the cost to you, and the perceived benefits of the purchase. This means that it’s not necessarily any easier to sell a low-margin product than a high-margin product. If possible then, a company should design a high-gross-margin business model.
As Jeff Bezos is fond of saying, “Your margin is my opportunity.”
Finally, most of a company’s operational challenges scale based on revenues or unit sales volume, not gross margin. If you have a million customers who generate $100 million per year in sales, the cost to serve those customers doesn’t change whether your gross margin is 10 percent or 80 percent; you still need to hire enough people to respond to their support requests. But it’s a lot easier to afford good customer support when you have $80 million in gross margin to spend rather than $10 million.
Conversely, it’s a lot easier to sell and service 125,000 customers who generate $12.5 million per year in sales and $10 million in gross margin than it is to have to sell and service a million customers who generate $100 million in sales to achieve that same $10 million in gross margin. That’s eight times as many customers and eight times the revenues, which means eight times as many salespeople, customer service representatives, accountants, and so on.
Designing a high-gross-margin business model makes your chances of success greater and the rewa...
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GROWTH FACTOR #4: NETWORK EFFECTS
Market size, distribution, and gross margins are important factors in growing a company, but the final growth factor plays the key role in sustaining that growth long enough to build a massively valuable and lasting franchise.
A product or service is subject to positive network effects when increased usage by any user increases the value of the product or service for other users.
The magic of network effects is that they generate a positive feedback loop that results in superlinear growth and value creation. This superlinear effect makes it very difficult for any node in the network to switch from an incumbent to an alternative (“customer lock-in”), since it is almost impossible for any new entrant to match the value of plugging into the existing network. (Nodes in these networks are typically customers or users, as in the canonical example of the fax machine, or the more recent example of Facebook, but can also be data elements or other fundamental assets valuable in
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Rather than simply imitate specific features, the best blitzscalers study the different types of network effects and design them into their business models.
Direct Network Effects: Increases in usage lead to direct increases in value. (Examples: Facebook, messaging apps like WeChat and WhatsApp) Indirect Network Effects: Increases in usage encourage consumption of complementary goods, which increases the value of the original product. (Example: Adoption of an operating system such as Microsoft Windows, iOS, or Android encourages third-party software developers to build applications, increasing the value of the platform.) Two-Sided Network Effects: Increases in usage by one set of users increases the value to a different set of complementary users,
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With network effects businesses, you can’t start small and hope to grow slowly; until your product is widely adopted in a particular market, it offers little value to potential users. Economists would say that the business has to get past the “tipping point” where the demand curve intersects with the supply curve.
A company can also reshape the demand curve by designing the product to be valuable to the individual user regardless of network adoption. At LinkedIn, for example, we discovered that public LinkedIn profiles had some value independent of the user’s network, since they served as an online professional identity. This gave people a reason to join LinkedIn even if their friends and colleagues hadn’t done so yet.
This is why the best entrepreneurs try to design innovative business models that leverage network effects.
Product/market fit enables rapid growth, while the lack of it makes growth expensive and difficult.
“Product/market fit means being in a good market with a product that can satisfy that market.”
Without product/market fit, it’s impossible to grow a start-up into a successful business.
When you start a new company, the key product/market fit question you need to answer is whether you have discovered a nonobvious market opportunity where you have a unique advantage or approach, and one that competing players won’t see until you’ve had a chance to build a healthy lead.
Most nonobvious opportunities arise from a change in the market that the incumbents aren’t willing or able to adapt to. In many cases, this can be a disruptive technological innovation, but it can also be a change in the law or financial regulations, the rise of a new group of customers, or any other major shift.
Frequently, you won’t be able to fully validate product/market
Designing a scalable economic model isn’t enough if you can’t scale up your operations to meet demand.
One approach is to design a business model that requires as few human beings as possible. Some software companies employ business models that allow them to achieve massive success with minimal numbers of employees.
“Do everything by hand until it’s too painful, then automate it.” Ultimately, even with clever business models and automation, nearly every massively successful company requires thousands or even tens of thousands of employees.
If a platform achieves scale and becomes the de facto standard for its industry, the network effects of compatibility and standards (combined with the ability to rapidly iterate and optimize the platform) create a significant and lasting competitive advantage that can be nearly unassailable. This dominance lets the market leader “tax” all the participants who want to use the platform, much as levies were imposed in the bygone Republic of Venice.
The incredible power of free makes it a valuable tool for distribution and virality. It also plays an important role in jump-starting network effects by helping a product achieve the critical mass of users that is required for those effects to kick in.
Sometimes you can offer a product for free and still be profitable; in the advertising-driven business model, a large enough mass of free users can be valuable even if they never pay for your service.
In contrast, Salesforce.com and other SaaS vendors can sell software licenses in any quantity, not only to Fortune 500 companies, but also to midmarket and small to medium-sized businesses, significantly enlarging their potential market. Internet delivery and self-service allow new forms of distribution that weren’t possible in the packaged software world, such as Dropbox’s viral incentive of additional free storage for referring new customers.
Another, less obvious benefit to this model is that once a subscription business achieves scale, the predictability of its revenue streams allows it to be more aggressive with long-term investments, since it isn’t obliged to maintain large cash balances to weather short-term variations in the business.
news feed pattern. The power of the news feed comes from its ability to drive user engagement, which in turn drives both advertising revenue and long-term retention.
Blitzscaling companies use automation. If they have the ability to perform a task (which is a big if), computers are almost always faster, cheaper, and more reliable than human beings.
“What important truth do very few people agree with you on?”
Brilliant thinking is rare, but courage is in even shorter supply than genius.
Being contrarian is often critical to the process of creating a massively valuable technology company. As we’ve discussed, key growth factors like distribution and network effects tend to provide disproportionate rewards to a company that is the first in its space to achieve critical scale. Being contrarian and right gives you a huge advantage because you get a head start on achieving scale.
Second, we had to rapidly scale a salesforce while we were still developing the product they were selling. This took a lot of hard work on the part of LinkedIn’s CEOs, Dan Nye and then Jeff Weiner, and their teams.
Remember, the objective of blitzscaling is to achieve “lightning” growth despite the increased risks and costs.
To achieve massive success, you need to have a big new opportunity—one where the market size and gross margins intersect to create enormous potential value, and there isn’t a dominant market leader or oligopoly. A big new opportunity often arises because a technological innovation creates a new market or scrambles an existing one.
Why was YouTube at the right time? Networks were finally big enough to stream video. Cell phone cameras allowed everyone to record videos. And the investment environment allowed a very capital-intensive bet.
By jumping into a market where even other Latin American entrepreneurs feared to tread, MercadoLibre was able to gain a head start on the competition and achieve first-scaler advantage.
It’s important not to confuse critical mass with first-mover advantage. Being first to launch in a market might earn you congratulations on being a product visionary, but if you aren’t also the first to scale, you’ll end up as a footnote in a Wikipedia article about your competitor who did.
Another way to use blitzscaling to create a lasting competitive advantage is to be the first to climb a steep learning curve. Some opportunities, such as self-driving cars, require you to solve hard, complex problems.
The world used to have a lot more businesses that were protected from competition by geographic fragmentation—such as regional newspapers and physical bookstores—much like Darwin’s finches on the Galápagos Islands. The rise of both the Internet and the Networked Age has connected those “islands” into a single, hypercompetitive market, with fierce competition for a few disproportionately valuable leadership positions.
The key nuance is that a company’s rate of growth needs to be measured on a relative rather than absolute scale. In a rapidly growing market, a company that grows 100 percent per year might be losing share; during turbulent times, a company that grows 50 percent per year might be gaining enough share to achieve market dominance.
No one truly knows whether the markets will go up or down in any particular year. But regardless of which direction they move, blitzscaling can be a key strategy for capitalizing on the biggest opportunities.
Once you decide to blitzscale, the key question you need to ask and answer is “How can we move faster?” This isn’t simply a matter of working harder or smarter with the same resources. It’s doing things that other companies normally don’t do, or choosing not to do things that they do because you’re willing to tolerate greater uncertainty or lesser efficiency.
One of the major challenges of blitzscaling is knowing when your business is outgrowing your current strategy, and when you need to change course. It’s unwise to wait until you stop growing to make the transition. Instead, you should pay attention to some of the leading indicators that can act as an early-warning sign that you’ve outgrown your strategy: Declining rate of growth (relative to the market and competition) Worsening unit economics Decreasing per-employee productivity Increasing management overhead
Blitzscaling can actually be dangerous when you reach the limits of your market. If you run out of market headroom, all that speed and momentum will come to a crashing halt as you slam into your market’s ceiling.
