How to scale?

This article sets out a simple formula that defines how businesses scale, the phases that businesses go through and then highlights the "danger zone". The danger zone is period that most start ups pass through and it is a time when many businesses fail. The article then diagnoses a major mistake that many entrepreneurs make in the danger zone (especially in alternative credit), and proposes a way forward.

This article was previously published in two parts on www.altfi.com, see Part 1 and Part 2 for the original article.

PrimaDollar is a global trade finance platform that is scaling quickly. A key question from all our stakeholders is: “How are you managing to scale?”.

How to scale is the major challenge for all start-ups.

The general formula for scaling up

There is a simple formula that explains the scale-up process, “SECA”:

S = (E x C) - A

S          is scale

E           is enquiry volume

C          is conversion rate

A          is attrition

What does this formula mean?

We want to grow – that means we want to make scale bigger.

We can do this provided enquiry times conversion is greater than attrition.

• Attrition: These are customers that we won previously but which are no longer active or leave the business. Attrition makes the business smaller and is a factor in every start-up. You have to beat the attrition rate to grow.
• Enquiry x Conversion: The volume of enquiry is the number of potential customers entering the sales funnel – the number of potential customers coming through your door. The conversion rate is the percentage of this enquiry that you manage to turn into business.

Of course, every business needs to ensure that attrition is minimised and that existing clients are looked after in order to boost their engagement. But these activities generally make a small difference to scale when a business needs to double or treble in size to gain traction with investors.

If we want to scale quickly, either we have to make enquiry bigger and/or we have to convert more. There are no other ways. Understanding this relationship is the key first to understanding how to scale, and then second how to scale safely.

General phases of development

Start-ups go through four main phases of business development. Moving from one phase to another often involves a “pivot” – a pivot is a usually a change to the business model or change in the mode of operation.

1.      The early months: start-up

Address a big market need, at the right price, and in the right way – you have a great opportunity. The early months are spent in price discovery, product design and designing product delivery systems. Where can your product be priced so that people will buy it? What kind of people should want to buy your product? How do you reach these people? How should the product be delivered in practice?

2.      Proof of concept

In this phase, enough has been built to go out to the market and trial the products. Ideally some good initial level of business is done, and a number of complete cycles of the product are achieved to validate that customers understand the offer, price points are checked, legal documents work, the path to purchase is clear, and the business works.

3.      The danger zone

Moving from proof of concept to initial scale is the most dangerous phase, and where most businesses go wrong. Funds are raised to “scale the business”.

This phase typically involves generating sales momentum in a situation when:

• Probably only a small part of the potential “addressable” market is actually being addressed; you do not have the cash to spend on marketing nor the cash to hire all the people that you really need to do everything 100 per cent.
• Your product is probably not deliverable in a fully convenient form as systems are not yet complete; customer service is not automated nor as smooth and online as it should be.
• Your costs are high because you do not have the track record with suppliers to buy in bulk or to demonstrate that risks are predictable.
• Your brand is largely unknown and customer trust is not yet built.
• Your shareholder base is still probably friends and family.

The SECA formula explains what needs to happen. Scale comes from increasing conversion and / or boosting enquiry. There are some business models where increasing conversion is a good way to make progress – for example, in the payments space or an online retailer.

But there are also situations where increasing conversion is dangerous. This is particularly true with credit platforms, which remain at the heart of the alternative finance market. If you are in the credit business, whether this is with your own money or with other people’s money, increasing the conversion rate means taking on business that you might normally turn away. This is a high risk strategy and a dangerous step to take.

The golden rule in credit is to reduce the conversion rate as you expand, and target scale through increasing enquiry.

The danger zone is where many start-ups fail.

4.      Path to profitability

Out of the danger zone, and institutional investors are keen to talk.

A business which has moved out of the danger zone looks more like this:

• The business is growing and this growth is driven by enquiry
• The cost of generating enquiry is lower than the value of the customers that are being converted
• The product is priced at its scaled-up level, reducing attrition and adverse selection
• Costs reduce as track record and credibility builds with suppliers
• Stability emerges as the number of clients and markets grows
• Fixed costs become spread over larger volumes of business

The potential for profitability moves into sight.

How do I scale up both quickly and safely?

The SECA formula rules the process. The best start-ups shorten the danger zone or even step over it completely.

The danger zone: the example of alternative credit

A good way to illustrate the danger zone is to consider a credit business or a lending business. This could be a balance sheet business like PrimaDollar, a peer-to-peer platform, or even a regulated business like a bank.

There are two big traps in the danger zone. Both traps relate to the conversion rate.

These two traps are:

A)     Push the conversion rate and write marginal business; typically this means more risk for less reward.

B)     Fail to manage adverse selection; filters on new business have to be more resilient to cope with the fact that early customers can simply be more risky than they seem.

The traps are real in the danger zone. At this time, the start-up or early-stage business is under pressure to grow, but it lacks the market reach, the deep pockets and the reputation. This means that generating more enquiry is difficult and relaxing the conversion rate becomes a major temptation.

Let’s look at these two traps in turn:

A)     The marginal business trap:

If enquiry stays the same and a credit business scales, then the conversion rate must have gone up. The credit business has most likely taken on more risk, and just at a time when it is ill-equipped to deal with it.

There are a number of ways in which businesses might convert more enquiry, some of which are not obvious:

• flex the product design and / or go into new markets;
• compromise on the underwriting principles or take short cuts; this is easy to do if controls are yet not fully established
• fall into the trap of thinking that credit risk is someone else’s problem (for example, your funders, your credit insurers, P2P investors)
• smoke your own stuff – assume that your algorithms and smart systems are capable of underwriting the business that the banks and others have turned down

All of these routes are nearly always going to be fatal. A credit business that scales up without generating more enquiry is simply taking more risk.

If you would like to discuss examples or case studies of businesses that have gone wrong in the danger zone, please get in touch with me directly.

The only way to scale safely is to generate more enquiry.

B)     The adverse selection trap:

At this development stage, costs are usually higher than they should be. Selling with a positive gross margin is essential, otherwise the more you sell the more money you lose. 

But selling with a high price can result in the enquiries being contaminated with adverse selection. Adverse selection means that your business is being sought out by poor quality clients. This happens if your proposition is targeted by, or is only attractive to, customers who have a higher risk (“adverse”).

This makes sense. Customers who are ready to pay an above-market price for a service are likely to be doing so for a reason. In a credit business, that reason is usually because the risk involved is high, perhaps higher than it appears on the surface. Moreover, this kind of customer is also the most likely to be getting in touch, and / or to be most enthusiastically responding to sales teams who are under pressure to delivery results.

At small scale, adverse selection may be invisible. But as a business starts to grow and cash starts to cycle back and forward to customers, buried risks can start to emerge.

Here is the catch:

• Keep the price high and you get adverse selection.
• Price the product low to obtain a representative flow of enquiry, and you make less money; you might even lose money on trades, and you can easily run out of equity before reaching critical mass.

In our view, the right answer is to set the price low – and this may seem to be counter-intuitive. Whilst this approach has a risk, pricing low can move you quickly out of the danger zone or even avoid the danger zone altogether.

A lower price results in less adverse selection and can boost enquiry. At PrimaDollar, we call this strategy: “tomorrow’s price today”.

How do I scale quickly and safely?

Jump over or shorten the danger zone by following three simple rules:

• Rule 1: Scale by increasing enquiry and not by converting more
• Rule 2: Scale-up in line with enquiry; if you scale faster than enquiry, investigate how this is happening
• Rule 3: Monitor adverse selection, use the strategy “tomorrow’s price today”

These three rules will get you onto the path to profitability.

What should investors look for?

A lot of peer-to-peer platforms, alternative lenders, and new credit providers have been set up in recent years all over the world. Many are looking for capital, whether from retail investors or institutions, both debt and equity.

But many of these platforms are not scaling safely. Moreover, there are platforms that have seemingly scaled up but have not moved out of the danger zone, even if they are already sizable. Issues can be buried if lending is long.

Critically examine the business and apply the rules:

1)     Is this business scaling by increasing enquiry or by compromising on conversion rates?

2)     Is the business scaling faster than enquiry, and if so, how?

3)     Is this business correctly pricing its product, and also managing adverse selection risk?

How do these rules apply to PrimaDollar?

PrimaDollar’s market opportunity provides a way to implement these two rules, and with a trade finance solution that turns full cycle every 90 to 120 days, issues become visible very quickly.

1. Our addressable market space is global trade, which we can address with a single, standardised product, without significant geographical restrictions. This means that we can increase enquiry simply by carefully expanding our footprint. We do not have to compromise on conversion – we can scale by boosting enquiry.
2. We have accessed low cost capital markets financing; this means that we can economically offer a low cost product. We can already offer “tomorrow’s price today”.

Of course, execution is challenging - it is a challenge in every business. But we are moving forward with every chance to get it right. We have moved out of the danger zone using these principles.

What about other types of business?

Other types of business should also remember the simple “SECA” formula:

S = (E x C) - A

Some of the dangers of adverse selection and increasing conversion rates may not apply to non-credit businesses. But the basic principle that a business cannot scale materially faster than its enquiry rate broadly remains.

Dealing with that issue and adopting a “tomorrow’s price today” strategy is brave, but probably the only real way to shorten the danger zone and get onto the path to profitability.