Premature Scaling: The Achilles Heel of Innovation

Innovation is a high priority in almost every company – consulting firms BCG and McKinsey have independently found that 7 out of 10 CEOs consider innovation a top-3 priority.

One reason is that innovation correlates with business success. Many studies have shown that innovation leaders have higher revenue growth and higher margins than their competitors. They also have a higher stock market value.

There is a second reason why innovation is high on companies’ priority lists. Innovation provides insurance against irrelevance. Data shows that the average lifespan of companies is getting shorter. At the current attrition rate, half of today’s S&P 500 companies will be replaced in the next 10 years. It can also be assumed that the Fortune 500 list of 2080 will consist almost entirely of different companies than today.

The ongoing search for new business models is crucial. Innovation managers must insure the company against irrelevance by capturing value through new business models. Companies that regularly renew their portfolio generate more shareholder returns than those that fixate on the business model that made the company great in the past. Six of the world’s 10 largest companies are serial business builders, having launched at least five significant new businesses in the past 20 years.

Yet not all companies see the importance of constantly seeking new business models. One reason could be top management’s relentless focus on day-to-day operations – it almost seems that staff is not allowed to think outside the box. Another reason could be that there is something seductive about success. It lures people into thinking that the future will be similar to the past. Especially with companies that have enjoyed years of success, it is hard to imagine that success will end. But it does end sometimes, as we all know:

• Fortune Magazine wrote a story in March 1998 on “How Yahoo Won the Search Wars,” just six months before Google was founded.
• In 2017, the Guardian asked, “Will MySpace ever lose its monopoly?” In April 2018, Facebook took the lead in user numbers, and MySpace spiralled into oblivion.
• In November 2007, six months after Apple introduced the iPhone, Forbes asked, “Nokia. One billion customers – Can anyone replace the mobile phone king?” Six years later, Nokia sold off the remnants of its unused mobile phones.

Companies regularly need to find a new, sustainable business model. If they fail to do so, they become yet another forgotten company in the S&P 500 statistics. And once the company is under attack, it may be too late for the ship to change its course and build the capabilities for success in a changing environment. Therefore, the search for a new profitable business model should begin long before the existing business model falls into decline. It should be an ongoing process, further helping prepare for unexpected attacks from unknown competitors.

There is one fundamental question on the table for companies: what should we do to create these startups with a good degree of certainty? There are three possible solutions to this:

1. First, the company could partner with external startups or integrate the technology and talent from a startup acquisition. This strategy is not easy. Statistically, 50 per cent of the top talent from an acquired startup has left the company after two years.
2. The second option is for incumbents to acquire innovative, existing companies. After the acquisition, the company would use the acquired company’s technology and personnel to implement the new company’s innovation agenda. This approach is a risky venture. The M&A failure rate is between 70-90 per cent.
3. Third, the company can build capabilities to build businesses. Success in this option depends on the company’s ability to implement a robust framework for validation and scaling and create a supportive environment for new businesses. Statistically, this is the best of the options for organic growth – and organic growth creates more value than mergers and acquisitions.

However, companies have great difficulty creating new businesses from innovation. Theoretically, there is an “unfair advantage”. Established companies in many industries struggle against VC-funded startups. While the chances for an individual “VC startup” to build a sizeable company are low, the VCs backing them have large portfolios and deep pockets. So how should companies with limited portfolios and budgets win this competition?

The answer is to act quickly and smartly by leveraging corporate resources. Large, established companies have a broad base of assets that a VC-funded startup can only dream of. Some of these assets are tangible (physical) assets, such as production facilities and proprietary outlets. Others are intangible assets (e.g. off-balance sheet assets) that can be highly relevant for innovation.

Besides resources and talent, intangible assets can in many cases be the source of an “unfair advantage” in building a sizeable business and accelerating its journey. Access to an existing customer base, for example, can lower acquisition costs and accelerate market introduction.

Unfortunately, established companies do not live up to the unfair competitive advantage. Established companies do well with incremental innovation. Within the proven, existing business model, they manage to achieve great success. But they struggle dramatically when they want to build new businesses outside their core business model. They are unable to turn their potentially unfair competitive advantage into a winning proposition. In other words, companies do well when they repeat past successes, but they cannot create new ones.

The problem of building a business is not one that only large companies face – it also applies to medium-sized companies. The common perception is that smaller companies are better at innovation because they are faster and more flexible in their decision-making and their organisation is less bureaucratic. They are supposed to be closer to the customer and are less tied to existing technology and infrastructure. Moreover, they often have fewer stakeholders. However, a study has shown that company size makes no difference. In other words, smaller companies are not significantly better at building new businesses than large ones.?

For most companies, there is literally a million-dollar question on the table:

Why can’t companies turn their innovative concepts into scalable and profitable business models?

To answer that question, it is important to know why most startups fail. A study found that most startups fail due to “premature scaling”.?Scaling up before an actual businessmodel-fit is established often leads to problems, which in turn lead to difficult discussions about who or what is to blame.

There are understandable reasons why companies are eager to start scaling. The three most common reasons are: thinking they have achieved a businessmodel-fit (when in fact they have not), pressure from top management to get moving, or enthusiasm about the first paying customers.

Often, startups have not yet ticked all the “ready to scale” boxes. In usually, they have not yet achieved “businessmodel-fit” and make typical mistakes such as:

• Overcompensating for a missing businessmodel-fit with marketing spend
• Spending too much on acquisition (before finding a repeatable and scalable sales mechanism)
• Investing development costs and adding nice-to-have features to keep initial customers happy
• Hiring too many staff too early
• Over-planning and brute-force execution without feedback loops

Premature scaling is not just about putting significant funding at risk. It is also about the level of success, with 93 per cent of premature scale-ups never breaking the monthly revenue threshold of 100k. Startups that start scaling up after they are actually “ready to be scaled up” grow 20 times faster than premature scale-ups. For this reason, I want to dedicate my next blog post to:

How to achieve businessmodel-fit?

If companies want to grow into a durable and profitable organisation, they need to know how to achieve a businessmodel-fit with the least amount of risk. Additionally, they need to correctly identify when this milestone is achieved. That way they avoid failing at the consequences of premature scaling.

Sources used:

• The book "The Lean Scaleup" by Frank Mattes