In Winner-Takes-All Markets, You Want To Be The 800-Pound Gorilla

by George Levitte

Startups often face difficult decisions surrounding when and how to grow, particularly regarding whether or not it’s necessary to fully validate a business model prior to scaling up. Under most circumstances it’s best to test and iterate over and over again until the model has been validated and the entrepreneur is confident that the startup can scale and eventually achieve profitability.

More specifically, in markets that do not have “winner-takes-all” dynamics (e.g. strong network effects or significant scale economics) it’s important to have validated the model prior to ramping up. Note that this does not require being profitable, but rather just proving that profitability could be turned on if necessary. Startups often refer to “flipping a switch” on profitability, which might mean adding more ads, charging fees for premium offerings, or any of several other avenues for generating revenue. It’s important to test and iterate sufficiently to prove that you have this switch, even if you decide not to flip it on immediately. That is what validation means.

Scaling up before validating the business model is dangerous for various reasons, and in markets without “winner-takes-all” dynamics it’s rarely worth the risk. Hiring more employees, investing in marketing, and building out a large user base all increase overhead expenses. And because these require formalizing business processes such that they can be replicated over and over throughout the company, it reduces the organization’s flexibility and constrains its ability to pivot quickly. So getting big can dramatically increase both expenses and risk of failure. Furthermore, scaling up in this situation heightens the chances that, in the event that business falters, the startup becomes unable to cover its bills by modifying its operations or finding additional venture capital.

However, in markets with “winner-takes-all” dynamics – particularly those due to network effects – scaling before validating the business model amounts to making a bet on the potential value of dominating that market and on the odds of being able to create new revenue sources sometime in the future. Like any educated bet, sometimes this works out and sometimes it does not. For Facebook, Twitter, Quora, YouTube, and several others it worked. Undoubtedly there are many more who tried and failed. But this is not unexpected given the high mortality rate among startups. The real question is whether scaling before validating increases one’s odds of success, and the answer is that it almost always comes down to an educated bet that could go either way. It depends on your specific market, product, customers, competitors, investors, and frankly – a lot of luck. So if your startup competes in a space where the endgame will likely involve one company dominating and all others failing, then getting big quickly can be a huge competitive advantage. In this situation you want to be the 800-pound gorilla, even if you are not yet sure of how profits might materialize in the future. But if your startup is not in a “winner-takes-all” market then keep testing and iterating. Wait until validating the business model before getting big.

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