3 min read

Unstructured thots on scaling

How should a small business or a business with volatile revenues make investment decisions to scale operations? What role do contractors play in solving the chicken-and-egg problem?

How should a small business or a business with volatile revenues make investment decisions to scale operations?

  • A small business characteristically has capital and time shortages that keep it constantly near survival mode
  • It constantly faces the chicken-and-egg problem of not being able to justify new investments to deliver more volume without having secured the volume in the first place, which it can’t really do without new investments to deliver…
  • A business with volatile revenues alternates between accumulating capital in bountiful harvests and spending down its earnings in droughts
  • It shares the same investment horizon uncertainty as a small business for similar reasons
  • See below profitability benchmark example for wineries in New Zealand, organized by size of the winery
Profitability benchmark for NZ wineries
  • Imagine a small factory that makes breadsticks: If you want to grow it, you’re going to need to find:
  1. New breadstick consumption - let’s assume you can capture more of it with a fancy new product
  2. New breadstick capacity - the part that needs to scale
  • You’ll need to minimize the capital outlay on projects that are one-way high conviction bets, before you’re sure you can capture the margin you lose by contracting
  • If you’re short on capital and time, like most small businesses, these high conviction bets can be existential
  • If you bet the house on a new machine or a new sales team and it works you have broken out of the chicken-and-egg pattern in an impossible to replicate way
  • If you bet the house and it doesn’t work, see below for ‘How do I fix overinvestment?’
  • Any of these new investments needs to return itself in a reasonable period of time after accounting for the cost of new capital to deploy
  • If the return period is unknown or unknowable, this is usually a marker for something that is worth keeping outsourced
  • If the return period is too long, this is usually a marker for an investment that is probably not worth pursuing
  • If the return period is within a reasonably short multiple of a regular operating cycle, the investment is worth prioritizing

What role do contractors play in solving the chicken-and-egg problem?

  • The difference between a small breadstick factory and a large breadstick factory is the number of expensive machines that can make breadsticks
  • At first, you’re probably better off not actually manufacturing any new breadsticks yourself, but producing it through a contractor until you find a market
  • You’ll probably start by selling these breadsticks with a lower margin than if you were a fully scaled-up in-house producer
  • Eventually, you’ll be selling enough breadsticks that you can think in terms of how quickly you can recover $1 invested in new machines through $1 in higher margin for each breadstick sold
  • This should not be a long time otherwise it might be worth investing elsewhere
  • Development time invested in producing software is similarly essentially a capital expenditure - upfront allocation of capital and time to producing a benefit later down the line
  • The equivalent to breadstick manufacturing capacity is the bandwidth in hours of available development time
  • Software development is usually in-housed for core projects that can either generate revenues or can be used internally to drive meaningful savings
  • Smaller or edge projects are better off produced through a development contractor at first
  • Individually, a project might be more expensive if contracted than if it was an in-house team
  • If a team is brought in-house for a specific project and, once the project is completed, maintenance or other new projects don’t fill their bandwidth, the company is losing money and keeping the in-house team is destroying capital
  • Contracting is useful, hard and expensive
  • Contractors have their own fixed costs to cover and will rarely quote on a fully variable basis
  • The advantage of leveraging them upfront is that you can essentially select what level of capital outlay you are willing to risk to retain flexibility to pull out if the project doesn’t succeed
  • The disadvantage is that the more customized or refined the product output, the closer it gets to representing a large existential investment that you wanted to avoid in the first place

How do I fix overinvestment?

  • The klapaucius;!;!;!;! cheat code approach is to jump the gun and over-invest before there is enough volume to feed fixed costs
  • There are only two ways out of having built operational bandwidth too big for the business at its current size:
  1. Fill the pipe
  2. Shrink the business
  • If you run into trouble filling the pipe, the only option left is shrinking the business
  • When shrinking the business, the quickest way to the bone is to ignore the ‘fixed-cost fallacy’ and assume that every single cost item is short-run variable