What a Startup Is and Isn’t
The word “startup” is so broken today. It’s a cheap catch-all for any new business. Or at least it seems like that from the flippant use of the label. Suddenly, your one-off coffee shop around the corner is a “startup.” And so is that freelance software engineer who works from home doing on-demand app development. Or the new barber shop that popped up last week that uses a mobile app to “revolutionize the world of haircuts.”
I’m not here to denigrate new services or to be some startup snob. New businesses are fantastic! They can provide valuable services or goods for consumers. But “new” is not the definition of a startup. Put another way, not every new business qualifies as a startup.
And for that matter, “big” also isn’t the correct definition. Let’s say you start a new chain of restaurants, and for argument’s sake, you somehow are able to launch 30 locations nationwide. Sadly, that’s still not what a startup is. Let me tell you why.
Adding discipline to the definition
A startup is a business designed to grow fast. More specifically, it is designed with two things in mind: 1) to provide something that lots of people want, and 2) to serve or reach all of those users quickly and flexibly. That means the fundamental DNA of a startup is different.
Now let’s go back to the restaurant from earlier. While it might appear to be a high-growth business, it ultimately still fails the startup definition test. Let’s assume that lots of people want to eat at this restaurant. That forcibly fulfills the first condition, but it still fails the second. No matter how many restaurants you open, you’ll always be bottlenecked by the physicality of the business. You only have so many hours in a day. And even if we suppose that every minute could stay operational, you’d still have unserved customers. The size of the restaurant seating is limited. The amount of inventory is also a constraint. You can’t control for the length of time diners spend, and in fact, the longer they spend, the worse off the business may be (since other paying customers can’t eat there due to limited capacity).
A startup is designed to grow big and fast.
So the only options for growth are to renovate your restaurant to a bigger size or to open another location. But you can’t open it too close by, because then you’d cannibalize your first location’s business. So you open the new location in a different territory. Except that new site also has the same problem as your first. See the problem? It doesn’t scale. No matter how many locations you open, each location can only serve a max number of customers per unit time. Growth is linear (at best), and correlated with the number of physical locations you have.
I’m not arguing that startups don’t have constraints. In fact, most startups are very restricted by virtue of their materials, tools, money, talent, or time. But what makes a startup a “startup” is that it is designed — from the start — with a business model and operational strategy to grow fast. Let me say that again: A startup is designed to grow big and fast.
Understanding growth rates and scale models
If there’s one absolute metric that startups should care about, it is the growth rate. That can be the growth rate of revenue, adoption, users, or any other measurement. But the key is that the growth rate must not be limited by the design or structure of the startup model. Get growth rate right and everything else will fall into place. Let’s use examples to make the point.
Your first business is the restaurant I mentioned. In its maximum case, each location can serve 1,000 customers a day. Assume the average diner spends $50 per meal. And that you have 100 locations. That means on your best given day, the business can make 1,000 x 50 x 100 = $5 million. I’m not saying that’s a small business. Each year, you stand to make 5 x 365 = $1.825 billion (assuming no differences between weekend and weekday demand)! That’s a successful and big business that serves a lot of people! But it’s not a startup.
If there’s one absolute metric that startups should care about, it is the growth rate.
Now let’s assume that the food there is so good, that in the second year, the total demand jumps threefold. So now, you actually have demand from 3,000 customers a day. But too bad, your location can only handle a maximum load of 1,000. (Remember?!) What are the other 2,000 to do? They have to wait. Take a reservation. Drive to a different location farther away. The scale of the restaurant is directly constrained by the number and size of each location. In this case, more demand does not necessarily translate to proportionally more growth. Because the service model is the bottleneck, you’d have to spend a lot of time building new locations. So in the short run, the even though demand has increased by 3X, your practical growth rate year on year is far smaller than 3X.
Scale effect and disproportionate value capture
Now let’s take an example of a website that plays music. The subscription is $10 a month for unlimited listening. At first the site only has 100 users. And in the best-case scenario, let’s say only 50% of users are subscribers, while the rest just use the limited free membership. That’s a meager 50 x 10 = $500/month revenue. In the first year, the music site can only make 12 x 500 = $6,000. By comparison, this is nothing to the restaurant business. Yet this is a startup.
Here’s why. As more users start to participate, the growth rate dramatically changes. Sure, more users drive up more compute and network resources. But the users also drive up revenue disproportionately too. Why? Well, simply because the business model and operational structure of the music site allows it to do so. Let’s take a look. Let’s say in the second year there are now 300 users per month. Still, only 50% are paying subscribers. So that’s 150 x 10 x 12= $18,000 revenue. The growth rate, year on year, was 3X what it was a year ago!
In the short run, it doesn’t matter if the whole world’s population wants to eat at the restaurant. The business and operational model can’t scale up quickly enough to serve the customers and capture value. Meanwhile, if the whole world wanted to consume music from that music streaming site, in relatively short time, enough compute resources can be spun up to meet those needs. And even at 50% paying conversion, you’re still going to be making money that is orders of magnitude greater.
And that’s what a startup is: a business that is designed to scale quickly in a short amount of time.