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Startups: Risk, Growth and Friction

When I work with a startup, typically one of the first exercises I help them go through is a visioning exercise that starts with a simple question:

“How big do you want to be five years from now?”

What matters in the answer is not the first digit of the number, but the quantity of zeroes after it. The mindset of companies that aim to grow to $5M, $50M or $500M in revenue after five years is totally different. They indicate different points in the risk/reward continuum and imply very different requirements for growth speed.

Regarding the risk/reward continuum, when we look for ways of investing our money it is painfully clear that there is no free lunch: you can either buy low risk instruments – US Treasury Bills, for example – and get a low return, or aim for higher returns by investing in things like stocks – with a substantially higher level of variability and risk.

The same is true for companies – some are happy to evolve into “lifestyle businesses” where they will produce enough income to satisfy their owners’ needs, whereas others want to change the world and become a great company. I am only interested in the latter kind – which is why we normally end up with a very steep growth curve drawn on the board.

This leads to several interesting discussions around their business model, including two key elements:

  1. Adjusting their target market to ensure it supports their plan
  2. Systematic identification and reduction of friction sources

 

Adjusting and evaluating the target market

During the startup phase, it is crucial that companies focus single-mindedly on ONE target market, and that it be the correct size – because:

  • Startup companies have few resources, the last thing you want to do is spread them to address different markets. If you think you have resources to go after two things, rethink your strategy and go after only one of them, but do it faster and better.
  • The growth plan needs to achieve a #1 or #2 position in the market. Since five years is typically a timeframe long enough to remove most initial constraints, if this is not the plan it means that the company’s value proposition is not differentiated enough or its competitive advantage is too weak.
  • The size of the target market matters. Since you aim to be #1 or #2, your revenue plan should get you to 15-30% of that market, which is the share that leaders typically have.
    • If your plan takes you higher, say to 60% share, then the target might not be big enough and it might be best to think broader.
    • If your plan takes you lower, for example to only a 3% share, then you might achieve better results by redefining the target to make it smaller, narrowing the focus to those customers who value most your differentiation.

 

Identifying and reducing friction

At the same time, the other element to keep in mind is friction. I call “friction” any element of your business that doesn’t scale up easily – thereby threatening the speed of the growth required to achieve the target.

To find sources of friction, imagine your business growing 10 (or 100!) times over a week and look for the largest gaps it would create. There are many sources of friction. Here are three of the most common ones with illustrative examples:

  • Product friction
    • High friction: A service that requires manual work (will limit growth the speed of hiring more people)
    • Low friction: A product made in a factory (scales much better)
    • Frictionless: Downloadable software from a website (scales almost effortlessly)
  • Sales friction
    • High friction: A direct sales force selling a complex product.
    • Low friction: Sales driven by marketing activities.
    • Frictionless: Viral sales driven by your own customers.
  • Capital friction
    • High friction: Businesses that require building expensive infrastructure upfront to support customer growth
    • Low friction: Models with inventory or capital needs that grow directly as sales or customers grow
    • Frictionless: Companies with a positive cash conversion cycle (since their growth is effectively funded by their own customers)

A key consideration when analyzing a source of friction is to determine whether it is central to a company’s value proposition and/or strategic differentiation in the market. Even though friction is always undesirable from a growth perspective, it might be worth having if this is the case.

Once you identify friction worth eliminating, there are several possible alternatives – ranging from simply outsourcing the process to one or more providers who can scale up as needed, to changing the business model and avoiding it altogether.

When a company is still small, it is easy to fall into “friction traps” because some elements are still distorted at this level. For example:

  • Sales friction might be hidden because the founders do the selling “for free” and don’t include the cost of their time in the analysis
  • Support friction might be hidden because there is no customer installed base
  • Product friction might be hidden because of a belief that only the first customer requires tweaking the product, but future customers will accept “cookie cutter” versions.

So think about your goals: Where in the risk/reward continuum are you? Is that where you want to be? Think about your business plan: Do you have the right balance between differentiation and opportunity size? And think of your plan to get there: What are your sources of friction? Do you really need them? If not, how can you get rid of them?

 

Comments ( 5 )

  • Vinicius says:

    Roberto, what a great article! I have thought about a potential start up in the retail space next year and your approach here ( specially on the friction factors ) was very helpful.

    abrazos

  • Carlos Castillo says:

    Roberto, very good article. The section “Adjusting and evaluating the target market” was particularly enlightening. That’s true rightsizing!
    You’ll hear back from me soon.

  • Glenn Jenkinson says:

    Hi Roberto,

    Thanks for this fine article.

    What growth curve slope do you typically seek for companies that aim to grow to $5M, $50M, or $500M in revenue after five years, respectively?

    Thanks.

    Glenn

    • Roberto Moctezuma says:

      Hi Glenn,

      It really depends on the offer type, business model and other factors (market being addressed, virality of the solution, etc).

      In general, however, the first year is slow as the offer is being finalized and market/product fit is being honed. After that, a successful company will start to scale and growth should ramp up.

      The shape of the curve will depend to a great degree in the amount of friction present. Companies with higher friction (services companies, for example) will tend to have a more linear growth pattern, whereas companies with less friction (software, media/content, for example) will exhibit a more exponential growth curve.

      By the fourth or fifth year, the question of whether the growth rate starts slowing down or continues increasing depends on the size of their target market/degree of market penetration and other elements like customer dynamics (attrition rates, customer acquisition costs, etc).

      If you’d like to talk a bit more about a specific example, feel free to contact me via email and we’ll discuss more!

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