Episode transcript:

M.K.:
Alper, last week we were talking about the team’s slide. So today is this fifth principle, right? Hmm. Hmm hmm hmm hmm. And what is the fifth?

A.R.:
Which is. Which is scalability.

M.K.:
Scalability. Tell me about that. What is the.

A.R.:
Fifth? Yeah, the fifth. The fifth criteria. Scalability. And in a nutshell, scalability is the ability to increase your margin, not your revenues, but your margin as as your company grows. And in this regard, in many of the misrepresentations, I also see a confusion between scalability and and growth or high growth. Yeah, I think it’s important to distinguish them.

M.K.:
When you said when you said scalability.

A.R.:
Sample.

M.K.:
When you said scalability, the first thing I thought was either that we’re scaling the revenues or we’re growing the headcount or something like that. But you’re saying no, scalability means something totally different, huh?

A.R.:
Well, we are scaling something, but it’s neither the headcount nor the revenues is actually the profit margin that the company can generate. Okay. And let me tell you more about that. So high growth or growth, for example, is being able to sell more products or sell more services or, you know, expand to international markets, increase your geographical reach, etc., etc., as the company grows.

A.R.:
Yes, those those things can happen. But the biggest difference between what scalability and growth are is let’s say you increase your sales from 10 to 100. But if you’re scalable, that means you’re not going to need to put ten times more effort into increasing your sales from 10 to 100. Okay. Which means as our company grows, you you generate more, more profits.

A.R.:
Yes, it can come in the shape of more revenue, by the way. But it’s not like one unit of production for one unit of sales. So for ten units of sales, I need ten units of production. And this is more visible, especially in the technologic technology startups. They spend a long, longer, a longer amount of time. In the beginning of the project of the company to to improve the project, to iterate, to reiterate, and then come up with with a viable version and one that is done.

A.R.:
You don’t need ten times effort to ink to, to sell to ten times more people. Okay. That’s basically the main difference between scalability and high growth. Okay. Now, why is this important? Yeah. As an investor and why is it important to see it in the investor presentation? Because as an investor, my goal is to be able to exit the investments, which we’re going to talk about in the next episode.

A.R.:
As an investor, my goal is not to remain as a permanent partner or share shareholder of the project. My goal is to invest in a in a in a good time and then exit when the valuation is higher in the future. And we’re going to we’re going to talk about exit strategies or exit possibilities. But scalability directly impacts the future valuation of the company.

A.R.:
So if you’re a scalable project, which means you will generate more revenue, not more profit in the future, which means you will have more margin in the future, then your future valuation is going to be is going to be high. That’s actually the reason behind all those crazy valuations for the technological companies. They are they are valuing, they are putting a value on the future possibilities of the company from today.

A.R.:
So that’s why you have you have those crazy, crazy valuations, because most of the cost associated with developing the product is all that is taken care of. You have a product in your hands right now or a service. If you’re especially talking about the technological companies and all you have to do is reach more customers and you’re not going to put the same effort that you did before, which means you’re going to generate more revenue and more profit with the same level of effort that that’s that you’re putting today.

M.K.:
Okay. So now let let me let me make sure that I’m following you correctly. Go ahead. So I need to show if I’m an entrepreneur and I’m making a pitch, I need to show that not only are my absolute number for absolute profits going up, but the percentage of margin, the percentage of profits are going up. So if I sell one unit, I’m making, for example, 10% profit.

M.K.:
And if I sell 100 units, I’m making, for example, 15% profit. Is that what you’re saying?

A.R.:
Well, I’m not I’m not sure about the percentages, but the main idea is that most of the costs associated with improving the products are are done. The product is is finished. Okay. So in the future, you are just going to sell without putting extra effort into maintaining, not maintaining, but improving the project. Of course there will always be improvements, but scalability gives you the opportunity to have a higher cash flow in the future because your costs of manufacturing or producing the product or the service is not going to be as high as they were before.

A.R.:
You will make more sales, you generate more sales, and since your costs are down, you will also be able to generate more cash flow. That’s that’s actually one of the biggest factors that will affect the future high valuation of the company.

M.K.:
Okay. And so how would I go about representing this on a slide, a meeting with a potential investor tomorrow? I want to represent this kind of scalability on a slide. How would I do that?

A.R.:
Well, one of the common issues that I see with with the investor presentation in terms of the scalability, like I mentioned, was the confusion between high growth and usually scalability is represented with with those concentric circles showing the markets like the addressable markets, total addressable markets and stuff like that. And my recommendation would be not to follow that direction, not to show our first goal is 100,000 people and then we’re going to scale up to 2 million customers.

A.R.:
Okay. My my recommendation will to be to to demonstrate scalability with with data, backing it up, of course, with with research and then show future potential growth, exponential growth, preferably if it exists in terms of the revenue and how it reflects into into the margin. So the margin is what I would recommend focusing on more not not necessarily the percentage of it alone, but also the the amount of it.

M.K.:
Okay. So let’s let’s let’s take ourselves back to our hypothetical example, our recurring hypothetical example, the orange. Orange entrepreneur. Orange juice. Yeah, the orange selling entrepreneurs in Barcelona. Okay, so I’m an orange selling entrepreneur in Barcelona. And so when you mentioned this word research, he’s saying, hey, Matt, go to Google and type in orange selling margins. Is is that what kind of research you’re talking about?

M.K.:
What kind of research are you talking about?

A.R.:
I don’t think so. I don’t think so. And it could be a little more complicated when there is a physical product involved, because eventually you will need to put in certain costs associated with the production of to the the thing that you’re selling. But for example, you might be talking about, okay, the first two years we’re going to invest in a system that will allow us to produce oranges.

A.R.:
For example, at a continuously lower cost. And at the end of two years there will be a perfect system for that. So costs of manufacturing one orange today is, let’s say $0.50 in two years is going to be $0.05. Okay. And after that, it will always remain as $0.05. Okay. But our sell price today is €1, and then it will remain as one, if not decrease.

A.R.:
So suddenly, not suddenly, but over the course of two years. And after that, my margin from one orange will increase from from $0.50 to $0.95.

M.K.:
Okay.

A.R.:
And that could be that could be the research that you might be putting and justify how your cost is going to go down while your revenue stays the same or increases and thus giving you a better margin.

M.K.:
Okay. And tell me again on the from the potential investors perspective, from the potential investors perspective, why does the potential investor consider this important information?

A.R.:
It’s is crucially important information because the only way I’m going to make money from investing in a startup is entering today at a at a certain price and then exiting at a later date at a higher valuation. And in order to be able to make money from my investments, I need the valuation, the future valuation of the company to be higher than what it is today.

A.R.:
And scalability of the margin is one of the main factors that will increase the future violation of the company because it means high cash flow in the future. Now, but does it mean let me clarify that too. Does it mean that if a project is not scalable, it doesn’t. It’s not going to receive any investment? No. It doesn’t mean that a non scalable project is not going to receive investment.

A.R.:
But especially when we talk about low liquidity periods and we are entering a low liquidity period, if not already have entered. By the way, the competition gets more fierce for non scalable projects to receive funding because while not impossible it will be, it will be more difficult. Okay, it is. It’s not going to be impossible. It’s going to be more difficult because the investors will be looking for for future future valuation.

A.R.:
By the way, it doesn’t mean that a non scalable project will have to end as well because you can create a project, you can come together, five founders, you can you can create a team of 20 people and you can create a sustainable company that will that will pay salaries, that will make enough, that will generate enough revenue, revenue to sustain these 20 people.

A.R.:
You can do that, but if it is not scalable, it will just remain as as as a company. So it won’t be very attractive for investors because like I said, my goal is to enter today at X if evaluation, let’s say, and then exit it with 2x3x or five X in the future. And the scalability is going to be the one of the main factors affecting that.

M.K.:
Okay. And we have time for for one more question, and I have one in particular on my mind. So give me an example of give me an example of somebody you can anonymize it. Of course. Give me an example of somebody who did this poorly on a recent pitch deck that you saw, somebody who was poorly representing their companies scalability or non scalability.

A.R.:
If what if we are talking about design terms at the moment, something specific doesn’t come to my mind. But I frequently remember thinking, Well, what you’re talking here is, is growth. You’re talking about high growth. This is not scalability, It is it is attractive, of course, high growth. That is there are no problems with high growth for sure.

A.R.:
But it doesn’t contribute to the to the enhancement of the valuation in the future as much as scalability. What so I think the biggest problem would be not differentiating between high growth and scalability. And usually that’s that’s represented on the slide deck as higher future sales, higher future team, for example, size or reaching a bigger markets under the scalability.

A.R.:
But it’s actually doesn’t it doesn’t have to do with scalability as much as it does with with what the future growth growth of the company. Okay.

M.K.:
And I know that on this topic you could go on forever, but for the purposes of this podcast, we just have a couple of minutes left. So in talking about this subject, is there anything that we’ve left out that you want to mention before we wrap up?

A.R.:
Well, I want to give a big shout out to my third answer from whom I’m learning all this all this information. Yeah, my mentor here in Barcelona. So like all the episodes that we’re talking about, what the criteria is, I would highly recommend connecting with him, following him on on YouTube or LinkedIn because he has an amazing wealth of information on the topic.

A.R.:
So I would I wouldn’t I wouldn’t have a peaceful sleep tonight if I didn’t mention him. So that’s what I’m going to.

M.K.:
Yeah. And I would totally second that It’s I’ve, I’ve, I’ve met Matthew before and he has been doing this for probably longer than any of us have been alive. He knows this subject really well. So so I would totally second that if you that you hit those links or click those links and go check out his videos.

A.R.:
Yeah. We’ll include them in the show notes.

M.K.:
All right. So that wraps it up for for this week. And thank you very much. All right.

A.R.:
I’ll talk to you later.