Bigger, faster, better? It is in these terms that ‘scaling a start-up’ is usually talked about. The trouble is, just because a company managed to capture a significant market share, it does not mean that it creates value for its employees, customers, investors, and other stakeholders. And who needs companies that do not create value? In our research featured in the Harvard Business Review, we studied companies that have not only achieved product-market fit, but profit-market fit. Companies that actually create value.
Let us take the case of Uber. Launched in the early 2010s, it grew extremely fast and disrupted the taxi market all around the globe, but is still unprofitable ($6.7 billion loss in 2020). This means that they got better and better at finding product-market fit, but not profit-market fit.
Although conventional wisdom (and traditional organizational theory) says there are only two, we think about the development of companies in three phases: exploration, exploitation, and extrapolation. In addition, for us there are three critical milestones: problem-solution fit, product-market fit, and profit-market fit – the key to profitable growth.
Exponentially growing your customer base and revenue is not enough.
At the very beginning, entrepreneurs need to prove that there is a problem worth solving and that they have identified a solution that works. In this phase called exploration, entrepreneurs explore a problem and potential solutions, and ideally find problem-solution fit. Typically, this phase lasts from three to twelve months.
Once a workable solution has been identified, entrepreneurs need to validate that the market that they want to address exists, and that they are able to grab it with their new product. They need to find product-market fit, which they prove by growing their customer base and revenue exponentially. This is traditionally referred to as exploitation.
Here’s the crux: Exponentially growing your customer base and revenue is not enough. To lead a successful business, entrepreneurs need to show that their start-up is capable of generating profit. They need to find profit-market fit. This is achieved when exponential top-line growth is accompanied by scaling economies and the product therefore achieves break-even above industry profit margins.
A business that has found profit-market fit can then focus on fine-tuning its business model. At this stage, growth will happen rather incrementally. This phase is traditionally referred to as peaking/steady growth or exploitation.
The phase from product-market fit to profit-market fit is often overlooked in the literature and in practice.
The phase from product-market fit to profit-market fit is often overlooked in the literature and in practice. Executives have long embraced the idea that companies need to balance exploration and exploitation based on a model originally proposed by JG March back in 1991. While powerful and persuasive, we find that this model misses a crucial transition stage, which connects the search for an opportunity with enterprise management at scale. We call this phase extrapolation. It usually takes 12 to 36 months.
What is ‘extrapolation’?
Extrapolation refers to taking a product that demonstrates uniqueness and the presence of a large addressable market to reach profit-market fit. Extrapolation unfortunately is temporary, first because growth cannot continue infinitely (there is a natural ceiling defined by the addressable market), and second as there will be competitive reaction.
An example of a business that went through a phase of extrapolation and found profit-market fit is King. This video game developer is specialised in social games, and most famous for Candy Crush. Their extrapolation period lasted from 2012 until mid-2013. In the second quarter of 2012, operating expenses were still higher than revenues. From the third quarter of 2013 on, revenues grew faster than operating expenses. A year later, the operating income (profit) grew exponentially.
We studied more than 20 cases of this kind in order to learn what makes certain scale-ups successful. We are sure that for extrapolation to happen, executives need to understand its drivers. This ongoing research has shown that these drivers are mostly internal and relate to the underlying business model of the product.
In a nutshell, extrapolation requires the interplay of three elements:
- Understanding its necessary and sufficient factors,
- Applying a strategic extrapolation process,
- Leading in an ambidextrous way and with autonomous teams.
Understanding the necessary and sufficient factors
A clear understanding of the necessary factors for such a phase to take place is crucial, since companies often start too early or too late. Two factors are necessary, namely a sufficiently large serviceable market, and product replicability and distinctiveness:
- The first refers to the size of the market of customers with similar needs. For example, King was addressing a market made of millions of customers with similar needs.
- The second refers to the ability to serve all customers with the same product without major modifications, such as King’s Candy Crush.
The lack of these two factors makes scaling an impossible task.
Moreover, executives need to know what drivers, or sufficient factors, will make extrapolation happen. We have identified 5 key factors:
- A value-creating monetization approach. This factor means how value is extracted from the customers either directly (by charging a price) or indirectly, by getting the customers to do activities that benefit third parties who pay the price (i.e. advertisers).
- A route to market that reaches customers through direct and indirect channels, converts them into customers, makes them come back as frequently as possible, and finally makes them brand ambassadors.
- Network and density effects that explain how the company can achieve both economies of scale and increase switching costs for all stakeholders.
- Throughput effectiveness in an operating model that can increase throughput while improving unit economics.
- Necessary funding which are the available funds that can be invested and reinvested to fuel further growth. Funding comes from positive cash flows as well as from external sources.
Applying an extrapolation (strategic) process
We also want to highlight the importance of a disciplined application of the extrapolation (strategic) process. It is different from a normal strategic process, as it tries to achieve exponential growth by seeking business model constraints that are then resolved sequentially. We found that successful executives apply a strategy with the following steps:
- Establish a clear and ambitious goal for the first wave of extrapolation (e.g. X10 revenue and X15 Operating Margin).
- Define the critical assumptions (WSBT: What Should Be True) to achieve the goal.
- Identify and prioritize the business model constraints.
- Develop and implement the solution to resolve the first constraint.
- If the constraint is resolved, go back to 3 to move to the next constraint. If the first goal is achieved, then start from 1 again. If the ceiling is reached (either the addressable market is saturated, or the product is no longer unique), then your product moves from extrapolation to exploitation.
Last but not least, we discovered that the culture in successful “extrapolatory” companies is very distinct from the culture in exploration and exploitation. Our research has shown that this culture is a combination of truly ambidextrous leadership coupled with innovative organizational forms that emphasize agility and autonomy in decision-making and execution. Ambidexterity refers to being able to do something just as well with your right as with your left hand. We found that leaders and teams need to seek creativity and disciplined execution at the same time.
Davide Sola is full professor at ESCP Business School and leads the Jean-Baptiste Say Entrepreneurship Institute’s London campus chapter. His research interests are in corporate transformation, entrepreneurship, and applied enterprise economics, with a particular focus on the Scale Up phases of Exponential technologies. Professor Sola is also President at 3HORIZONS, an innovative, tech-led strategy platform provider, delivering strategy activation at Scale.
Jeffrey F. Rayport is a faculty member in the Entrepreneurial Management Unit at Harvard Business School, where he teaches in the School’s MBA and Executive Education Programs, and on HBS Online. His primary focus in teaching and research is on growth-stage technology ventures, and how to scale them.
Martin Kupp is an associate professor for entrepreneurship and strategy at ESCP Business School, Paris, and a visiting professor at the European School of Management and Technology, Berlin. Martin mentors start-ups in various accelerator programs, focusing on positive impact start-ups in emerging economies. In 2019, he helped launch Renaissance Fusion with the objective of bringing fusion energy out of the lab and onto the grid.
Sophia Braun is a PhD student and the head of communications at ESCP Business School’s Jean-Baptiste Say Institute of Entrepreneurship. She conducts research on entrepreneurial thinking and action.