Scalable Business Model

What is a scalable business model? Definition and examples

A scalable business model is one whose cost of serving the next customer is small relative to the revenue that customer pays, so revenue can multiply while costs rise slowly. The test is observable: hold the revenue line's gross margin up against its growth rate and see whether cost of revenue grew far less than revenue.

Scalability is a property of a revenue line, not a company

Most companies are a bundle of scalable and unscalable lines, and the useful question is what the mix is and where it is heading. Public filings make this legible because companies must report revenue and cost of revenue separately for each line.

CrowdStrike's registration statement is a clean instance. For the three months ended April 30, 2018 the company reported subscription revenue of $39,758 thousand against cost of subscription revenue of $15,171 thousand, and professional services revenue of $7,531 thousand against cost of professional services of $4,223 thousand. Two lines, two different businesses.

• Subscription gross profit was 39,758 minus 15,171, or $24,587 thousand, which is 24,587 divided by 39,758, or 61.8 percent. The filing rounds it to 62 percent.
• Professional services gross profit was 7,531 minus 4,223, or $3,308 thousand, which is 3,308 divided by 7,531, or 43.9 percent.
• Blended, total revenue of $47,289 thousand less total cost of revenue of $19,394 thousand gives $27,895 thousand of gross profit, or 59.0 percent.

Check the sums: 39,758 plus 7,531 equals 47,289; 15,171 plus 4,223 equals 19,394; 47,289 minus 19,394 equals 27,895; and 24,587 plus 3,308 equals 27,895 as well.

A single blended number of 59 percent hides the fact that one line at 62 percent scales and one at 44 percent does not.

The real test: what happened to cost as revenue grew

Margin level is a snapshot. Scalability shows up in the derivative, and the same filing supplies the comparison a year later.

For the three months ended April 30, 2019 CrowdStrike estimated subscription revenue of $83,800 to $85,600 thousand and cost of subscription revenue of $23,600 to $24,300 thousand, with subscription gross margin of 71 to 72 percent. Professional services revenue was estimated at $9,800 to $10,100 thousand against cost of $5,500 to $5,700 thousand.

Work the growth rates against the prior-year actuals. All arithmetic below is on the filed figures.

• Subscription revenue growth. 83,800 divided by 39,758 equals 2.108, so 110.8 percent growth at the low end. 85,600 divided by 39,758 equals 2.153, so 115.3 percent at the high end.
• Cost of subscription revenue growth. 23,600 divided by 15,171 equals 1.556, so 55.6 percent. 24,300 divided by 15,171 equals 1.602, so 60.2 percent.
• Professional services revenue growth. 9,800 divided by 7,531 equals 1.301, so 30.1 percent. 10,100 divided by 7,531 equals 1.341, so 34.1 percent.
• Cost of professional services growth. 5,500 divided by 4,223 equals 1.302, so 30.2 percent. 5,700 divided by 4,223 equals 1.350, so 35.0 percent.

There is the whole concept in four ratios. Subscription revenue roughly doubled while subscription cost rose by roughly half, and the margin moved from 62 percent to 71 or 72 percent. Services revenue and services cost grew by almost exactly the same percentage as each other, leaving that margin where it was. One line bought leverage with growth; the other bought nothing.

A worked example you can rerun

Scalability is worth modeling as marginal margin, meaning the gross margin on the increment rather than on the base. Using the CrowdStrike figures at the low end of the estimate range:

• Incremental subscription revenue. 83,800 minus 39,758 equals $44,042 thousand.
• Incremental cost of subscription revenue. 23,600 minus 15,171 equals $8,429 thousand.
• Marginal gross margin on subscription. 44,042 minus 8,429 equals $35,613 thousand of incremental gross profit, and 35,613 divided by 44,042 equals 0.809, or 80.9 percent.

Do the same on services.

• Incremental services revenue. 9,800 minus 7,531 equals $2,269 thousand.
• Incremental cost of services. 5,500 minus 4,223 equals $1,277 thousand.
• Marginal gross margin on services. 2,269 minus 1,277 equals $992 thousand, and 992 divided by 2,269 equals 0.437, or 43.7 percent.

Re-check those. 83,800 - 39,758 = 44,042 and 23,600 - 15,171 = 8,429, so 44,042 - 8,429 = 35,613 and 35,613 / 44,042 = 0.809. 9,800 - 7,531 = 2,269 and 5,500 - 4,223 = 1,277, so 2,269 - 1,277 = 992 and 992 / 2,269 = 0.437.

A marginal margin of 80.9 percent on one line and 43.7 percent on the other, from the same company in the same quarter, is what venture investors mean when they ask whether a model scales. The marginal number is also the one that predicts the future blended margin, because as the high-margin line grows faster it pulls the average toward itself.

Mix shift cuts both ways

Scalability is not a synonym for rising margin. Duck Creek Technologies disclosed the opposite dynamic in its own registration statement: because its subscription gross margin percentages were lower than its license gross margin percentages, it expected its overall gross margin percentage to decrease as it shifted focus to software-as-a-service customers. Its blended gross margin percentage also fell, from 60 percent in fiscal 2018 to 58 percent in fiscal 2019, though the filing attributes that particular move primarily to a lower license gross margin percentage, partly offset by a higher subscription gross margin percentage, rather than to the mix shift.

That company's model was arguably becoming more scalable, in the sense that ratable subscription revenue is more repeatable than upfront license sales, while its reported gross margin fell. Two lessons follow.

• Direction of margin and direction of scalability can diverge during a transition. Read the segment lines, not the blended one.
• A high gross margin is not proof of scalability. Upfront license revenue posts an excellent margin and does not recur.

Where it shows up in documents

For a private company, the artifacts are the monthly gross margin by revenue line and the customer-level unit economics. Ask for cost of revenue split the way a public filer must split it, and ask whether implementation, support and hosting are inside cost of revenue or hidden in operating expenses.

For a public comparable, three places in a filing carry the answer.

• The statement of operations, which separates revenue and cost of revenue by line.
• Management's discussion of gross margins, which explains why each line's margin moved. Duck Creek's discussion attributes each move to the specific revenue lines whose margins changed.
• The key metrics section, where net revenue retention and customer counts appear. CrowdStrike reported growing subscription customers from 1,491 to 3,054, an increase of 105 percent, alongside a dollar-based net retention rate of 123 percent a year earlier and 137 to 141 percent at the later date.

Common mistakes

Reading the blended gross margin. A 59 percent blended margin can contain a 62 percent scalable line and a 44 percent unscalable one, and the mix will change the blend without anything improving.

Calling a business unscalable because margin is low today. The marginal margin is the forward-looking figure; a low base margin with an 80 percent marginal margin converges upward.

Assuming software is automatically scalable. Hosting, third-party cloud costs, support and per-seat license fees all sit in cost of revenue. CrowdStrike attributed part of its expected margin improvement to moving operations to colocation data centers from third-party cloud providers and renegotiating a cloud contract, which is a reminder that software margin is engineered, not given.

Ignoring the sales cost of the next dollar. Gross margin excludes sales and marketing. A model with an 80 percent marginal gross margin and a payback period measured in years is not delivering the leverage the margin implies.

How it relates to adjacent terms

Gross margin is the measurement instrument, and the key discipline is to read it per revenue line rather than blended.

Unit economics extends the question below the gross margin line to include the cost of acquiring the customer, which is where a high-margin model with expensive distribution stops looking scalable.

Venture scale is the fund-level consequence. A fund needs outcomes large enough to return the whole fund, which requires a business whose revenue can multiply without its cost base multiplying with it, so scalability is the precondition rather than a preference.

Related tools and reading

• SAFE Calculator
• Carry Calculator
• Best Fund Administration Software
• Best Startup Accelerators