Many companies get stuck on a plateau, unable to grow and burning through cash at a frightening rate. Frank V. Cespedes discusses how focusing on the right customers can generate growth again.
by Sean Silverthorne
Starting a successful business is often considered the hardest thing entrepreneurs do—but growing an existing venture may be even more difficult. Many companies get stuck on a plateau that inhibits their ability to grow: a scale stopper.
Call this barrier the "Devil's Triangle": the place where a company seems weighted down by the bounds of its original start-up business model, a lack of experience by its founder(s), and an accelerating, expense-fueled burn rate through working capital and investor patience.
"Once a venture reaches a critical size, its complexity greatly increases," write the authors of How to Identify the Best Customers for Your Business, published in the Winter 2013 issue of the MIT Sloan Management Review.
“Ineffective opportunity management eventually leads to loss of money, time, and positioning with customers.”
At this point, it's time to identify your core customers and build a scalable platform for growth around them. That's the message from Frank V. Cespedes, the MBA Class of 1973 Senior Lecturer of Business Administration at Harvard Business School; James P. Dougherty, cofounder of the health-care IT start-up Madaket; and Ben S. Skinner III, head of the Atlanta-based consultancy LCS Partners.
The article discusses the importance of understanding your ideal customers; the implications for selling, cost management, growth strategy, and organizational relationships; and a process for putting it all together.
We asked Cespedes to expand on how firms can break free from the grip of what he refers to as the Devil's Triangle.
Sean Silverthorne: Describe the Devil's Triangle and how it can hinder a firm's ability to grow.
Frank Cespedes: We use this as a metaphor for framing the following facts about entrepreneurs:
Fewer than half of US start-ups in the twenty-first century have survived beyond three years. As everyone knows, it's not easy to start a venture that gains traction with paying customers. But it's even harder to grow beyond certain levels of sales: Of the nearly 44,000 firms founded in 2000 and listed in the Capital IQ database, fewer than 6 percent achieved more than $10 million in revenues by 2010, and fewer than 2 percent grew to more than $50 million. The percentages are worse for US and international companies founded in years since 2000.
The increase in angel groups, advent of crowd funding, proliferation of accelerators, and continuation of VC investments have made it increasingly possible to start a business, and in some sectors entrepreneurs were able to attract funds without a real monetization strategy. I agree with venture capitalist David Lee, who said, "It has never been easier to start a company and never harder to build one," and with Dan Isenberg, who notes that equating entrepreneurship with a start-up is not wrong, but is an incomplete picture of business formation. Significant value creation cannot occur without growth, so the failure to scale has social as well as investor and managerial costs. It affects job creation and innovation throughout society.
Once a venture reaches a critical size, its complexity greatly increases. The original business model must deal with new market and organizational realities, and behaviors that established the business are often inadequate for scaling. SG&A (selling, general, and administrative) costs then rise faster than revenues, and resource-constrained ventures are forced to raise a dilutive round of capital, operate in small niches, or go out of business. Our research and advice focus on dimensions within an entrepreneur's circle of influence: how to identify a venture's core customers and the implications for selling, cost management, growth strategy, and required organizational relationships.
Q: Why is it important for companies to select the right customers? Along these lines, what's the difference between what your article terms as partitioning and segmenting a market?
A: Every company, large or small, does things that make it easier for some customers to do business with it and harder for others. Without clarity about core customer characteristics, entrepreneurs will rely on ad hoc approaches to evaluate business development opportunities. Driven by cash needs, they may call this "experimentation," but in effect they tell salespeople to "go forth and multiply!"
By selling to anyone, though, ventures fragment their resources. As customers use it, the venture modifies the product and the activities associated with making and selling it. Selling becomes a function of individual "heroic" efforts, not a scalable platform for profitable growth.
Equally important, this inhibits adaptive learning—a crucial requirement for a venture—and can blind a leadership team to what is actually going on. Effective customer selection requires segmenting a market based on the benefits that customers receive and perceive in the product or service. It focuses on buyers: understanding their problems and opportunities, and how that differs across the potential customer base. But many ventures simply partition markets based on what is identifiable and accessible via purchased customer lists, SIC codes, LinkedIn, Facebook, or the sheer number of cold calls. Sales may be made, but it's the result of a random-walk process analogous to throwing darts while blindfolded at a list of opportunities. With an amenable burn rate and enough throws, the venture will indeed stumble over value, but those "hits" can blind management to the limits of its sales process and prevent scaling.
The results cascade throughout a business. Customer selection impacts operating costs and profit margins; initial sales also influence the venture's trajectory of organizational skills because firms develop capabilities and routines in interactions with customers. There is also an opportunity cost: money, time, and people allocated to customer A are resources not available for customers B, C, or D.
The fact is that, no matter how large or growing a market may seem to an entrepreneur, the venture can add and extract more or less value from different opportunities in the portfolio of possibilities. Ineffective opportunity management eventually leads to loss of money, time, and positioning with customers who are (or should be) core customers. Over time, this process also nurtures the development of "commodity competencies." The venture gets better and better at activities that customers value less and less.
Selecting the right customers, therefore, should be an ongoing topic for founders and investors. But relatively few start-ups (and surprisingly few VCs) clarify ongoing customer selection criteria.
Q: In the article's step-by-step process, you emphasize the "ideal customer profile." Can you talk a little about that?
A: Entrepreneurs usually find that, until they are out there selling, they really don't know the crucial differences between early adopters and others along the relevant spectrum of opportunities. Our ideal customer profile [ICP] is basically a low-cost, practical, and fast process for learning about these differences, incorporating that knowledge into decision-making, and clarifying the possible responses. It has four generic steps that I'll outline here but direct the reader to the article for the methodology and a detailed example:
- Assemble and analyze available data. At this stage, the important thing is examining the variables that align with different customer types. Given the competing priorities in any venture, we've found that an ICP process must come from the top team to be credible and effective. Conversely, the process itself often helps to reestablish a shared vision across the venture about what the company is about.
- Develop preliminary hypotheses. The key here is hypotheses based on criteria and data that the venture can use to test things both internally and in the marketplace. This may sound obvious, but start-ups often try to substitute purpose and passion for cause-and-effect business hypotheses. And, again, there are other benefits. This stage of an ICP often leads to faster decision-making and pivots in a venture where founders and others have strong entrenched opinions about why things have or have not worked.
- Revise and modify the hypotheses. In most ventures, the people with the best understanding of the behavior that distinguishes customers are in sales, marketing, and service; however, the cost implications of customer behavior are often managed by people in operations, product groups, and finance. An ICP starts at the top but involves cross-functional input in discussing the hypotheses and potential responses.
- Communicate the "ideal client profile" and the implications. An ICP typically implies changes well beyond sales and marketing. The example in the article indicates how it led that venture to modify its product features, product line, go-to-market assumptions, business partners, incentive systems, and employee selection criteria. Given the scope of the changes, communication is critical.
Q: What are the most important lessons you hope readers will take away from the article?
A: First, while we focus on scaling for start-ups, established firms have a similar issue. In fact, the global recession has made that issue more visible: production efficiencies have reduced the cost of goods sold at S&P 500 companies, while SG&A as a percentage of sales has not decreased. If you were running a big company, where would you—and should you—look next for a source of competitive advantage?
Second, for entrepreneurs and investors, the article has governance implications. Telling the board that the sales pipeline grew by $X should not qualify as a good answer if the board and founders are serious about good governance and profitable growth. How did the pipeline grow? Did we add lower- or higher-profit and lifetime value customers? Are we targeting shorter or longer selling-cycle prospects? What are the implications for the "center of gravity" in the venture's business model? An ICP process increases transparency about these issues. Investors should require it, and entrepreneurs should welcome it.
Third, even the best ICP process cannot substitute for a flawed business model or a team unwilling or unable to make required changes. But it can do two important things: identify key links in business development activities, and help entrepreneurs better understand the implications of change.
Q: What are you working on now?
A: I'm finishing a book on aligning strategy and sales. I am faculty chair of an executive program on this topic at HBS and have worked with many firms on the issue, and there's a yawning gap here in both theory and practice.
In the United States, for example, the amount invested in sales forces exceeds an estimated $800 billion a year. That's more than three times the money US firms spend annually on all media and advertising, at least eight times the amount spent on strategy consultants, and more than 25 times the amount spent on "hot" topics like online this or that. Yet, while there are now many books and ideas about strategy formulation, there is very little research about how to link strategy with the nitty-gritty of sales execution. In fact, a lofty combination of "reorganizing" and "incentives" is usually the primary prescription if and when strategists even discuss sales.
On the other side, there is a vast amount of anecdotal advice, mainly from consultants and trainers who believe in the universal efficacy of a particular selling approach. But it is typically context-specific and severed from strategic goals.
One result is that, like clockwork every few years, someone publishes a study finding that relatively few—some research indicates less than 10 percent—of even effectively formulated strategies carry through to successful execution and reach their espoused financial goals. And you can see why: strategic direction is essential for sales effectiveness, and sales knowledge of actual customer behavior is essential for ongoing strategic relevance. But the current situation between strategy and sales at many companies brings to mind Gandhi's quip when asked his opinion about Western civilization: "I think it would be a good idea."
So do I. The book provides a framework, examples, and what research does and doesn't tell us about this link, and I hope to discuss it with Working Knowledge when it's published.