The Scale Series — Part I: How and why brands overscale

This is Part I of The Scale Series, which explores how brands scale—successfully and unsuccessfully—in the fashion industry.

A person starts a business to grow it. The general goal is to earn some revenue, and then some more revenue, and then lots and lots of revenue, while being profitable along the way. The process of getting there is often called scaling the business, with different definitions of what scale is.

Three types of startup capital

One needs to fund a business to grow it and there are three main ways to do this.

  1. An entrepreneur can use her own money to get started. Unless she is very rich, this often means there is a relatively small amount of capital available to get the business going. Think of what someone would use to open a store in a local town—probably a multiple of tens of thousands of dollars. This is often called bootstrapping. If an entrepreneur starts a company with her own money, she will own the entire company.
  2. She can get a loan from a bank, which will charge her interest on the loan but allow her to pay back the money over time. The interest the bank charges her is often instead of asking for equity. As a result, the entrepreneur still owns all of her equity.
  3. She can raise money from investors, be it angel investors, venture capitalists or institutional investors. This type of investment is almost always in exchange for equity, and the entrepreneur is no longer the sole owner of her company.

Each of these investment scenarios also has a corresponding set of expected outcomes for the business. If the entrepreneur is operating with her own money, she needs to pay herself and her staff, while hopefully being profitable. But the entrepreneur remains the only one setting the expectations for the business. If a bootstrapped company can operate sustainably, everyone earns a good living and the business spins off a profit. In this case, the expectations are relatively straight forward. Although there is pressure to keep a bootstrapped business above water, building a sustainable business is a definite success. The expectations here have both a capped downside (the entrepreneur can only lose the money she invested) and a partially capped upside (bootstrapping often limits the growth rate compared to someone with lots of capital to spend on expansion). Scale, from both a time and resources perspective, is limited. This is not a bad thing, it's just the reality.

Taking money from a bank also has implicit expectations. The business needs to have enough cash flow to pay back the loan on the agreed upon timetable. If a business has a quarterly bank payment of $50,000, it better have that money or the bank will soon own the company. The more a business scales, the more capital intensive it becomes, especially when making physical goods. But as long as the bank is happy, the entrepreneur is free to set the expectations. Besides setting the expectation floor (the entrepreneur needs to make enough money to pay the loan back), financing a company with a loan also leaves the upside mostly uncapped (the company can grow faster since it has access to more capital). Scale, from both a time and resources perspective, is not as limited as bootstrapping, but is limited by the size of a loan the entrepreneur secures and the company's ability to generate cash flow. Again, this is not a bad thing, it's just the reality. (Phil Knight, the founder of Nike, spent most of his autobiography "Shoe Dog" writing about the constant tension from running a business on debt, and it's by far the best read on the topic.)

Taking money from professional investors (venture capitalists, private equity or institutional investors) has the most specific set of expectations. Because venture investing follows a power law, meaning that a very small number of investments make the majority of returns, companies with venture money need to swing for the fences. Power law outcomes are mostly binary, and the performance of a good fund over a bad fund has to do with the success of the winners, not the failure of the losers. A venture investment in a company has a capped downside (the money invested) but an entirely uncapped upside (the potential returns are exponential). A VC can only lose the money he puts into a company, but the potential for a massive payday is always possible. For example, although it was not a VC investment, Linkedin founder Reid Hoffman invested $37,500 in Facebook early on, which grew to be worth over $100 million after the company went public. At worst, Hoffman could have lost $37,500, but at best, which is what happened in this case, he made over 2,600 times his investment. That is uncapped upside.

Neither of these funding methods is better than the other, but each has different implications. A professional investor-backed company has a very different expected outcome than the company funded with personal savings. Specifically, professional investors need their businesses to grow large very quickly.

Post-internet capital

Although venture capital existed before the internet, the emergence of the internet—which fundamentally reshaped the possibilities for scaling a business—energized this new form of private equity. Today, with an investing climate driven by low interest rates, the possibilities are even bigger.

This investing climate is the result of two linked factors. When interest rates are low, investors look for other places to put their money. This usually means a flight of money from the bond market (debt) to the equity market (investing), as investors are looking for a better return on their investment (often known as yield). This leads to an abundance of capital, which makes it very easy for businesses to raise more money to expand more quickly. People will often remark how "cheap" capital is in times like these, as investors are simply looking for places to park their money, and can be much less picky about the conditions of the investment.

Scaling a business

Once a business exists and has some sort of funding, there are two ways a business grows: organically or artificially, the latter of which means the company paid for growth. (Many businesses grow with some combination of the two.) Organic growth means the business has grown on its own without paying to acquire customers. This organic growth is often the result of virality—digital or analog word of mouth—or network effects, which means that a given product becomes more valuable as more people use it (i.e. Facebook or any messaging app). Artificial growth means proactively spending marketing dollars to acquire customers. This could be brand advertising (TV) or direct advertising (Facebook)—or a combination of the two.

Neither of these methods is inherently good or bad, but they are very different. Organic growth, if done correctly, can lead to a great return on investment, especially for a bootstrapped business, since the investment per customer is often zero. (Facebook grew for years with little to no money spent on customer acquisition.) Paid growth can also lead to great returns, but it requires upfront capital to get there and a talented team to make the acquisition math work as the business grows.

Post-internet scale

Both organic and artificial growth existed before the internet, but the internet fundamentally changed the potential scale of a business. A company launching on the internet can reach exponentially more people across the world than it could before. This byproduct is nothing new and has been repeated ad nauseam. What is rarely talked about—and much more interesting—is how this fundamental shift has impacted the expectations for scaling a business, and more specifically a brand. Given the potential windfall—I'm going to be the next Google or Apple or Amazon—loads of people have rushed towards this potential, launching startups, raising boatloads of venture capital and reaching for the stars. The allure of potential scale remains unrivaled.

This mentality, in spirit, is a good thing. The secondary effect of this mentality, however, is that every new startup, and especially every venture-backed startup, should scale infinitely. Since businesses currently have access to an abundance of capital, many are going right to paid growth since securing the money to do so is strikingly easy and the allure of being a first-mover in a lucrative market is very desirable.

Scaling the brand and the business

However, a business and its brand are not isolated. A brand is a promise—it's something for a customer to buy into, both literally and metaphorically. When one buys a Hermes bag, she is buying the promise of immense scarcity and luxury along with (or even more than) the bag itself. The sometimes years-long waiting list for Birkin Bags feeds into this promise, not to mention it starts at ten thousand dollars and goes upwards of a hundred thousand dollars. If one could pickup a Birkin Bag on the corner of 5th avenue, it's no longer the Birkin Bag and Hermes is no longer Hermes. The brand would have defaulted on its promise. If Apple started shipping devices that were as big as a brick and never worked, it would be defaulting on its promise. If Walmart substantially raised its prices, it would be breaking its promise of "everyday low prices." It's impossible to decouple a brand from the scale it operates at.

As a result, scaling a business while keeping the brand intact is very hard. While the internet has rewarded those who are skilled at scaling a business, it has been less forgiving to those scaling a brand. When a brand is first created, it can hold up to anything. If the brand doesn't mean anything yet, it's impossible for it to mean the wrong thing. But once the brand starts to grow from people buying into it, the brand's promise is now established and it will be held accountable. When a brand has one hundred customers it has different pressures than when it has one thousand, and then ten thousand, and then one hundred thousand.

The best analogy I've heard for what it's like to build a company that grows quickly and moves through the rungs of scale is from Airbnb CEO Brian Chesky. From an interview he gave at Stanford:

I think being a CEO in a hyper growth company is every 6 months you have a completely new job. It’s like if you were a pro bowler, then became a pro football player, then a pro hockey player, etc. Every stage is a completely different sport.

Chesky is speaking here about his role as a CEO changing, but the same applies to the company and brand itself. Every time a company grows, its brand needs to weather a different set of challenges.

A brand that grows organically, often via word of mouth, will usually look different than a venture-backed brand that is actively acquiring customers to reach scale. As a very simple example, think about a recent Parsons graduate who is interested in designing experimental eyewear. Compare this to Warby Parker, a company that has raised over $370 million in venture capital and wants to become a multi-billion dollar company. The Parsons graduate's definition of scale might mean dressing a celebrity or a small group of people and having a business that does a few hundred thousand dollars of sales every year, whereas Warby Parker's definition of scale is millions of people wearing its glasses all over the world. There's no right answer; success is relative.

The fundamental paradox of the internet is that even though a brand can technically reach the billions of people with internet connections (the total addressable market), it should not try to do so. Instead, the power of the internet is the ability to reach the people that will care the most about a brand (the target market). That Parsons graduate could try to sell her experimental eyewear to millions of people but it would require her to ignore the people that made her successful in the first place.

Non-commodity brands get into trouble when they try to scale beyond the people that "love" them to people that might just "like" them. Doing so often alienates what excited the original fanbase in the first place. This means that not every business, and more specifically every brand, is meant to scale massively. Some of the clearest and most-concerning examples of brands scaling past their promises take place in the fashion industry, which we'll cover in Part II.

Part II will look at brands that have wildly overscaled their brand while scaling their business. Part III will look at brands that have successfully scaled both their brand and business. Part IV will look at the path forward with a framework for scaling without defaulting on a brand's promise.