Following up on my thoughts on whether we need a new funding model for starting businesses…
How will venture capital and the broader “funding and business support” ecosystem evolve with a changing business and cultural approach to entrepreneurship and collaboration?
- Businesses are learning that developing a “collaboration strategy” is a key part of corporate strategy (perhaps even a core competence) in a world where collaboration tools are increasingly rich, interaction costs are decreasing, and the “unlocked value” of their firms are increasingly in the heads and opportunities of potential partners outside of their firms (e.g. partners, suppliers, customers, prosumers, fans).
- Younger people (currently the Millennial generation) entering the workforce are realizing that few companies offer them the opportunity to take on the responsibilities and audacious goals that they have grown up believing is a birthright. Instead of accepting the established order, younger workers are establishing their own order, creating companies based on their world view. And by doing so, younger people are demonstrating the potential choices to older non-Millennial generation workers.
Given that, will entrepreneurs and investors in new companies realize that the traditional “grow and sell” economic model of startups and venture capital is a poor fit for this new business and cultural environment?
At the very heart of this thought is a realization that there is a fundamental difference between starting a business based on selling time v. selling a product.
Product-based business can scale with increasing returns (e.g. output, profits) to the basic inputs (e.g. capital, time, people). Time-based businesses, however, scale linearly, with returns limited to the fundamental productivity ratio of outputs to inputs.
Meaning: if you’re getting paid by selling hours of consulting, you are limited in your growth by the number of hours you have, the number of people you can “hire out” or the prices you can charge. But if you sell a product that can be manufactured, replicated and distributed to the masses, your growth is created by and bound to a very different set of constraints, limited to your access to capital, labor and market demand.
For many entrepreneurs, their business ideas are based on selling their most valuable resource: themselves.
In a business and social environment of rising entrepreneurship and collaboration built on increased sharing of the value creation chain, there will not always be opportunities to create scalable, product-based businesses. Many interactions will be based on selling time and not products.
Businesses based on selling time can be easy/hard to start and very difficult to grow:
- Easy to start if they are part-time and not a primary source of income.
- Difficult to start as full-time endeavors without sufficient space (i.e. money, and thus time) to give the company time to grow, since the traditional source of funds to give a company space - venture capital and bank loans - do not find these types of businesses the right investment opportunities for their economic models.
- Difficult to grow because they are fundamentally tied to one’s available time or prices. Scaling by hiring people or developing partners is a typical growth model for these businesses, but it can be difficult to execute when the primary value of the company is largely locked in the entrepreneur’s head and non-transferable skills.
The basic cultural and economic blueprint of startups are built on the idea of “millions of funding, thousands of man hours, and dramatic risk”, leading to a binary outcome set: go big or go home.
Why?
Instead, “not all companies are meant to have thousands of employees or a billion-dollar market cap.” Some people are more interested in the entrepreneurial lifestyle. Outsized financial profits are not everyone’s goal; not everyone wants to commit the time or resources of take the risks necessary to create huge businesses.
And why should that be the goal? Why can’t running a “lifestyle business” be a goal? And why can’t we create a funding model to help give “lifestyle entrepreneurs” the space, time, resources and the opportunities to create valuable, cash-flow based businesses?
Why are entrepreneurs not demanding this type of investment structure? Perhaps because they don’t even know it’s an option.
Fund companies, not startups.
Funding startups is how traditional venture capital makes money. The ecosystem is based on an economic model that demands hyper-growth, clear exit strategies and significant valuation multiples due to the simple need to match risk with reward. Since most startups fail, most investments will be worthless, and thus the “big wins” are a necessity for venture capital to make money.
Instead, fund companies. Fund people. Fund value-creating enterprises regardless of their size or growth potential. Entrepreneurs will not be able to bootstrap all the potentially great ventures out there that do not fit the traditional venture capital model.
What should an investor look for businesses created from this environment of entrepreneurial collaboration? (in addition to the usual management, market, product, etc.)
- Invest in collaboration: collaboration can be a core competence.
- Invest in openness: openness of ideas is a signaling behavior. Openness in sharing ideas demonstrates commitment to the idea and a true understanding of the difficulty of execution.
- Invest in value, not potential: growth is merely an option.
- Think about what risks you want to fund. Technology risk can be mitigated through lower startup and testing costs. Market and consumer adoption risks can be reduced in a “stay small”-type business. Management risks can be reduced by investing smaller amounts of money in more opportunities to “test” more entrepreneurs. Exit risk can be reduced in a business based on recurring cash-flow not aiming for large, risky exits to create shareholder returns.
- Scale attention and time according to the required level of investment and support. Not every company in this model requires a board seat and close interactions.
I admit it’s just a start. But realize that entrepreneurs and investors each have the potential to choose new ways to succeed. Pick the type of success you want to create.
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[1] There is an active debate about this… check out posts by Union Square Ventures and Techdirt to understand the debate.
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If you are focused on managing a fund which invests small amounts into companies and a significant chunk of your investment is going into paying service provider fees, why don't you subsidize those costs with in house accountants, assistants and other related services?
So, the model is pretty straightforward to me, you exchange a smaller amount of cash (maybe just to fund living expense), but provide the needed infrastructure and advice to start the business and focus on generating dividends for the investors and founders as quickly as possible. That can be organized pretty much anyway you want, via standard/convertible debt, and/or preferred/standard equity.
The bigger problem is efficiency. Why, as a manager of this type of fund, want to deal with 20 small companies when you could deal with 4 large ones? That's a major limiting factor and not an easy problem to get around.
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In my mind, an incubator under this model would provide:
1) just enough capital under the right economic and incentive model
2) advice & connections
It strikes me as fairly inefficient for an incubator to provide in-house legal, accounting, etc. when there are so many companies that provide these services on an outsourced basis, and would likely be able to provide it better, cheaper and more efficiently than an incubator.
Providing office space on a co-working model may fit, however, depending on the types of businesses that are being incubated, and most likely in a partnership with an established co-working or flexible office space (I've been thinking about workspaces also, with this article on IDEO's site as an example: http://www.ideoeyesopen.com/assignments/story/w... ).
In any case, what are investors best at? Investors know how to start businesses and provide the advice and connections to enable them to succeed. Getting into the range of services seems to stray from core competencies.
The more important point, though, is around the economic model. Agreed that there are a range of instruments to provide investment capital: the key to me is that different types of investment capital create different incentives to entrepreneurs and are only "economically relevant" for certain types of businesses.
Which simply means be smart in how you (investor and entrepreneur) structure an investment, to make sure it fits your goals (as an investor and entrepreneur).
Efficiency is a concern, of course, and perhaps my biggest. Personally, whether I want to work with 20 small or 4 large all depends on 1) my goals as an investor, 2) what I'm really "providing", 3) how deep I need to provide, and 4) how I'm getting paid. If I'm getting recurring cash flow as returns instead of the promise of a portion of an M&A exit (or at least a mix of the two streams), then it could make sense to me.
I know that doesn't fit the traditional VC model, but that's the point...
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- Maybe M&A strategy is broken? Some might say it always has been ;-) e.g. Yahoo...a web service conglomerate? They haven't leveraged their purchases. Goog has done a better job, using acquisitions as a hiring strategy, that's good. How might larger companies leverage lifestyle businesses, in a perfect situation?
- VC math v. 1987 record label math. Pretty similar (hits subsidizing the rest). A&R focused, "picking the winners" is the core competency. Basically the same w/ VC. Why not turn VC into a service for entrepreneurs...a bank that takes on high risk investments. Consulting, board management, connections...all the things that "smart money" VC's provide could be sold as a service to lifestyle entrepreneurs.
- Ethan
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Do larger companies need to buy lifestyle businesses? In my mind it depends on whether the lifestyle business is selling time or products. Google is perhaps the most recent and well-known example of buying companies to hire employees, but it might be one of the more successful models of M&A.... which points to how hard M&A is to execute.
Perhaps larger companies can use lifestyle businesses to continue to outsource and disaggregate functions? Or simply to replace / reduce the need to hire full-time employees?
Music label and VC comparison is interesting, except 1) music labels take much more control over product than VCs, and 2) music labels make money from recurring cash-flow rather than one-time exit events. Cash flow and operating models very different. Perhaps music labels are more like consumer-packaged goods companies?
"VC as service" is more what I'm thinking, although the term "VC" gives the wrong idea.
The only problem is in the risk / reward structure and the inherent problem in selling services to people / companies that aren't making money.
Let traditional VC fund businesses that require significant capital to fund the positive revenue / no profit run-ramp, and let the "high-risk bank" fund businesses that have less risk / lower rewards.
Perhaps that is just venture debt?
Ultimate goal is to create an economic model that helps people create businesses. High growth / high risk / high reward businesses are not the only option, yet our entrepreneur and startup ecosystem almost dictates that as the goal.
The key difference is whether the entrepreneur & investor economic model is based on recurring cash flow v. one-time exits, because the economic model creates the incentives, goals and cultural expectations.
In any case, all of this is just a part of the entire economic model, just a niche. Question is over how large the niche is and will be.
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making money."
lol
This will take some hacking.
You've posed many more great questions here, I'm loving this. I agree
totally with your idea of "lifestyle businesses" just being part of the
outsourced ecosystem. For any business worth acquiring, there's no
incentive to sell out in the landscape I'm imagining. Also I like the
implications for meritocracy/competition among the outsourced labor pool.
Sooooooo much inefficiency when you're working for a large company. Maybe
this model we're talking about is a way to achieve the effect of "employee
ownership", but in a more distributed way.
I'll have to hit on these other ideas more in a future thought, I'm out of
time as usual!
And really: all that being said, I think our first priority should be to
dream up some new parlance for "lifestyle business", otherwise this
conversation may never get off of taylordavidson.com ;-)
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"VCs invest in potentially disruptive businesses, and disruptive businesses usually need to achieve scale before they can do so. And, more often than not, disruptive businesses do not grow steadily and "earn a living" - they are high risk, high reward and that's precisely what attracts that kind of money."
I guess my thought is that lifestyle businesses will almost by nature NOT be disruptive, and that in an environment of rising collaboration and entrepreneurship, the likelihood of an endeavor being disruptive goes down.
But so what? There is a lot of money be made from non-disruptive businesses, and the more we can help them form, the better business and society will be for it.
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