Saturday, January 22, 2011

Is there too much emphasis on scalable startups?

Enterpreneurs, especially technology-based ones, are encouraged to "think big" and build startups that have the potential to grow to an enormous size. Steve Blank, the father of the Customer Development process, calls these types of business "scalable startups". As he puts it, "A 'scalable startup' takes an innovative idea and searches for a scalable and repeatable business model that will turn it into a high growth, profitable company. Not just big but huge. It does that by entering a large market and taking share away from incumbents or by creating a new market and growing it rapidly."

By definition (and as Steve says in the very next paragraph), "A scalable startup typically requires external 'risk' capital to create market demand and scale." This is the very definition of the role of conventional venture capital: Invest a large amount of money in a startup, with the hope that the business will grow big enough to exit, either through an acquisition and IPO, and pay the investors a huge multiple on their original investment.

Steve calls the alternative to a scalable startup a "small business", while venture capitalists have a more derogatory name: "Lifestyle business". These businesses don't have the potential to become huge (with equally huge valuations), and are therefore bad. Or are they?

Somewhere between a "mom & pop" business like a local hardware store or restaurant and, say, Facebook, there are a lot of businesses that have the potential to grow into valuable companies that can be sold at a good multiple, but don't have the potential to be "huge". In software, there are development tools, utilities, and vertical applications that can be significant businesses. On the Internet, there are countless online services that could grow into significant businesses and be acquired by larger companies. These opportunities are right in the wheelhouse of angel investors.

Consider a startup that an angel invests $100,000 in and ends up being acquired at a 20-to-1 multiple. The angel walks away with $2 million. To a venture capital firm, that's not even worth wasting time on, but it's a good return for an angel. Compare that to a VC that puts in $1 million to get a $20 million return. The VC's financial exposure is ten times as much, and the probability of getting back $20 million is lower than that of the angel getting back $2 million.

Obviously, any angel would give their right arm to get the return that Peter Thiel got from Facebook ($500,000 invested for a $1.7 billion valuation of his share of the company as of last November, and undoubtedly, more now.) However, the odds of that kind of return are incredibly long, even for the best VCs. The new model is smaller investments in more companies at earlier stages. The larger number of investments, and their small size relative to historical VC investments, compensates for the higher risk of seed investments, as well as lower absolute rewards if and when the companies exit.

To be clear, a startup that has no hope of an exit with a 10X to 20X return to investors won't get funded by angels, let alone VCs. Those businesses have to bootstrap and/or call on "friends & family" for financing. However, there are a lot of "non-huge" startups that can still exit with a good return on investment, and dismissing them as "lifestyle businesses" means closing off a lot of good opportunities to make money.
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