Startups are not Homogeneous

Dave Bayless identifies five types of startups:

Most new businesses lack a competitive differentiation. They don’t really earn a significant profit; they provide a wage to their proprietors. These marginal businesses — most consulting practices, contractors, cleaning services, restaurants, beauty salons, and the like — make up 90% to 95% of business startups. The cost of launching such a business is low, as is the level of uncertainty. Even though there are a lot of marginal businesses, they tend to come and go without much of a net impact in terms of innovation, wealth creation, or economic development.

Revolutionary ventures are the stuff of legend. Irreducible uncertainty, initial investment requirements, and likely profit are all high. FedEx is a classic example of a revolutionary venture. So, too, was the ill-fated Iridium. (Recall that Iridium had to spend umpteen zillion dollars to launch a ring of satellites around the globe before it could find out if there was actually a market for a new kind of global cell phone. In Iridium’s case, uncertainty was resolved in a rather painful manner.) Revolutionary ventures make for great stories, in large part because they are exceedingly rare.

Corporate initiatives leverage big companies’ ability to tap large pools of capital. The flip side is the requirement for rigorous analysis, exhaustive testing, and stringent financial controls. Of course, all that is very expensive, so corporate initiatives are untenable unless the likely profit is commensurately high. Some economic developers out here in the boondocks can’t help but aim for this big game. But, the truth is, most corporate initiatives are still bagged by the urban mainstream.

Over the last decade, VC-backed startups have captured our collective imagination. Nevertheless, Bhidé makes a compelling case that VC-backed startups have more in common with corporate initiatives than they do with gritty entrepreneurs working out of a garage. Experienced management; a large, growing market; thorough planning; and the opportunity to make a significant initial investment are all desirable traits to a venture capitalist.

The last category, promising startups, is the most interesting to us. Promising startups are very similar to their marginal business brethren in two respects: the initial investment is modest as is the likely profit. However, promising startups differ from marginal businesses in a very important way. With promising startups, there is at least a small chance of a big profit. That’s because promising startups cluster in market niches characterized by technological, regulatory, or other uncertainty. Alternatively, they cater to the “fuzzy” wants of customers — trendiness, elegance, responsiveness — that is difficult to define, measure, or emulate. As a consequence, promising startups face a “heads I win, tails I don’t lose very much” scenario.

In summary, there is more than one kind of startup. Each type is adapted to a different set of initial conditions, which lead to different developmental trajectories. Marginal businesses, while plentiful, don’t have much net economic impact. Revolutionary ventures and corporate initiatives are very rare on the economic frontier. So, from here on out, we’ll focus on VC-backed and promising startups.

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