Investors, founders face strategy conundrum

15/06/2016 - 15:23

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There’s an ongoing debate in the startup community about whether to develop customer-focused businesses or pursue an investor-driven model.

MARKET KNOWLEDGE: There are opportunities for Perth startups in Asia, but finessing a product to match consumer needs will take work.Photo; iStockphoto/xijian

There’s an ongoing debate in the startup community about whether to develop customer-focused businesses or pursue an investor-driven model.

Investors have different priorities from founders. Actually, different types of investors have different priorities, but they all have different priorities from founders.

Investors and founders take a portfolio approach to their businesses. The portfolios have different characteristics, driven by the owners’ different needs.

Investors invest in several businesses simultaneously, in parallel. The portfolio as a whole can tolerate individual business failures, but to counter these losses, the winners from the portfolio need to win big.

A venture capital fund is typical of this thinking – it invests a fixed amount of money over a fixed amount of time. The fund bets on a standard pattern of returns. Most of the fund will fail or make up to two times the investment (‘lifestyle businesses’).

A minority makes decent (10 times) returns. One wins big (100 times) and makes most of the returns for the entire portfolio.

Founders also invest in several businesses in a portfolio, but they invest in them in series, one at a time. The portfolio can tolerate business failures, as long as they’re not catastrophic. The proceeds from one business (if any) fund the next one.

The normal pattern for founders is that the first few businesses experience varying degrees of failure. Failure in this sense means that they don’t scale. Then one succeeds, gets big enough for the founders to never worry about money again. This whole process takes anything from 10 to 25 years to happen.

So the investor needs each business to win big. Investors encourage founders to take bold risks and swing for the fences, because the investor doesn’t care that much if the business fails (and so wants one of the portfolio to go huge).

The difference for a VC between a 10-times and a 100-times business is significant. The difference between total failure and a ‘lifestyle business’ is small.

But the founder wants to limit risks where possible. The difference for a founder between 10 times and 100 times is not huge. The goal is to never worry about money again, which a 10 times business return will do. There are only so many penthouses you can live in. But there’s a huge difference between bankruptcy and a ‘lifestyle business’.

Startups’ style

This difference in outlook drives a dynamic within the startup community.

There are some founders who see investment as an integral part of starting a new business. They judge ideas with the eye of an investor. Is the market big enough? How much competition is there? How defensible is the intellectual property? They don’t care so much about customers because they’re targeting investors. They aim for scale first, then revenue.

There are also founders who see investment as ancillary. The business needs to stand on its own feet first. They judge ideas with the eye of a customer. What problem does this solve? How much will customers pay for it? How can they reach those customers?

They don’t care so much about finding a vast market, as long as it’s big enough to support a business. They care more about finding a market they understand so they can be sure of creating a valid business. They aim for cash flow first, then scale.

So there’s an ongoing debate in the community. If we build safer, customer-focused businesses then we end up with a tiny domestic market. If we go the riskier investment-focused path then we take these huge gambles and risk it all. Because of the lack of investors, we tend to see smaller, safer, startups in the community.

Perth’s geographic position close to Asia is often touted as an advantage; it’s the only Western city in this timezone. But it’s only an advantage if we build businesses that target Asia.

Most of Perth’s startup founders are Westerners; we don’t understand Asian customers well enough to target them.

Building a thriving startup community here will mean solving this problem somehow. Investors will invest in businesses targeting Asian markets, because they’re big markets, and growing. Hopefully they’ll be Perth investors. If not, there’s plenty of Asian money getting funneled into startups.

So we either need founders able to think like Asian customers, or founders willing to take some massive risks. We don’t have many of either yet.


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