I find myself returning frequently to the concept of (tech) small businesses versus startups. This is partly because it seems everyone in the ecosystem — founders, businesses, suppliers, partners, investors and larger stakeholders (government) — seems to forever be confused about the differences.
At the same time, we’re seeing a huge rise in tech businesses who are looking to take a non-traditional pathway. These tech businesses often struggle to understand what they are, what they want to become, and how to navigate challenges like funding (including whether they should take it at all).
It can also be hard to understand your role within a sector that celebrates funding rounds above practically all else (see also: growth of revenue over signs of profitability).
I’m not going to rehash my views on the basics, that’s covered in my recent post on the small business vs startup differentiation. I guess this is my ‘next step’ on that view.
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Caveat on this post: here I’m talking about tech or tech-enabled businesses. Sometimes the same description is used for other industry segments and can vary!
Defining different business styles
Small businesses and startups are already covered in the post I mentioned above, but in short, startups:
- Are high growth — in the early days, you expect huge growth month-on-month;
- Are high risk — most of the time, they die, they don’t struggle along, they just die; and
- Go big or die — if successful, a startup becomes Facebook or Google (or exits along the way), if not successful, it goes to zero and everyone is unemployed.
Small businesses don’t have that profile — they usually grow at a smaller rate, have a lower risk profile, and aim for comfortable profitability and growth over time rather than growth at all costs. Lifestyle, bootstrapped and indie businesses are subcategories of small business.
One of my most hated terms is ‘lifestyle business’ because people seem to use it interchangeably with ‘bootstrapped business’ or ‘indie business’.
A lot of people see any tech company that isn’t profitable with a multi-billion-dollar value to boot as a ‘lifestyle business’, and I actually consider that an insult unless that’s what the business actually is or wants to be.
I define a lifestyle business as one where the founder(s) are building a company to have a small profit (in relative terms) that pays for them to work as little as possible on the business. It’s realistically a subcategory of small businesses.
It’s the quintessential dream of the person who wants to travel the world and not need to do much work.
Typical ‘lifestyle businesses’ are things such as drop-shipping e-commerce companies or affiliate sites, where once the flywheel is spinning they usually need minimal intervention to run and operate.
A lot of the people I know who are into this kind of company will often have five or six different revenue streams, where they might add up to $100k in annual profit and have some volatility, but they have ‘spread their bets’ a bit in case a big Google algorithm update wipes out one of their companies or something.
I hate the term because people often say I run a lifestyle business. Yes, I have flexibility in how I work and operate, but I like working! I am an unashamed workaholic and I’m generally not very comfortable with any level of success, as there’s always an opportunity to do better as a business and for our customers. On a technical level, we also aren’t exactly the kind of business that involves no work or intervention.
A bootstrapped business is one that funds itself mostly out of its own revenue. This is increasingly common in software-as-a-service, where (if you charge enough) you can grow organically alongside your customers. Typically these are more ‘small business’ (in growth and risk profile) than ‘startup’.
Initially, a bootstrapped company was also seen to be one that never raised any funding, but in reality, many of the celebrated bootstrapped businesses actually have taken funding (Buffer, Wistia and Basecamp for example). Others, of course, don’t (Atlassian and Mailchimp famously at the big end, but also Envato in Australia), or at least not at the start.
The reality is though, on the whole, a bootstrapped businesses will take a relatively small amount of capital (if any) upfront, to get the revenue flywheel spinning and then self-fund from there.
In a lot of ways, the ‘indie business’ term is an iteration bootstrapped business. Indie businesses in tech are often the ones that will do an early seed round, and then fund growth from revenue. Their growth profile is usually a lot smaller than a ‘traditional startup’ and their expectations are never to swing for the fences — instead to produce a stable profitable company.
Typically indie businesses don’t need a lot of capital to get going (like a bootstrapped company) or operate. You don’t see (m)any of these businesses who are launching hardware products or doing ‘deep tech’, but there are tons of opportunities in software, for example.
Equally, it seems we’re already starting to see confusion as to whether an indie business is more lifestyle-oriented or not. In my view, they aren’t, even if they have some similarities.
Understanding how venture firms work
We love to celebrate big capital raises from businesses in tech (mostly startups). The bulk of the capital comes from venture firms, but I often have to explain the business model of a venture firm to founders.
Venture firms are the petrol on your business’ fire. They are the fuel for growth (at pretty much all costs) and the ultimate aim is that your business either blows up and is written-off to $0 or smashes a home run and returns 100x or 1000x the money they put in.
This is necessary because of two things.
1. Most venture funds have a 10-year lifespan.
A typical venture fund (in Australia or elsewhere) has to both invest and return all its capital in a 10-to-12-year lifespan. That means they spend the first three or so years finding investments, and the remainder following on investments or getting companies to the point that they can exit. This means you will need to have some kind of exit pathway for them. Unlike what some say, I don’t think you need to have an ‘exit plan in mind’, but they need to be able to see how the company might return capital — and a lot of it.
2. Venture firms are illiquid and high risk, so have high return expectations.
Venture firms have their own investors, and those investors have their money locked up for (up to) that 10-to-12-year period.
They (practically) can’t pull their money out even if they want to.
As a result of that illiquidity, venture firms have to return a lot of capital. The typical internal rate of return (otherwise known as IRR, which is essentially the amount per annum in ‘interest’ the investor should expect on their investment) promised is 25%. Imagine putting your money in a deposit account you can’t touch for 10 years, but it goes up at 25% each year.
This, when combined with the fact startups are high risk (many go to $0), means a typical fund that invests in say 15 companies will have between one and three who return the bulk of the fund (100x money back), five to seven who return roughly what they put in or a small multiple (one to five times), a few who return a little bit more (somewhere between five and 100 times), and then probably seven to eight will return $0.
The business of venture capital is to find those three investments that can both return a lot of capital and do so within that timeframe, and then keep focussing on doubling down to get the best result from them. Everyone who they invest into needs to have the potential to end up like that.
Over time, more information is gathered (for example, how the market responds to the company), and the level of confidence of whether you will be one of those companies is adjusted. If it looks like you aren’t going to be one of those companies, you’re pretty much dead to the firm — they need to focus their resources mostly on those big home runs, as while a three or five times return might be life-changing for you, it won’t help the fund much (those smaller returns usually balance out the ones that return $0).
Understanding how angels work
Some angels have similar views to venture capital firms: they want to find the investments that swing for the fences.
After all, given it’s illiquid and high risk, you may as well play in smallcap listed equities (high risk but at least vaguely liquid) or put your money into index funds for a 5-8% p.a. return that is (relatively) ‘safe’ and liquid.
Others are a bit different, and invest because they just like the journey or the fun. A 100x return is, of course, welcome, but a smaller return is still great and they enjoy the journey. Investors who are previous founders usually are more about the journey than (just) returns.
A small number of angels take this to the extreme — they actively look for lower risk investments that are still illiquid (such as early-stage tech small businesses or indie businesses) but will slowly pay them back over time via dividends from company profits.
When you talk to an angel, ask them about their investment strategy. They may not have as clear an answer as a venture firm, but they should be able to tell you the types of companies they look for and their typical return expectations. A good question is always: ‘What other companies have you invested in?’ Then go home and google them afterwards.
There is nothing worse than having an angel who thinks you are trying to smash for the fences but you instead want more of a bootstrapping or small business profile. There is good friction (investors and boards should challenge founders, not just be ‘yes people’), and bad friction (they are trying to force you to be what you don’t want to be).
New models are starting to evolve in the space between angels and venture funds, like indie.vc, ‘venture debt’ and a whole lot of weird and wonderful instruments to give downside protection for investors along with upside, but retained optionality for founders. I suspect we’re going to see a whole lot more soon.
Know what you are and what you want to be
The biggest thing I say to founders is you need to know what your business currently is, and also what you want it to be.
The ‘current state’ isn’t changeable, but you should know if you are growing like mad or just growing along at a low rate, or struggling to grow and still trying to find any kind of early product-market fit.
The future state you do have some choice in.
I say ‘some’ because one of the saddest things is when you meet a founder who wants to have a big venture-funded startup journey, but the company or product-market fit won’t support that.
Sometimes they manage to raise heaps of money anyway and grow like crazy, but at the cost of profitability and it all ends up coming to a sad end when instead they could have instead chosen to grow slowly and have a smaller top line revenue, but profitability and optionality (not to mention longevity).
Talk to your prospective (and current) investors about what it is you want to be, and ask them if they think that’s reasonable. Is the total addressable market really $1 billion? It’s fine if the answer is no, but don’t delude yourself or your investors about it all.
It’s okay to not be big
The final comment I’ll make is that it’s okay not to be a big startup raising money all the time. I feel like I have to keep repeating this as founders (myself included) increasingly get a sense of jealousy (?) at times about people announcing these huge rounds or growing at a crazy rate.
But with that money comes strings. Sometimes the strings are big (liquidation preferences can often wipe out any cash returned to founders or employees even at a 3-5x multiple).
Slower growth is still great. The business is still getting bigger every year! Profitability is great. You have options for what you want to do and aren’t reliant on a revolving door of investment rounds to survive!
While big venture-funded startups can make you and your investors heaps of money, they also have their own challenges. Hiring like mad is actually not something that many founders enjoy, and as the company gets bigger it becomes more and more of your time rather than the things you want to do. Fundraising is soul destroying. Missing that quarter’s targets is potentially life-threatening for the company. You’re statistically more likely to walk away with nothing than you are with a yacht in the French Riviera — no matter how hard you work.
Small businesses have their own challenges too. In a venture-funded startup, you’re always hiring for 12-18 months in the future (in other words, senior people to rapidly build out teams), while in a small business you’re hiring for six months in the past (in other words, you’re always under-resourced). You usually don’t have a cushion of millions of dollars to fall back on if situations change and you fall on hard times. You can’t front-run the cost of acquiring a customer that much (and have multi-year payback periods), because that’s just not sustainable.
Both are incredibly hard work. I know literally zero founders who do not have at least some time of the business’ life where they are working 18-hour days, seven days a week, whether they are venture-funded, bootstrapped, or otherwise.
At one point in the life of every company — tech startup, bootstrapped business, or even café — the company will ask you to write a cheque for your soul. You need to be willing to immediately sign that cheque and hand it over because that is (in my honest opinion) a necessity for the company to survive.
What I’d like to see though is more celebration about the diversity of businesses, because it’s not fair to suggest anyone who is not venture funded doesn’t work hard (has a ‘lifestyle business’), or that fundraising is a success metric (you’re kicking the can down the road, so it’s great that you’re not dead yet and have shown progress but that’s not the goal).
All that does is make people think everyone should raise and that they’re a failure if they don’t or can’t —which often forces companies into trying to become what they simply cannot be.
The number of people I’ve met running companies that pump out consistent profits every year and have done it for quite some time (common in family businesses) is starting to go up. But you don’t see them in the press often — they have no need or want to be. Historically many of these companies are in places like manufacturing, distribution, franchising or travel, but we’re starting to see more and more tech companies like that. A lot of people just have no idea that they exist.
This post first appeared on Hugh Stephens’ blog and was republished with permission.