Plan B to start or grow your business

What are you working on?

My new work was brought about by what I think is an overemphasis on venture capital in the entrepreneurial world. There seems to be an assumption that if you’re an entrepreneur and want to build a high potential business, what you should do is come up with a great idea, write a business plan, raise some venture capital and a few weeks later you’ll be rich. That’s the default idea.

But it’s basically wrong.  The vast majority of companies that grow to be large and successful never raise any venture capital. So why are we so focused on raising money and putting the investor at the centre of this entrepreneurial phenomenon? I think the person who ought to be at the centre of it is the customer, not the investor.

So I started looking at companies that had funded their business with money from their customers – by selling something.  I knew this phenomenon existed, but didn’t know how widespread it was. And I wondered if there were different approaches to making this happen. I looked for examples of companies that had managed to get their customers to give them money because the customer was so eager to get whatever it was they were going to produce.

And how many approaches to this did you discover?

So far, I’ve identified five different models. And interestingly, some of the most intriguing applications are happening in India and other emerging markets.

The first is what I call the matchmaker model.  If you’re a broker – eBay or Expedia for example – you don’t ever have to own any goods and you don’t need a lot of cash. Think of eBay, which gets a fee from both buyer and seller. Similarly, Expedia gets a fee from the seller. Anyone in the brokerage business basically has a matchmaker model. They bring buyers and sellers together, the buyers and/or the sellers pay them to do so, and they can grow the business to a surprising extent without external capital. Straightforward.

Is there another example of this model in practice?

A great current example is Airbnb. Two graduates of the Rhode Island School of Design, one of the top design schools in the US, lived in San Francisco. A big design conference was coming to town and all the hotels were booked.  They said, why don’t we let some people stay in our place and we’ll give them a more personal introduction to San Francisco?  They bought a couple of air mattresses, put them on the floor, and got some people to book their place. Two air mattresses and $1000 later they were in business.

They then thought there are lots of conferences, we could do this elsewhere. It doesn’t cost much to find somebody with a spare couch, spare bedroom, or spare floor, and the customer will pay us for the floor space and the person who lists the accommodation will pay us to be listed.

Today Airbnb has 200,000 properties listed in 2,600 cities and 192 countries. Though it started with no external capital, Airbnb eventually raised $120 million in funding from top tier VCs.

My argument is that if you can find a way for the customers to fund you at the beginning and you can get further down the road and get some proof points, both for yourself and for others, then you’re way better off because you’re going to raise the money on far better terms, if you need the money at all.

What are the other models you have discovered?

The second model is what I call the pay-in-advance model. Consultants and architects have being practising this forever.  They agree they’re going to design your building and take a third of the fee upfront and additional payments along the way, so they always have some of the customer’s money upfront.

There’s a really interesting company in India called Via (www.viaworld.in).  As you might imagine, everybody in India is trying to figure out how to bring India’s travel ecosystem into the 21^st century.  Via noticed the profusion of mom and pop travel agencies in small cities, none of which were online and most of which couldn’t give real-time ticketing to their customers. So Via said, what if we give all these travel agents real-time ticketing capability and better commissions on their tickets? 

The deal is that Via goes to the travel agents and takes a $5000 rolling deposit, against which the agents issue tickets and also receive a laptop, online capability and real-time data. Suddenly the travel agents can do a better job for their customers and make more money. Via has the customer’s – the travel agent’s – money before it needs it. Via’s sales are now some $50o million and the business is only six years old.

Via has created a phenomenal brick and mortar travel network in India and been able to grow it internationally. It did eventually raise some venture capital to get into hotel, rail and bus ticketing, but was able to grow in the early days because the customer – the travel agent’s deposit – was funding the business.

And the third model?

The third kind is the subscription model.  If you subscribe to the Wall Street Journal or the Financial Times you pay the subscription amount in advance.

There’s an Indian company called TutorVista (www.tutorvista.com) that identified a need to help high school kids with mathematics, physics and other subjects in English-speaking counties. They said we have lots of underemployed teachers in India; could we somehow connect the two groups over the web?

They hired three teachers, built a simple web interface so an  Indian teacher could connect – live – with an American high school kid.  It worked pretty well so they hired more teachers. Initially, TutorVista charged per hour, but they discovered customers didn’t want to buy that way. What customers wanted was a monthly subscription so they could get assistance for their children on any subject when needed – an all-you-can-eat subscription model.

Again the customer is putting up the money and building the business. Pearson now owns nearly 80 per cent of TutorVista. Its investment valued TutorVista north of $200 million. Not bad for another six year-old business.

And the final models?

In addition, there are scarcity-based models. Consider retailing. In the last couple of decades, abundance has been what’s driven retailers. So you have Carrefour, huge stores with enormous assortments; and category killer retailers like Best Buy in the US, where everything you could possibly imagine in the consumer electronics category is under one roof.

The fashion retailer Zara turned the abundance approach on its head. Its assortment changes all the time, so there’s always new stuff coming into the store. So if the customer doesn’t buy the knock-off of the dress Britney Spears wore last week on TV now, it’s gone. Scarcity drives the purchase.

There are flash sale sites which have taken this scarcity notion to a whole new level. One of the most interesting is a French company called Vente Privée (www.vente-privee.com) which is now in seven European countries.  Its founders all had deep roots in what you might call the discount designer fashion business.  They helped fashion designers get rid of unwanted inventory at the end of the season. They were good at taking these goods and selling them at basement sales without disrupting the higher priced channels.

Then they thought, couldn’t we do this on the internet and make it into a bigger thing? As a member of the Vente Privée network, you get an email every couple of days, saying, two days from now there’s going to be a sale of a particular designer’s fashions. The sale goes up, it’s only there for three days and it’s only a fixed amount of goods – the unwanted quantities that the designer made too many of. Vente Privée does its own video shoots and presents it all extraordinarily well. The customer buys the goods online, at 70 per cent less than the regular price.

So, it’s win-win. But how does Vente Privée use the customers’ money?

At the end of the three days Vente Privée has the customers’ money for all the articles the customers have bought, right? But it has not yet placed a purchase order with the vendor for the exact quantity. It then orders the goods -- paying the vendor in 60 days, receives them and ships to the customer.

Nice and simple. What about the fifth model?

This is what I call the service-to-product model.

As an example consider the Indian mapping industry.  Amazingly, until the 1960s it was illegal for anybody but the military to have or use a map in India. Consequently, there’s no real map-reading and map-making culture in India.  Now, in 1995 Coca-Cola re-entered the Indian market, after an earlier entry that didn’t work out.  They bought the biggest cola brand in India. Along with the purchase came this huge notebook detailing the territories of all the bottlers. It was described in words.  There was no map.

Rakesh and Rashmi Verma had been marketing American mapping software to the nascent mapping industry in India. They found out about Coke’s problem and said, we can help you; we can turn that information into maps. So they got whatever rudimentary maps there were in India at the time, cut them into A4 size, placed them on a scanner to digitise them, then overlaid demographic and demographic information. Over time they began helping one B2B client after another with mapping solutions.

Over a 10-year period, they became the dominant map player in India.  They then raised some venture capital and today, under the name MapMyIndia, dominate the Indian satellite navigation industry: think TomTom or Garmin and MapQuest all rolled into one.  A customer-funded service became a range of products.

What can and should entrepreneurs learn from this research?

There are some real drawbacks of raising VC too early.  Number one, it’s a huge distraction because it takes most of your time. You’re spending your time raising money, rather than spending time building the business.  Number two, you are spending all your time trying to convince people that your idea is wonderful rather than getting data to prove it’s wonderful.    

Number three, risk is much higher when you try and raise money early because nothing’s been proven about the business yet.  Consequently, the valuation you get and the stake you’re going to get to keep in your business is much lower.  Number four, there’s a lot of baggage that comes with VC, so the terms and conditions are onerous and the riskier the venture, the more onerous the terms.  So, you have all of that to deal with.  Even worse, it’s really hard to raise money in the best of times and these are not the best of times. 

So, there are a lot of reasons why not to raise capital early. If you can raise capital from your customers – by selling them something they simply must have – then you can go to the capital markets or VCs later and say, look, I’ve got customers, I’ve got traction. You can raise money on much better terms and consequently grow faster.

What’s the upside of this message for VCs then?

VCs have tended to move later in the investment cycle over the last decade or so.  VCs actually prefer to invest later and to invest when at least the concept and its marketability have been proven to some degree, so that they’re investing in growth, rather than in potentially unproven technology or in a venture where there’s unproven demand. 

What surprised you as you encountered these companies?

I think it’s surprising how many clearly discrete different ways there are to do this.  We’re at five models and counting. And there’s the surprise of putting the kibosh on another of the many myths in entrepreneurship theory and practice. There’s so much mythology.  There’s the mythology that it’s all about tenacity and perseverance and if you just work hard enough to knock down the wall, the wall will eventually fall.  Well, actually you’ve got to change course and you’ve got to go around the wall – that’s the heart of my book Getting to Plan B (co-authored with Randy Komisar).  There’s also this myth that it’s all about raising capital. My current research may help demolish this one, too.

There is a time and place for venture capital but the best time is later and if you can get to that later point by getting your customers to fund your business, then both you and the investor are going to be much happier.

London business School - Business Strategy Review