The Inelasticity of Start-Up Capital

Think of an entrepreneur with 100 Million Dollars start-up capital (The 100 M Guy.) Now think of an entrepreneur with 200,000 Dollars of start-up capital (The 200 K Guy.) Both don't have any ideas for what kind of business they want to start. Both have a need to receive a return of at least 40% on their capital amount in order to feel satisfied. I say at least 40% but entrepreneurs being entrepreneurs usually want the moon (and occasionally get it.) Who is likelier to succeed in founding a star-principle business (a market leader in a fast growing niche that's likely to grow at at least 10% p.a. for the next many years)? Note: I'm not talking about businesses where land is one of the key factors to success (so that rules out industries like real-estate development, mining, oil drilling etc.)

You'd probably say that the one with the 100 Million Dollars of start-up capital would have a better chance.

Now let me add a little twist to our thought experiment. The 100M guy does not understand positioning (and I mean really understand it ... not just know it by reading a book) and the Star Principle. On the other hand, the 200K entrepreneur understands positioning, differentiation, the importance of creating a beach-head in the market, the notion of finding a gap in the market, the idea that a gap in the market may not necessarily translate into finding a market in the gap and more.

I would probably bet on the 200K entrepreneur.

First off, the 100 M entrepreneur needs to produce 40 million dollars in free cash flows every year while the 200K guy needs to produce only 80K in free cash flows. I call this the Warren Buffet problem. But it's a good problem to have. If you have such a problem, you'll most likely gravitate towards businesses that are safe (not likely to pull down your portfolio IRR through losses), established and cash cows (possibly low growth but market leaders in their sector.) But the challenge here is to build a star-principle business.

If the 100M Entrepreneur is a real go-getter and if his ambition (and confidence) exceeds his understanding of positioning, differentiation, category leadership and the star-principle, he'll probably try to build a business (or two) on his own. I've heard a few folks tell me that their approach is to throw a couple of things at the wall and see what sticks and works. Somebody whom I know started a variety of businesses almost at the same time in a bid to build a multi-national conglomerate. He was charismatic, bold, confident and the ultimate he-man. The problem was that all of the businesses were "Dogs" (followers in low-growth markets) and so the entrepreneur was deep in debt within a few years. The story has a happy ending. The entrepreneur had the courage to shut down all the bad businesses (or euthenize all the dogs :)) and after going back to the one business that he really understood was able to salvage his life and fortunes. But he sure could have done without the drama and stress.

Alternatively, the 100 M guy has been told that TEAM is everything. So he sets about building a team of the world's best engineers, designers etc. And to keep up morale, he sets up an equitable stock option plan. And then the team starts thinking about what business to build, how to build it, the differentiators etc. You have to assume that they are likely to be successful at this since an all-star team is likely to have the track-record and the experience. But even here, success is not assured. And the cost of failure can be very high. Just ask the folks at Long Term Capital Management.

Let's assume that both the 100M Entrepreneur and the 200K Entrepreneur spend their start-up capital in the most optimal manner relative to their financial circumstances. And that is to focus on the three most important words for a start-up which are "Positioning. Positioning. Positioning." Now let's look at the actual way that money gets spent. The first entrepreneur (assuming he's wise) will hire a good consultant for a couple of months to help him pick a business and define a positioning statement. However, as any of us who have gone to business school know ... 99% of the strategy consultants don't deserve what they are paid. In fact they add negative value to businesses. A pretty PowerPoint presentation packed with numbers is not the same as applying the right framework based on a sound understanding of first principles of start-up strategy. For this thought experiment let's assume that the 100 M entrepreneur has hired a good consultant who gives him the right guidance. The cost of this engagement is likely to have cost him only a couple of hundred thousand dollars.

Now let's look at the 200K entrepreneur. All he has (in addition to inner skills such as committment, passion, courage, confidence, even-temperament, flexibility etc.) is his thorough understanding of the Star Principle. So he goes out and finds a sounding board (possibly his future business partner) and selects a few areas that he understands or has an interest in. Then he searches for gaps in the market and attempts to come up (on paper) with a product that is sufficiently different from the rest of the market offerings. Then he begins test marketing his concept in order to refine it. His motto like the open-source software developers is "Release early. Release often." The idea is to ensure that there is a market in the gap and that profitable variation is actually possible. Once there's some positive feedback he begins other processes to protect his future business (such as patents) and while staying below the radar begins hunting for capital. If he's on the right path with regard to the market opportunity, additional expansion capital should come to him with ease regardless of the state of the economy. In some businesses, it's possible that internal accruals will fund future expansion and so no additional capital will be necessary.

So what's the point of the thought experiment? To prove that you don't really need too much capital to start a business. Just a few hundred thousand dollars is more than enough to start building a business. Even a big business. Think about Amazon. Jeff Bezos was no multi-millionnaire. He had no start-up success track-record. But he was able to raise financing because he was able to prove that he had a plan to become a category leader in a high-growth business.

Positioning is the great leveler. Prove that you've got the positioning right and the rest of the ingredients (team, capital, customers, fame and of course money) are yours for the taking. Start-up capital is inelastic. Just because you throw more money during the initial months of your start-up journey does not mean that you're chances of success will increase. There is no substitute for rigorous thought experiments, brainstorming and research in an effort to get your positioning right.

Fail small. Learn fast. Don't repeat the same mistakes. But if you think you're on the right path. Don't play to avoid losing. Play to win!