The current economy being a bit recessed across the US, a lot of people are unable to find jobs and are turning to entrepreneurship and starting their own companies instead. The dream of entrepreneurship has become more motivating than the goal of working for 40 years and living out your final years on retirement savings.
There are a lot of different companies to be started: small businesses, service-oriented businesses, and startups. There is a bit of confusion about what it means to start a startup. Not all new companies are startups, nor should they be.
Definition of a Startup
A startup is an organization that has the potential to grow very rapidly, ultimately becoming a “real company” (with an HR department, divisions, and processes).
Steve Blank calls startups a “temporary organization designed to discover a business model.” Startups, when they begin, have no process, no culture, and no repeatable business model. All they know is that they have the potential to address a huge market if they can figure their business model out, and then scale quickly enough to stay ahead of the competition.
Startups must grow fast because they are going after a potential market worth hundreds of millions, or billions of dollars. The size of the potential market enables the startup to grow from the founding team into dozens of employees at first, and then hundreds, and possibly even thousands of employees, all within only a few years.
Compare that to a smaller niche business that has a market cap of a few million dollars. That’s a definition that fits most service and family businesses. It also fits most niche product businesses. Capturing a few million dollars worth of a market allows a company to hire a handful of employees and make a nice living for the entrepreneur. But a few million dollars isn’t a scalable business, and doesn’t inspire much fierce competition.
Rapid Growth Rate
Rapid growth is essential because competition for a hundred-million dollar market will be intense. The company that wins is going to have to do more things right than all their competition. That usually means some sort of brutal combination of working longer hours, living in front of your computer 14+ hours a day, and surviving on ramen in order to make it to profitability and continue growing fast enough to first of all survive, but ultimately be the company to capture the market.
Paul Graham, the founder of Y Combinator, has the following to say in his essay on startups:
To grow rapidly, you need to make something you can sell to a big market. That’s the difference between Google and a barbershop. A barbershop doesn’t scale.
Compared to the barbershop, startups have a huge amount of upside: if you successfully build one, you stand to have a bank account with a lot of zeros. But, startups also have a proportionate amount of risk. In other words, failure is a more likely option with your startup than your neighborhood barbershop, but the barbershop stands less of a chance of making you absurdly rich.
The rapid pace of a startup is one of the biggest differences in becoming a “startup entrepreneur” than an entrepreneur of an SMB barbershop or a niche software company. A startup entrepreneur is signing up for a company that is filled to the brim with rocket fuel—the entrepreneur is either going straight to Mars, white-knuckling their company the entire way, or they are going to blow up, painting the horizon and the tech news blogs spectacularly along the way. Either way, it’s quite romantic.
Because of the stiff competition for the very large market, the startup has to move quickly. This is why startup companies often talk about funding rounds where investors put millions of dollars into the company. The funding itself isn’t important, except that it allows the startup to grow faster than profits alone. Funding is like rocket fuel to move faster than the next guy in a highly competitive space.
The outcome for the successful company comes within a decade of starting up. The startup will have grown by leaps and bounds, and either been acquired by a larger company, or will have completely captured the new market and reached an IPO.
Example Market: Ridesharing
Uber and Zipcar are two recent examples of billion-dollar markets being captured by rapidly-growing organizations that have secured millions of dollars in funding. Uber currently has $57.1MM in funding, and Zipcar raised $60.7MM before going public and being sold off to AVIS for $500MM.
Where Uber is still working on their growth, Zipcar reached their “startup event” by going public, allowing investors and the founders to cash out, and then finally selling to AVIS.
Uber is a high-growth (read: scalable) company that has created a global market for people who want to hail a cab using their smartphone. Their product is both the ability to call a taxi from a smartphone, and once the car arrives, Uber also provides a more pleasant experience than riding in a cab. Uber has created a new marketplace for passengers to pay drivers for a ride from point A to point B. The way Uber makes money is from the transaction every time that a passenger uses their smartphone app to hail a ride.
Uber started in 2009 in a single city with $200k in seed funding. Today, Uber is in 38 cities, and has closed $57MM in funding to spur their growth. They are growing at 29% monthly just 2.5 years after founding – that’s faster than eBay grew in its heyday.
Funding is a key part of Uber’s ability to grow quickly enough in a competitive market where Lyft, SideCar, and Flywheel are all competing for the same riders. Having millions of funding in the bank allows Uber to hire quickly, build new features, and expand into new cities ahead of the competition.
A company that can’t grow rapidly, isn’t a startup. You’re still an entrepreneur.
What if you wanted to start a small agency or consulting firm? You’re definitely an entrepreneur, but your company isn’t a startup. The rapid growth of a startup is in pursuit both of the right economies of scale, as well as a large enough market. The sweet spot of the right economies of scale and a huge market is where the company can make the optimal profit from every dollar spent operationally.
The consulting firm’s revenue is limited by the number of hours they can sell because it doesn’t have an actual product to sell. An hour can only be sold once, and you have to keep selling more hours in the form of future consulting contracts in order to make enough revenue to stay alive.
To increase profits at your consulting firm, you have to hire more employees and sell their hours too. Assuming the market is actually large enough to create enough demand for your services, consulting can be a lucrative business. But consulting companies don’t have good economies of scale—and their employees, while necessary to grow, are also liabilities. If a client backs out of a contract suddenly, your consulting firm may not be able to make payroll that month.
A startup will have a much more profitable relationship between their employees and their profit margins.
What about a niche software company?
But what about a software product that solves a niche problem, generates regular revenue, and can be automated to a large degree? That’s certainly a technology company, but it’s not a startup. This is the technology version of an small, family business because the market is limited in scope.
An example is BingoCardCreator.com, founded by Patrick McKenzie, that automates the process of creating bingo cards for school lesson plans. First off, by the name, you wouldn’t necessarily think it would make much money (at least, I didn’t at first), but it does. It serves a small, niche market, using technology to simplify teachers’ lives. But it’s not attacking a huge market, and therefore also isn’t terribly disruptive, and can’t scale.
The size of the potential market is directly related to how scalable the product might be. Education is a trillion-dollar market, but automating bingo card creation doesn’t completely disrupt the nature of education top to bottom. While it does give teachers back a bit of their most valuable resource, their time, it doesn’t fundamentally alter how information is transmitted in the classroom, and make schools incredibly efficient. BingoCardCreator.com makes plenty of money and is successful, but since its product is only serving a niche marke, there’s no opportunity to scale into a large organization.
If BingoCardCreator.com was just the first step in a series of products designed to revolutionize the way that children learn, and forced public schools to change the way they operate, it would be a startup.
Where do startup ideas come from?
Now that we’ve got a decent idea about how startups are distinct from other types of companies, let’s cover where “startup ideas” come from. I’ll give you a hint. It’s not the stork.
Startups start with an idea about how the world should be different in a very significant way. Uber started with the belief that it should be easier to call a cab from your smartphone. Zipcar started with the idea that you should be able to have access to a car without paying the full cost of ownership. PayPal started with the idea that it should be easy to make a payment with a credit card online. Microsoft started with the idea that everyone needed a personal computer. Amazon started with the idea that you should be able to buy books easily online. And so on…
The companies we know today exist because their founders built businesses around those ideas. And the ideas were so groundbreaking that they turned billion-dollar industries on their heads. Microsoft ended the era of the typewriter with the personal computer. Amazon owns a lof of responsibility for Borders closing their doors because it was easier to shop from your living room.
These companies used technology to shorten the distance between two points, and therefore create a new, more efficient way for people to live and work. Using a PC was more efficient than a typewriter, which means Microsoft opened up billions of dollars of productivity by shortening the distance between writers and writing. Uber shortens the distance between passengers and drivers. Zipcar shortens the distance, in terms of dollars spent on car ownership, between people and their destination.
Shortening the distance between two points with technology is called “disruption,” because it upsets the pre-existing balance in the market, often the result releases billions of dollars of productivity into the economy. Recently, there have been valid discussions about what disruption means, and whether market disruption is always a good thing. Those topics have been covered well in other places, so I won’t extend this article on those.
When does a startup cease to be a startup?
Now that we’ve got a good idea what a startup is, we can start to look at when a startup company has achieved its ultimate goal of finding a scalable business model, and then ceases to be a startup. In many ways, the point of a startup, as celebrated as startups are, is to someday cease to exist as such. Not cease to exist as in “go out of business,” but as in “turn into a real company.”
Like Steve Blank said, the startup is “temporary organization designed to discover a business model.” Once the startup discovers the scalable business model, it ceases to be a startup.
Microsoft was once a startup, and it no longer is. Apple used to be a startup too. Facebook and Google still retain a lot of the qualities of a startup, but are no longer truly startup companies.
Let’s go back to the PayPal example. PayPal is no longer a startup. It’s a “big company,” and was acquired by eBay in 2002. A startup is a good target for acquisition under a few specific circumstances.
One instance is when the startup has achieved product success and captured their market, and a larger company wants to add the product and the revenue in the market to their warchest. Another instance is when the startup stops growing quickly enough to keep moving forward, but a larger company recognizes the talent pool the company has gathered. The larger company then buys the startup to add the employees to their ranks, called an acqui-hire. The final instance is when the company is tanking, and arranges to be purchased by a larger company so that the investors can get their money back and the employees can land safely.
In each of those instances, the startup ceases to have the same mission to make the world a different place, and to capture a large market. They’ve either reached their goals and discovered a business model, or they haven’t. Either way, the “startup phase” is coming to a close.
This process of becoming a real company and ceasing to be a startup is a gradual one. A startup of 100 employees will retain less of the “startup feel” that was present from 0-20 employees as the bureaucracy and processes are implemented.
The final way a startup ceases to exist as a startup is to go public.
It’s easy to look at a startup and say that it ceases to be a startup company once it goes public. By a time a company goes public it’s probably matured past startup-phase. Once a company has its initial public offering of stock, it ceases to be able to move quickly because it now must report to shareholders every quarter. That’s part of why Michael Dell is in the process of buying all the shares in Dell Computers in an attempt to take it private. The company needs radical reinvention that it cannot achieve with quarterly earnings reports to shareholders.
The nature of a startup is to grow rapidly, hiring as to improve its offering, but at some point the company reaches a certain size where it stops being able to grow rapidly and begins to plateau. A billion-dollar company cannot continue to grow like Uber at 29% month by month.
As, I mentioned, startups aren’t real companies, but as Steve Blank calls them, a “temporary organization designed to discover a business model.” As soon as the business model has been fully mastered, the company’s growth stabilizes and then ceases to be a startup.
Taking money off the table – the circle of startups
At some point, many startups have their “exit” moment where they are either acquired or have their IPO. In both cases, the investors see a return on the money they put in, and the founders and early employees are allowed to take money off the table.
“Taking money off the table” sounds a lot less romantic than “discovering a business model.” But a primary motivator behind starting the company was to make a lot of money while also changing the world. Taking money off the table is simply the final act of successful startup entrepreneurs and investors. The money off the table is often poured back into the next generation of startups, and the cycle starts all over again.
Elon Musk and Peter Thiel sold their billion-dollar shares in PayPal and have gone on to create massive value in companies like Tesla, Space X, Facebook, and on. Uber has investment from Jeff Bezos, who has a portfolio of disruptive companies that he has invested the profits he’s earned by running Amazon.com.
Startups become companies that generate cash, which goes into other areas of the economy, stimulating growth in other areas, including philanthropy. The most successful titans of business are often typically massive donors to charitable organizations. In many cases, the process began with a few people who had an idea and the gumption to succeed.
Wrapping it all up
The goal of every startup is to change the way the world works in a meaningful way, and in the doing, to create a massive amount of value for the founders, their investors, their employees, and the markets they disrupt.
The process of creating that value is risky and unstable, but the risk is in direct proportion to the potential rewards. Startup founders stand to make millions if they successfully grow their startups into companies.
The final element of a startup is the people who step up and join the battle. Startup life is volatile and risky. The hours are long and grueling. One of the bigger challenges is the constant changes that the company is undergoing in their rapid growth. Each change in the company requires that every employee, from the founders and the executive team on down, be willing to evolve and adapt to the changing needs of the company. This requires a high degree of introspection and adaptability.
In addition to the huge markets and the “disruptive” products, one of the biggest products of a startup is its people. They form a sort of family, and fight through the trenches of growth together. When all is said and done, a successful startup will generate a cadre of battle-hardened people capable of achieving great things again.
If you’re starting the next startup, we salute the effort.
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