Originally posted June 12, 2008 on taylordavidson.com/writing, reposted here to provide easier access to fundamental thoughts behind Unstructured Ventures. Click here to see comments on the original post.

Following up on my thoughts on whether we need a new funding model for starting businesses…

How will venture capital and the broader “funding and business support” ecosystem evolve with a changing business and cultural approach to entrepreneurship and collaboration?

• Businesses are learning that developing a “collaboration strategy” is a key part of corporate strategy (perhaps even a core competence) in a world where collaboration tools are increasingly rich, interaction costs are decreasing, and the “unlocked value” of their firms are increasingly in the heads and opportunities of potential partners outside of their firms (e.g. partners, suppliers, customers, prosumers, fans).
• Younger people (currently the Millennial generation) entering the workforce are realizing that few companies offer them the opportunity to take on the responsibilities and audacious goals that they have grown up believing is a birthright. Instead of accepting the established order, younger workers are establishing their own order, creating companies based on their world view. And by doing so, younger people are demonstrating the potential choices to older non-Millennial generation workers.

Given that, will entrepreneurs and investors in new companies realize that the traditional “grow and sell” economic model of startups and venture capital is a poor fit for this new business and cultural environment?

At the very heart of this thought is a realization that there is a fundamental difference between starting a business based on selling time v. selling a product.

Product-based business can scale with increasing returns (e.g. output, profits) to the basic inputs (e.g. capital, time, people). Time-based businesses, however, scale linearly, with returns limited to the fundamental productivity ratio of outputs to inputs.

Meaning: if you’re getting paid by selling hours of consulting, you are limited in your growth by the number of hours you have, the number of people you can “hire out” or the prices you can charge. But if you sell a product that can be manufactured, replicated and distributed to the masses, your growth is created by and bound to a very different set of constraints, limited to your access to capital, labor and market demand.

For many entrepreneurs, their business ideas are based on selling their most valuable resource: themselves.

In a business and social environment of rising entrepreneurship and collaboration built on increased sharing of the value creation chain, there will not always be opportunities to create scalable, product-based businesses. Many interactions will be based on selling time and not products.

Businesses based on selling time can be easy/hard to start and very difficult to grow:

• Easy to start if they are part-time and not a primary source of income.
• Difficult to start as full-time endeavors without sufficient space (i.e. money, and thus time) to give the company time to grow, since the traditional source of funds to give a company space - venture capital and bank loans - do not find these types of businesses the right investment opportunities for their economic models.
• Difficult to grow because they are fundamentally tied to one’s available time or prices. Scaling by hiring people or developing partners is a typical growth model for these businesses, but it can be difficult to execute when the primary value of the company is largely locked in the entrepreneur’s head and non-transferable skills.

The basic cultural and economic blueprint of startups are built on the idea of “millions of funding, thousands of man hours, and dramatic risk”, leading to a binary outcome set: go big or go home.

Why?

Instead, “not all companies are meant to have thousands of employees or a billion-dollar market cap.” Some people are more interested in the entrepreneurial lifestyle. Outsized financial profits are not everyone’s goal; not everyone wants to commit the time or resources of take the risks necessary to create huge businesses.

And why should that be the goal? Why can’t running a “lifestyle business” be a goal? And why can’t we create a funding model to help give “lifestyle entrepreneurs” the space, time, resources and the opportunities to create valuable, cash-flow based businesses?

Why are entrepreneurs not demanding this type of investment structure? Perhaps because they don’t even know it’s an option.

Fund companies, not startups.

Funding startups is how traditional venture capital makes money. The ecosystem is based on an economic model that demands hyper-growth, clear exit strategies and significant valuation multiples due to the simple need to match risk with reward. Since most startups fail, most investments will be worthless, and thus the “big wins” are a necessity for venture capital to make money.

Instead, fund companies. Fund people. Fund value-creating enterprises regardless of their size or growth potential. Entrepreneurs will not be able to bootstrap all the potentially great ventures out there that do not fit the traditional venture capital model.

What should an investor look for businesses created from this environment of entrepreneurial collaboration? (in addition to the usual management, market, product, etc.)

• Invest in collaboration: collaboration can be a core competence.
• Invest in openness: openness of ideas is a signaling behavior. Openness in sharing ideas demonstrates commitment to the idea and a true understanding of the difficulty of execution.
• Invest in value, not potential: growth is merely an option.
• Think about what risks you want to fund. Technology risk can be mitigated through lower startup and testing costs. Market and consumer adoption risks can be reduced in a “stay small”-type business. Management risks can be reduced by investing smaller amounts of money in more opportunities to “test” more entrepreneurs. Exit risk can be reduced in a business based on recurring cash-flow not aiming for large, risky exits to create shareholder returns.
• Scale attention and time according to the required level of investment and support. Not every company in this model requires a board seat and close interactions.

I admit it’s just a start. But realize that entrepreneurs and investors each have the potential to choose new ways to succeed. Pick the type of success you want to create.

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[1] There is an active debate about this… check out posts by Union Square Ventures and Techdirt to understand the debate.