Chapter Nine: There Is Good Money and There Is Bad Money

Chapter Nine: There Is Good Money and There Is Bad Money

Chapter Nine: There Is Good Money and There Is Bad Money


Does it matter whose money funds the business I want to grow? How might the expectations of the suppliers of my capital constrain the decisions I’ll be able to make? Is there something about venture capital that does a better job nurturing disruptive businesses than corporate capital? What can corporate executives do to ensure that the expectations that accompany their funding will cause managers to correctly make the decisions that will lead to success?

Getting funded is an obsession for most innovators with a great idea; as a result, most research about raising capital has focused on how to get it. For corporate entrepreneurs, writers often describe the capital budgeting process as a cumbersome bureaucracy and recommend that innovators find a well-placed “champion” in the hierarchy who can work the system of numbers and politics in order to get funding. For start-ups seeking venture capital, much advice is focused on structuring deals that do not give away too much control, while still allowing them to benefit from the networks and acumen that venture capital firms offer.[1]

Although this advice is useful, it skirts an issue that we think is potentially more important: The type of money that corporate executives provide to new-growth businesses and the type of capital that managers of those businesses accept represent fundamental early choices when launching a new-growth business. These are critical fork-in-the-road decisions, because the type and amount of money that managers accept define the investor expectations that they’ll have to meet. Those expectations then heavily influence the types of markets and channels that the venture can and cannot target. Because the process of securing funding forces many potentially disruptive ideas to get shaped instead as sustaining innovations that target large and obvious markets, the very process of getting the money to start a venture actually sends many of them on a march toward failure.

We have concluded that the best money during the nascent years of a business is patient for growth but impatient for profit. Our purpose in this chapter is to help corporate executives understand why this type of money tends to facilitate success, and to see how the other category of capital—which is impatient for growth but patient for profit—is likely to condemn innovators to a death march if it is invested at early stages. We also hope this chapter will help those who bankroll new businesses understand the forces that make their money good or bad for nurturing growth.

The most commonly used theories about good and bad money for new-growth ventures have been based on attributes rather than circumstances. Probably the most common attribute-based categorization is venture capital versus corporate capital. Other categories include public versus private capital, and friends and family versus professionally managed money. None of these categorization schemes supports a theory that can reliably predict whose money will best help new ventures to succeed. Sometimes money from each of these categories proves to be a boon, and sometimes it becomes the kiss of death.

We’ve already demonstrated why the money that funds a new-growth business needs to be patient for growth. Competing against nonconsumption and moving disruptively up-market are critical elements of a successful new-growth strategy—and yet by definition, these disruptive markets are going to be small for a time. The only way that a venture can instantly become big is for existing users of a high-volume product to be enticed to switch en masse to the new enterprise’s product. This is the province of sustaining innovation, and start-ups rarely can win a sustaining-innovation battle. Money should be impatient for growth in later-stage, deliberate-strategy circumstances, after a winning strategy for the new business has emerged.

Money needs to be impatient for profit to accelerate a disruptive venture’s initial emergent strategy process. When new ventures are expected to generate profit relatively quickly, management is forced to test as quickly as possible the assumption that customers will be happy to pay a profitable price for the product—that is, to see whether real products create enough real value for which customers will pay real money. If a venture’s management can keep returning to the corporate treasury to fund continuing losses, managers can postpone this critical test and pursue the wrong strategy for a long time. Expectations of early profit also help a venture’s managers to keep fixed costs low. A business model that can make money at low costs per unit is a crucial strategic asset in both new-market and low-end disruptive strategies, because the cost structure determines the type of customers that are and are not attractive. The lower it can start, the greater its upside. And finally, early profitability protects a growth venture from cutbacks when the corporate bottom line turns sour.[2]

In the following sections we describe in more detail how good money becomes bad. We recount this process from the point of view of corporate investors, with the hope that this telling of the story will help managers who are seeking funding to know good and bad money when they see it, and to understand the consequences of accepting each type. We hope also that venture capital investors and the entrepreneurs whom they fund will be able to see in these accounts parallel implications for their own operations. Bad money can come from venture and corporate investors—as can good money.

[1]Many books have been written on the challenges of matching the right money with the right opportunity. Three that we have found to be useful are the following: Mark Van Osnabrugge and Robert J. Robinson, Angel Investing: Matching Startup Funds with Startup Companies: The Guide for Entrepreneurs, Individual Investors, and Venture Capitalists (San Francisco: Jossey-Bass, 2000); David Amis and Howard Stevenson, Winning Angels: The Seven Fundamentals of Early-Stage Investing (London: Financial Times Prentice Hall, 2001); and Henry Chesbrough, Open Innovation: The New Imperative for Creating and Profiting from Technology (Boston: Harvard Business School Press, 2003).

[2]A stream of academic research explores the nature of “first-mover advantage” (for example, M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 [1988]: 41–58). This can manifest itself in “racing behavior” (T. R. Eisenmann, “A Note on Racing to Acquire Customers,” Harvard Business School paper, Boston, 2002) in the context of “get big fast” (GBF) strategies (T. R. Eisenmann, Internet Business Models: Text and Cases. New York: McGraw-Hill, 2001). The thinking in this field is that in some circumstances it is preferable to pursue a particular strategy very aggressively, even at the risk of pursuing a suboptimal strategy, because of the benefits of establishing a significant market position quickly. The drivers of the benefits of a GBF strategy are strong network effects in customer usage (N. Economides, “The Economics of Networks,” International Journal of Industrial Organization 14 [1996]: 673–699) or other forms of high customer switching costs. The arguments of this school of thought are well articulated and convincing, and suggest strongly that there are conditions when being patient for growth could undermine the long-run potential of a business.
Harvard Business School Professor William Sahlman, who also has studied-this issue extensively, has noted in conversations with us that on occasion venture capital investors en masse conclude that a “category” is going to be “big”—even while there is no consensus which firms within that category are going to succeed. This results in a massive inflow of capital into the nascent industry, which funds more start-ups than can possibly survive, at illogical valuations. He notes that when investors and entrepreneurs are caught up in such a whirlwind, they almost have no alternative but to race to out-invest the competition. When the bubble pops, most of these investors and entrepreneurs will lose—and in fact in the aggregate, the venture capital industry loses money in these whirlwinds. The only way not to lose everything is to out-invest and out-execute the others.
The challenge is determining whether or not one is in such conditions. Compelling work by two scholars in particular suggests that network effects and switching costs that are sufficiently strong to overwhelm more prosaic determinants of success arise far less frequently than is generally asserted. See Stan J. Liebowitz and Stephen E. Margolis, The Economics of QWERTY: History, Theory, Policy, ed. Peter Lewin (New York: New York University Press, 2002.) As an example, Ohashi (“The Role of Network Externalities in the U.S. VCR Market 1976–86,” University of British Columbia working paper, available from SSRN) argues that Sony under-invested in customer acquisition in the VCR market, suggesting that it could have been successful had it “raced” harder. Economic modeling suggests that indeed, controlling for product quality, it makes sense to invest more aggressively in customer acquisition when network effects are present than when they are not.
This ceteris paribus assumption with respect to product quality, however, is somewhat heroic, for it assumes away the very reason to be patient and avoid racing. As Liebowitz and colleagues (The Economics of QWERTY) have shown, in the case of the Betamax/VHS battle, a critical element driving customer choice was recording time: Although first to market and offering better video quality, Betamax did not permit two-hour recording times—the minimum typically required to record a movie being broadcast over network television. This turned out to be a critical driver of consumer adoption. JVC’s VHS standard did enable this kind of recording, and met at least minimum acceptable standards for video fidelity. As a result, it was far better aligned with the job to be done, and this superior alignment overcame Betamax’s first-mover advantage. It is doubtful that the incremental market share that a more aggressive marketing spend by Sony might have yielded for the Betamax standard would have beaten back the superior VHS product.
With these caveats in place, it is nevertheless important to recognize the possibility of powerful payoffs to optimal racing behavior, which, in our language, would capture a particular aspect of the job to be done by a given product or service. In the case of network effects, this is captured by the notion that in order for a product to do a job well for me, it must also be doing this same job for many other people. To the extent that such competitive requirements undermine profitability where racing behavior is called for, the need to be patient for profits can be mitigated.
Because the focus of this book is to help corporate managers launch new-growth businesses consistently, we anticipate that they will be caught in GBF racing situations less often than, for example, certain venture capital investors whose strategies might be to participate in big categories.