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Startup or Small Business – The Other Chasm

There’s a world of difference between a scalable technology startup and a small business.  Decide which you are.

 

Crossing the Chasm is a startup classic written in 1991 about the challenge of going mainstream with a technology product.  I see an earlier mindset-based chasm with startups.  It’s summed in this question:  Are you a startup or a small business? 

The terms are sometimes used interchangeably, but the confusion on this point tends to be cataclysmic.  There’s alignment that comes from meaning the same thing when founders, investors, and employees talk about these organizations in the same way.  Using a bit of the mindset and vernacular of Silicon Valley, let’s explore the difference and the implications of the chasm between startups and small businesses. 

Steve Blank showed the world that startups are not just small versions of large companies.  Applying big company management within startups leads to frustration and failure.  A similarly critical distinction separates startups from small businesses.  Silicon Valley thinks of startups as organizations that are designed to become very big (my rule of thumb is $20 mil. in 5 years and $100 mil. in 10) and are characterized by extreme uncertainty because they seek to do something very new.  In contrast, small businesses are designed to meet the income, lifestyle, and other needs of their founders and are characterized by execution risk within known business models (dental practice, restaurant, building contractor, etc). 

Small businesses can be awesome.  But they are different from highly scalable technology startups.  The disaster lies in trying to operate as both.  At the core, startups have so much business model risk that they need to eliminate all the unnecessary risks and uncertainties of their structure so they can focus on validating their business model.  Here are some differences I’ve observed in how startups vs. small businesses organize and operate themselves. 

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Legal Entity – Startups are Delaware C-Corporations, small businesses are LLCs organized in their home state.  Startups intentionally pick a more expensive state to incorporate in and an entity type with big tax disadvantages, because you can scale a C-Corporation dramatically easier than an LLC. 

Shares vs. Percentages – Startup stake-holders think in terms of shares, then calculate their percentage ownership.  Small businesses just think in terms of percentage ownership—which is often 100%, as in “I own this business.”  Percentage matters second in a startup because the value in the end can be so dramatically higher by making smart decisions to trade percentage ownership for key resources like talent, advice, and capital. 

Key Personnel Exits – Startups take ownership back when key personnel exit.  Without compensation.  Small businesses buy that ownership back at a profit to the departing partner.  That’s because the early value of the organization is nill in a startup, and everyone needs to sign on to make that value huge.  If you leave before the company’s had time to do that, vesting agreements come into play in which players agreed at the outset to give up their equity.  In contrast, small businesses have buy-sell agreements in which the parties agree at the outset as to the value of their stake on exit.  This works great with a dental practice or law firm.  In contrast, the presence of a buy-sell agreement in a startup makes it unfundable.

Eccentrics and OTJ – Startups have room for approximately one less than fully baked executive.  Sometimes brilliance can outshine eccentricities (Steve Jobs) and inexperience (Mark Zuckerberg) to create real magic.  But more than one only creates real problems.  Small businesses, by contrast, can have room for the slower pace and unnecessary missteps that accompany nepotism, dysfunctional habits, and inexperience.  There are limits either way, but those limits hit much earlier in a startup.  The corollary to this rule is that startups can have little tolerance for drama while a small business can have as much tolerance as its founders have patience for.

Employment Agreements – Startups use ‘At-will’ employment agreements.  Because business model uncertainties are so extreme, a startup has to have full flexibility to separate when things don’t work out.  There’s precious little room for fixed term employment and generous severance.  In contrast, a small business can structure its agreements to give maximum protection to founders and key internal partners. 

IP Ownership – In a startup, the company owns the intellectual property.  Founders and employees sign all rights to all past, present, and future IP related to the company’s business that they have developed or will develop so long as they are with the company.  There’s zero room for less than full clarity on this point as operational execution and funding prospects both rely on the company fully controlling its IP.  In a small business, IP ownership disputes can be equally devastating but there’s more latitude for informal understandings and ambiguity.

Control – I was once considering investing in a semiconductor startup.  When we asked the CEO if he needed to remain CEO forever, he replied “I’d rather be rich than king.”  That’s the startup mindset.  Startup founders are willing to intelligently trade off control such as board seats, dilution, voting rights, and executive positions to enable the company to maximize its success.  Small business founders, by contrast, may prefer to maintain full and final control.  That’s ok, but it doesn’t work with startups.  A few wildly and instantly successful startups like Google and Facebook are the exceptions that prove the rule.

Capital Sources – Startups are self- and friends and family funded, then angel and venture capital funded.  Small businesses start on the same self- and F&F sources but quickly diverge to funding through retained earnings and bank loans.  Startups have too much business risk, too little history, too negative profitability, and too few tangible assets to be candidates for bank financing.  In contrast, small businesses have too little scalability and the wrong governance and control structures to be candidates for venture capital

Copernicus --  What is the central focus your company revolves around?  In the sixteenth century, the Copernican Revolution established that our planet revolves around the sun, not the other way around.  Startups establish their own Copernican Revolution by deciding their company revolves around customers or users and shareholders.  In that order.  Small businesses share a central customer focus, but are also all about their founder.  This will be controversial, but I believe even a team focus is wrong for a startup.  Successful companies often outgrow their founders’ abilities.  That’s success!  At some point, a commitment to keeping team members in place for the duration will run counter to building the best company that delivers the most value to its customers. 

Customers or Profits – Do customers or profits come first?  Here’s one where small businesses ofttimes have the edge.  Apple last week set the record for the highest market value of any company in the U.S.  Paradoxically, its mantra of “insanely great” products got it there while a mantra of profits and stock options would have prevented it.  It takes some balance, but startups are well advised to let vision and passion for delivering to customers carry the day.

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The distinction between startups and small businesses is well understood, but hasn’t sunk into the common business vernacular in most parts of the country.  Refer to The Founder’s Dilemmas and the book’s excellent discussion of the “high-potential startup” vs. the small business, and this talk by ‘super angel’ investor Mike Maples for some of the thought leadership on the subject.  In Silicon Valley, the culture and advisors preclude confusion.  It’s difficult to overstate the competitive advantage this brings the Valley’s startup ecosystem.  In the rest of the country, it’s crucial that advisors, investors, entrepreneurs, and community leaders understand and articulate the differences.  Helping companies intelligently choose to be on one side of the startup-small business chasm or the other will dramatically increase successful business outcomes with both.  Stuck and struggling deep inside that chasm is no place from which to be running a business.

This blog post is being simultaneously published on Startup Finance and CFOwise, the outsourced CFO solutions company.

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