Is Your Startup Linear or Exponential? – Pitching Angels
Why venture investors avoid service businesses and what to do about it
Most small businesses are service businesses. Doctors and lawyers, accountants and agents, plumbers and electricians, gardeners and hair dressers, even dog walkers and babysitters — are all service businesses.
Service businesses are great. They’re easy to set up. Just put out a shingle and start selling your services (though you may need to get a medical license or pass the bar exam first.)
My startup consulting is a service business, as is my wife’s ikebana (Japanese floral sculpture) business. If my startup consulting business becomes popular, I can hire more consultants to join me. The more clients I sign up, the more I can expand.
Most service businesses are truly small, like my writing here on Medium, while others can have dozens to hundreds or even thousands of employees generating billions in revenue.
With so many great service businesses, it’s no surprise that early-stage investors hear many pitches for them. Most of the startups I meet at university accelerators are service businesses of some kind.
Service businesses are good businesses. If I can sign up even a few clients to keep me busy, the business will be profitable from the start. A successful service business should be profitable and able to generate dividends every year.
But despite service business being easier to build and far more likely to be successful than product businesses, investors always pass.
Here’s why. And what to do about it.
Why Venture Investors Won’t Invest in Service Businesses
Imagine the following pitch: PalterStart is my vision of a startup consulting business. Give me $2M to hire 4 consultants, a graphics designer, and a social media expert, and within days, I can start offering PalterStart’s consulting services to desperate founders.
Sounds like a great business idea, right? You’d pay an expert like me to help develop your go-to-market, craft a killer pitch deck, and find investors, wouldn’t you?
We’ll be at break even within a year and ready to disrupt the industry. With a $100M seed round, I can expand the business around the world. We’ll become the McKinsey for startups. World domination is only a few years away. Better write your check now before our pre-seed round fills up.
It’s a good pitch. It’s a good business. But it’s a bad investment.
Here’s the thing: services business can’t grow exponentially. They grow linearly. For every new client we land, we need to hire more consultants. We can’t take on more jobs than we have consultants to fulfill them.
Word of mouth, a great reputation, even my brilliant marketing can’t increase sales faster. Contrast that with software where there’s no limit on the number of copies I can sell. Or even to batteries, where I have to build a manufacturing plant, but once I do, the marginal cost for each battery should be small. Once those businesses succeed, they grow exponentially.
Worse, there’s no good exit strategy for a service businesses. Who would want to acquire it? Private equity will buy a profitable, cash-generating business, but not at the kind of multiple needed for venture success.
Perhaps McKinsey or another consulting giant might decide to get into the early-stage startup space, but they wouldn’t pay much to acquire another consulting business. Like most service businesses, we depend on people. And when the people leave, they take their clients with them. That limits the value of the business to potential acquirers.
Further, there’s no barriers to entry. If McKinsey decided to get into startup consulting, they could compete with us tomorrow. And so can 100,000 other startup mentors on LinkedIn.
My only hope of creating a competitive moat is through massive advertising and brand building, but that will be tough when there’s no magic sauce, no reason to expect one startup consultant to be any better than another.
The Platform
Imagine instead, I create a consulting project posting board called StartupConnect, a kind of Upwork for startups.
I get those 100,000 startup mentors, pitch deck designers, digital marketers, legal advisors, and all the other startup community service providers to post their profiles, their portfolios, and their prices on StartupConnect. And I get startups to post their projects. Maybe even add a little AI to help identify the best matches between startups and providers. Now we have a platform. I’ll take a 15% cut of every project.
Give me $2 million and I can have the first users onboarded in 6 months. Gimme another $10 million, and I can expand across the entire startup ecosystem next year.
Instead of selling consulting services, I’m selling a platform for startups and consultants to find each other. You may call this software as a service, but it’s a product. I’m not consulting for you, or finding you consultants but giving both sides a platform to conduct business. What I create once can be used by an infinite number of users.
With a small amount of money to build and market the platform, revenues can grow exponentially. Within a year, we’ll be the go-to solution for everyone in the startup world. With all the consultants signed up, all the customers will come. With all the startups here, every consultant will sign up. The classic startup flywheel. Competitors will be unable to compete with our size and reach.
Best of all, while revenues grow exponentially towards a billion dollars, expenses grow linearly. Sure, cloud costs increase with usage and we’ll need to up our marketing game, but there’s no reason why we’d need to add a lot of new employees, open offices in fifty cities, or do much else to expand the platform.
If Upwork wants to get into startup consulting, they’ll have to buy us. If Carta wants to grow beyond cap tables, they’ll have to buy us. If Google, Amazon, or Microsoft wants to become the center of the startup world, they’ll have to buy us. I guarantee we won’t be cheap. And if they can’t afford us, we’ll IPO like Uber and AirBnB. That initial $12 million investment will turn into a multi-billion dollar exit. Put in a $100,000 investment, get out a billion. That’s the type of returns VCs are searching for.
This is why venture investors want to invest in us, not individual consulting businesses, no matter how big or profitable. That’s why they invested in Uber rather than buying taxi operators, AirBnB instead of vacation homes, Teladoc rather than medical clinics.
What To Do With Your Service Business
You’re a dog walker. It generates a decent revenue, but it’s hard to find investors.
One option is to remodel the business as a platform. It’s a huge opportunity. That’s why there are already a dozen startups in the space. Plumbers and electricians? We already have Yelp and Angie’s List, but someone ought to make a more specialized platform.
But I hear you — you’re not a programmer. You don’t want to build a platform. You’re a doctor and the community needs you caring for sick people more than it needs you to become another programmer. But you need money to open a clinic.
The simple answer is if you’re building a service business, don’t bother pitching to venture investors. Venture investors put money into exponential businesses like AirBnB. If you’re planning on generating profits and paying dividends like a normal business, you’re in the wrong room. Unless you have an exponential business, it doesn’t fit the high-risk, high-reward model of venture capital.
But venture is just one kind of investor. You need to be looking for other types of investors, the ones who are interested in receiving dividends or interest from investing in lower risk businesses.
Who’s going to give you a loan to start your service business? They’re not venture capitalists, startup investors, or people who call themselves angel investors. They’re friends and family. They’re local banks and the Small Business Administration. They’re specialists who understand your industry and know a good opportunity when they see one.
Real estate investors buy, sell, and operate vacation homes. Local investors buy taxi medallions. Specialized investors offer loans to doctors to buy medical clinics. Private equity investors love businesses that generate consistent cash flows.
But most often those investors are yourselves— taking out a second mortgage on your house, running up credit card bills, or building that ikebana business while your spouse pays the rent by writing articles on Medium.
Although a teleporter provides transportation services, it’s fundamentally a product. Once SüprDüpr builds their chain of teleporters they’ll be able to teleport a nearly infinite number of users. That’s why SüprDüpr has the venture capitalists drooling and all of Silicon Valley buzzing. But what happens to their valuation when employees begin disappearing? Find out in my crazy, award-winning Silicon Valley mystery novel, To Kill a Unicorn.
