Models of Business

Aug 2016

 

“Your work is going to fill a large part of your life, and the only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do.”

— Steve Jobs, founder and CEO of Apple Inc

 

“I knew that if I failed I wouldn’t regret that, but I knew the one thing I might regret is not trying.”

— Jeff Bezos, founder and CEO of Amazon Inc

 

A startup is not the same as a business. These aren’t synonyms rather a startup is a certain type of business. But there are other types of businesses also. Often just as successful but overlooked. We’re going to explore what they are.

 

 

Mittlestand

 

 

The Mittlestand is where the notion of dominating a global niche came from. It was a style of business pioneered in Germany whereby a company would make superior quality products and aim to dominate a small niche and create a small monopoly in a market with few to no competitors. The reason there’d be no competitors is because the market is too small.

Mittlestand companies make much of what you would normally overlook. The company that makes tags for shirts, or makes a certain type of button or manufactures the lids for pens or soy sauce container or a certain type of high quality zipper used by big pants makers or a type of glass screen used by televisions or the best quality steel for a certain type of kitchen knife etc etc.

They become very very good at a handful of very very specific things, which they then make and sell all over the world. A Mittlestand company typically grows to $10 million to $50 million in size and then stops there because they have saturated their market. They become the go to brand in the given niche and become virtually unassailable.

It is said that an economy made up of Mittlestands is highly resilient because the economy is made up of thousands of medium sized companies instead of just a few very large ones.

 

 

Keiretsu

 

 

A Keiretsu is a Japanese word which, translated literally, means headless combine and is basically a network of companies that are all shareholders in one another. It was created in feudal Japan and was a method the Japanese used for protecting their industries from competition. It creates like an interlocking web where lots of companies own a stake in all the other ones and will therefore help them and prevent them from dying. They will give contracts to each other, channel sales to each other and save costs by co-utiising resources.

To beat one, you have to beat all of them. So what the business can do is make a loss on one kind of company while making the profits on another kind of company. A great example is Coles in Australia which also owns Officeworks and Bunnings. They are all separate companies but use each others logistics networks to send products around the country. What they also do is use the profits from Officeworks and Bunnings, highly profitable companies, to fund the steep grocery discounts that Coles offers, which is a low profit company.

It creates a big safety net for all the companies involved and they receive a kind of safety in numbers. They are all less likely to fail as a result of things they can’t control like technology, competitors and are more likely to capitalise on new opportunities because they operate in so many industries with which they can do so.

But there are good and bad Keiretsu’s. The good kind are like Virgin and Tata Groups. Companies that just operate in a lot of different industries and spin up many distinctive independent companies that all vertically and horizontally integrate. Virgin runs an airline and a rocket business and you’d bet they use the same factories to build their spacecrafts as they do their aeroplanes. These are the good kind of Keiretsu’s.

The bad kind are usually ones associated with governments and are frequently caught up in corruption allegations. Does that sound familiar? A bunch of companies started by friends who then give contracts to each other? That may seem like an adequate description of a lot of government practices. What they are doing is the same thing the Japanese did hundreds of years ago. It’ll start to sound a lot like a cartel. If I prosper, we all will and I can use my influence to help you and you will use your influence to help me.

I think a Keiretsu exemplifies the who you know principle. Where the business succeeds or dies based on who you know. And if you’re not part of the club, you are explicitly at an unfair advantage. But people with lots of advantages of course don’t want to admit to having them. So what you get today is people who only start a company because they know it will be successful because they have friends in high places who will give them all the work.

This is perhaps the one people feel the most unhappy about. It’s because the whole premise is based of high ranking and highly influential people, at the helm of companies, channelling money to their subsidiaries and friends. It snowballs the rich get richer rhetoric and the practice in a lot of places is actually illegal.

What a company could do was start lots of competitors to itself while owning stakes in all of them. Then make the competitors which they own to lower their prices to unsustainable levels, effectively destroying the company and the market and hopefully taking their legitimate competitors with them. Or by using these side companies to follow around competitors and box them out of entire industries. That’s how you get the effect of when a store opens, sometimes a competing store that makes the same thing will open across the road.

Today, companies can’t own multiple competitors in the same industry and meritocratic tendering processes are enforced by regulators and tax officials. It is deemed uncompetitive and governments try hard to maintain free markets. This is all to protect consumers. The Keiretsu as a business artform is in decline. Probably in proportion to the rise in regulation because regulators are on the lookout for their practices. A lot of which are seen as anti-competitive. Whenever regulation is lax, the Keiretsu rears its head.

 

 

Lifestyle Businesses

 

 

This is the younger cousin of the Mittlestand and was popularised by the Tim Ferris book the 4 Hour Work Week. The premise goes, you create a business that solves a niche problem for a customer, make it profitable quickly in a way that does not require consistent effort, then earn a small income on the side for the duration it is operating. So you work on the business only a small amount and earn money from this effort in a highly automated way, so it is like the business runs itself and grows slowly.

But because the business is not generating a huge amount of income, you are not earning very much from it, the approach goes hand in hand with reducing expenses and moving to a low cost country where purchasing power is greater and money goes a lot further. You then benefit from this purchasing power discrepancy. So the business runs in the US earning in US dollars and you move to Asia or South America where the cost of living is much lower and you can get the same quality of life for a lot less. So $1,000 USD dollars earnt might not get you very far in the US, but will in Brazil.

You usually earn a large amount per hour that you spend working on the business and one day you might sell the lifestyle business for a small amount of money. The key word is in the name. The goal of the business is to provide a good lifestyle. Additional income to be able to take extra holidays, buy some more stuff and earn a small income that doesn’t require much effort and removes the individual from the “rat race” of a 9 to 5 job and gives them the freedom to be self employed. The companies are explicitly not started to become huge and mostly could never become large companies.

 

 

High Growth Silicon Valley Power Law Distribution (A Startup)

 

 

This model is the newest of all the models of successful businesses and probably will be the most influential in the future. The concept is largely piggybacking Moore’s Law and exists due to the growth of technology and personal computing. It is also capitalising on another phenomena that we are only just realising exists. The notion of a winner take all market.

Around 1930 began what is a tsunami of technological progress that hasn’t stopped and will likely never stop. The invention of computers. From then you have this wave of computers revolutionising every industry it touches. Industries that have existed for hundreds of years all suddenly find they are being revolutionised by computers and software. This is best summed up by the Marc Andreeson quote that “Software is eating the world.” Every company will someday be a software company.

Because of the leverage effect technology has on industries. We are starting to realise that many industries actually create monopolies and are winner take all. Google Search is a monopoly on web searches. Facebook is a monopoly on social networking. Microsoft is a monopoly in desktop software. Apple is a monopoly in computer hardware. Intel is a monopoly in microprocessors.

This is a recent phenomenon. Classical economics always believed that markets would create natural competitors which would compete to lower prices. And that is true. In most markets. But what makes the High Growth Silicon Valley Power Law Distribution company unique is that they specifically are companies going for such unique markets, it takes over the market and then grows the market. The company literally forces the market to exist.

Nobody knew they wanted to search so much until Google was making a good search product. The advent of a product like that, in the hands of millions and millions of people literally created the search market, which they then dominated a monopoly in. Nobody knew they wanted a computer until Apple started making a good computer and created the computer market. This is an unintuitive idea but it is important. That the company creates the market for its own product to dominate in. That is the idea that encapsulates these types of companies.

And technology has made it so cheap to get a product into the hands of so many people. That a good product, that creates a market, dominates to such a degree, it is a veritable monopoly. It will be a very long time before another company takes over the internet search market quite the way Google has. Or another company takes over the desktop software market the way Microsoft has.

These types of companies also have certain types of unpleasant characteristics that people take largely for granted. They are very very very expensive. Because they are growing with the sole intent of creating a market, dominating a market and becoming a monopoly in that market. They have to grow to saturate an entire market very very quickly. That costs a lot of money

Markets are quite large. For Facebook to saturate the social networking market, it has to be in the hands of literally everyone. And so it’s not surprising that these types of companies need to raise lots and lots and lots of money to even exist in the first place. And each of these companies are searching for large markets that skew towards a monopoly winner take all model. Meaning if they succeed in getting one, they will have longevity since they are able to extract money and value from those markets with few to no competitors, for a long time.

As we began to realise this, it gave birth to a new kind of company. A company that is geared to grow really fast and be the winner take all leader in a given market. Because of that effect, it justifies the large amounts of capital invested in them. The growth is often fuelled by investor money. Because markets are huge. And dominating a market extracts so much money and value from it. An entire industry emerged to support the birth and growth of these types of companies. Silicon Valley.

Many of the companies in Silicon Valley are explicitly started and funded with the view to go big or go home. You either win and become the leader in the market or you fail and go bankrupt. There is very little middle ground. And a certain type of financier has emerged in the last 100 years just to finance these kinds of companies. The Venture Capitalist.

Venture capital as an industry is only 100 years old. People forget that. But it’s a type of financing that emerged just to back these types of companies. Where 99 of 100 investments will fail and make nothing. But the 1 success will become a very large monopoly company. The venture capitalist is the only person who can sustainably fund these types of companies.

When people don’t understand how venture capitalists can comfortably lose millions and millions of dollars on failed investments, it is because of this axiom. The winners really do take all, and make up tenfold for the losers. Venture capitalists are the lifeblood for the creation of these types of companies. Bold, crazy new companies trying to pioneer new ways of doing something.

When these companies don’t work, because of their experimental nature, large companies of today use acquiring young companies as a way to expand faster and invest in new products without needing to build them themselves. They let young companies take on the risk of conducting research and development then they buy the one that seems to be winning. So many of these businesses that fail actually get bought and acquired.

In most industries, it is completely unheard of for a billion dollar company to be created in a short amount of time. But in this world, billion dollar companies are created in a short period of time, at a consistent rate almost continuously. And that is a beautiful thing. Because the creation of new companies and new products is the turning gear by which society and humanity becomes better and the world improves.

 

 

Legacy Generational Family Businesses

 

 

Historically, commerce has been conducted by families which would start and then run forever, growing slowly each year into a giant snowball. A business would open and then the owners would get their kids to work on the business, then they would get their kids to do the same and so on. These companies are in a sense started not to be sold but to endure and run forever.

The notion of starting a company and then exiting it is actually relatively new. Where companies today are often founded with the explicit purpose of being acquired one day. Rewind a few 100 years and a business that would be sold was a social stigma of inadequacy and failure.

The theory went that if a business needs to be sold, then it must have failed because a successful business would stay independent and grow into a mega corporation. And if it failed then it must have been the fault of the founders. A successful business is one that becomes an enduring one.

Family owned businesses account for over 30% of companies with sales over $1 billion and 70% of multimillion dollar companies worldwide are family businesses. These are by far one of the largest drivers of growth for an economy. Most family businesses are over 10 years of age and it is not uncommon for very large family businesses to be hundreds of years old.

If you looked into the history they are usually started by one or a handful of people who struggled for a long time, they then succeed and then it runs forever with every new generation of their family joining the company. You’ll find most of these business families will idolise their own history and turn the original founder into a type of hero worship since they created the vehicle that provided the wealth of every successive generation of that family. The history of the company becomes blended into the history of the family. They become inseparable.

With each new generation of the family going to work in the business, they benefit from the compounding growth that the previous generation put into it. The time compounds onto itself and turns the growing business into a form of mega snowball that has been rolling down a hill for many many years. By the 3rd or 4th generation this snowball has gained so much momentum, over 50 or 100 years that these companies are usually massive.

Most enormous companies, until recently, are actually of this nature. You can typically tell which ones they are if a person’s first or last name is in the name of the company. Sam Walton of WalMart or Fritz Hoffmann-La Roche of Roche Pharmaceuticals or Fred C Koch of Koch Industries or Henry Ford of Ford Motors. This is not always the case. Others are just normal brands such as Samsung. But it’s a helpful shorthand for identifying them.

A lot of people think these types of companies are evil since the children of these companies basically won the genetic lottery. They will have the rest of their lives set out for them. And all they did was be born. The business will usually already have a management team running the business. The children had their livelihoods created for them before they were even alive.

The children basically just have to not screw it up. Their talents don’t really matter to the business because of the way compounding growth works. A very large company that is growing and has all their operations taken care of, it doesn’t matter who is at the helm of it, if they just don’t interfere, it will likely keep growing. And if it has already had 25 years or 50 years or sometimes even 100s of years of growth behind it, very little can stop it.

This is illustrated with a simple thought experiment. If your goal was to start 100 stores. It is much much easier to get there if your business already has 50 stores. But if you have 1 store, it is next to impossible. In fact, if this business is growing at 30% per year. It will take the first business that started with 50 stores only 3 years to get to 100 stores. An appreciation of 50 stores. But for the second business, starting with 1 store, it will take 25 years to get to 100 stores. But both businesses are growing at the same rate of 30% per year. That’s the power of time and compound growth.

When a person inherits a big family business, they are inheriting the equivalent of 50 stores that are already growing in our example. Getting to 100 stores will largely happen anyway, regardless of what they do. From the outside that growth looks incredible for the person running the business, as if they are some business genius. But this was largely going to happen anyway. The person actually running the business isn’t necessarily a major contributor to it. But people have a habit of taking credit for the actions of their ancestors.

It’s why the next generation children of family businesses who take responsibility for the growth of the family business are frequently considered douchebags. Because they ascend to high ranking professional positions they would otherwise likely not have been able to reach. It’s basically luck based, applied nepotism.

And also because in many cases their business was growing anyway. They just needed to not screw it up. This is also the type of business you might consider the most “unfair”. Because your place in life is largely determined by which family you end up born to. Not because of the merits the individual possesses. If you were born to one of these types of businesses. Congratulations. But if you were not, there is nothing really you can do. That’s the luck of the draw.

What is sometimes a very potent combination is when a talented individual joins a family business but it’s difficult to discern how much was the individual versus the companies own merits. The benefit of a family business is based in biology, the instinct of a parent to nurture and protect their child from the realities of the world. It is the equivalent of a parent protecting their child from the economic realities of the world.

The sad part of these types of companies is when they don’t work. Because the business is comprised of family members. The family usually blows up and fails as well. This is how you get sad cases where siblings are suing each other. There is no protection as the lines between family and business blur into one. Succession problems frequently cause such companies to tear themselves and their families apart. Many of the problems are actually family problems.

In addition, the parents of children being born in family companies like this also have to go to extreme lengths to make sure their children don’t become spoilt, incompetent and useless as a result. People born knowing they never have to do anything in life to be well off, is a dangerous thing to their mental health. Children of such family businesses frequently experience depression, poor mental health and the feeling of never being able to live up to their expectations. They live their lives in the shade of a very big shadow.

The idealogy of a family business is baked in the notion of lineage, royalty and serfdom. With the historical origins of family businesses actually being a sad one. They were a way of keeping wealth insular and protecting a family from the world. Because the world was actually a bad place to be a few hundred years ago. A lifelong career and a livelihood was a difficult thing to earn. And they were a way for parents to ensure the survival of their children and to prevent their wealth from being taken forcibly by conquerors and governments. But this practice also led to some very distasteful activity such as inbreeding and incest as a means of keeping the wealth within the family.

Most of the failure of family businesses is when a new generation of family members enter the picture and tries to run the company without the talent to. They are at the helm of the company primarily due to their last name and bloodline. They then don’t have the business experience or acumen to be able to steer the company to continue being successful.

There is a famous saying about family businesses. Generation 1 starts the company and knows the value of work. Generation 2 grows the company, working with their parents. Generation 3 and 4 lose the company because by the time they arrive, the company is already huge. They have no idea the amount of work that went into creating it.

Indeed, less than 30 percent of family businesses survive into the third generation of family ownership.

 

 

Search Funds

 

 

Search funds are like business plans on steroids. While the startup world communally disregards the business plan, the search fund embraces it. What they do is design a theoretical framework for what an ideal company looks like, in an ideal market, then goes and creates it.

The way a search fund company starts is someone will research a market. They will then research consumer sentiment. They will try to design a product offering for these consumers. They will identify the key drivers of growth for this market segment. They will construct a brand based on current market leading brands, develop the product for these consumers and market and then finance the business. They will hire people to operate and scale the business while they move on to the next one.

The reason that paragraph sounds very dull and business-like is because this is what they are like. It’s why most search fund companies are started by finance types or MBAs or rich people. They have pre-created templates for companies that are in search of problems to solve. The premise is that a search fund company has no risk because it is a proven model of success. There is very little innovation going on. They are just taking a proven model and transporting it somewhere it is yet unproven. Frequently search funds literally copy verbatim existing businesses and just launch them in a different geography, somewhere it doesn’t exist.

What they are is solutions in search of ideas. Instead of the common silicon valley proverb of trying to solve a problem that you personally experience. This is the younger cousin where they design their solution, then go in search of problems. And the problems are not solved bottom up ie User X has this problem, if we just fix it for them then find more people like User X we will have a business, but top down ie there is this big market with people who buy Product X, if we just sell Product X, we will have a business.

The criticism of search funds isn’t that they aren’t effective but that they have no soul. There is no passion for the company. It is spun up almost arbitrarily. The most famous of modern day search funds is the notorious Rocket Internet and private equity firms looking to fund and create businesses. They’ll see a successful business in the US, then almost create exactly the same company in a different country.

 

 

Paths

 

 

Within each of these models there are two side pathways that you can take. The funded route and the non-funded route, more commonly known as bootstrapping.

The funded route is when you raise money from outside investors and means you grow faster but give up ownership, control and subject yourself to the economics of the investor. The non-funded route means you grow slower because you use the profits that you generate from the business to grow the business, but have more ownership and control and are subject to your own economics.

One of the stressful stories you hear about being an entrepreneur are the constant burdens of taking other peoples money. The third route, which is ill advised, is to borrow money from a bank or other financial institution. Don’t do this if you can help it.

Going into debt to fund a company can be one of the worst decisions an entrepreneur can make because if the business fails, and statistically it will, then you don’t just lose your money, but are liable for the interest and repayment of the loan. This can easily turn into a downward spiral and many lives have been destroyed as a result.

I wouldn’t recommend it unless a person is certain of repaying whatever is borrowed. Going into debt is something companies further along think about as the risk of cashflows is significantly reduced. It is cheaper for them to borrow money and pay the interest than it is to sell equity to outside investors. During the speculative early stages, as a general rule, you should not go into debt.

After deciding how to fund these models, there is another decision to be made. How do you go about starting a company? The common wisdom is that you need a cofounder but this is more for the high growth Silicon Valley model. If you’re going to grow really fast, to the point it is condensing decades of working life into a few years, then you need to spread those stresses over a greater surface area and therefore need more than one founder. But in any other model, starting a company by your self isn’t just encouraged, it’s more likely to result in success.

In every model that is not a high growth tech company. One of the most common modes of failure is co-founder infighting. So simply by not having a co-founder you can remove one of the major stress points of failure. This will, all things considered, improve the odds of succeeding. This is not to say that at some point business partners aren’t brought in to help grow the company. But the founders need not necessarily be more than one person.

You can also move faster and remove decision making burden since the only decision that matters is yours. I’ve experienced first hand what it’s like to have crappy co-founders; people who were talented, I’d known for a long time and trusted, who inevitably screwed over the company. It sucks. I was fortunate this experience happened young so the company wasn’t caught in the crossfire. But I can understand how many do.

Just because you’re not a high growth tech company doesn’t mean you can’t be a high growth company. Every company is capable of being a high growth company. The major difference between a company that is designed for growth versus one that isn’t is that the processes are systemised and easy to replicate.

McDonalds doesn’t just open stores and run them. They have a system for opening stores and a system for how they run. It’s why every McDonalds runs more or less the same way and they can replicate their success with ease, resulting in their high growth. It is also why you can walk into just about any McDonalds in the world and the products will still taste the same.

The main advantages of high growth technology companies is they have effectively 0 fixed costs, no upper limit on how many units they can produce and aren’t limited by geography. Most companies are not like this. They have fixed costs and can only serve some limitation of units and are geographically constrained. If you tried to ship a burger across the world, it wouldn’t be very tasty when it arrives and it would cost you money to ship because a burger is a real physical good.

 

 

Types

 

 

There are also different types of product companies. Which are defined by the different models for work and creating something new. There is the kind of work where you make something very hard for a short period of time, then release it and never work on it again while earning money from it forever model which typifies music, movies, books, houses, buildings, paintings etc.

Then there is the model popular in the startup world, which is spend only a short amount of time and release incremental versions of your work constantly, then work on that same thing over a long period of time, constantly selling it while building entirely new works, which also get released iteratively. Things like software or social networks or search engines run on this principal.

And then there is the in between. Where you spend lots of time creating something new, then you spend nearly all your time manufacturing, building it and sending it out to people who then sell it to other people. Then spend time releasing small improvements to it each time. This is most companies, particular real world product companies. The quantums of innovation in a sauce bottle are not the same as that of cloud computing. And this model applies to burgers, laptops, furniture, fridges, televisions, bottles, etc. Most things in fact.

Another model is you invest a lot of money into creating a machine that can manufacture and create things. Then you market how good you are at making stuff for other people. Once orders come in, you manufacture the thing and send it to people, typically in bulk and are paid for it, usually on credit. Almost every manufacturing company runs like this. Examples are metals, cars, microprocessors, etc. These companies are usually involved somewhere in the making of other things. As in they are good at making metal into shapes. Then other companies pay them to make their televisions, laptops, steel, zippers. Anything that the metal might be used for.

And the final model is a company that invests in really good operations or really good knowledgeable people who know about something, then it makes money holding things for other people, finding things for other people, and companies and moving those things around or by giving advice or trading in their hours for providing value. It doesn’t really sell anything per se or have a product per se. It makes money doing things for other people or discovering new things. Things like shipping, storage, logistics, law firms, consulting, services, mining companies etc.

 

 

Configurations

 

 

In each of these models is the number of people involved at the founding. Sometimes it’s 1 or 2 or 3. Other times it’s entire families that start a business. But they usually fall into a handful of reasonably predictable configurations. Most technology startups are founded by 2 people. Most family businesses are started by 1 person. Most search fund companies are founded by 4 or more people.

Another varying degree is how much of the company the founders will end up owning in the end. Typically with a high growth tech company, after multiple rounds of financing often the founders are left with less than <10%. But a small stake in a big pie is still a very big stake. While in most of the other scenarios the founders own the majority of the business. But it is usually a much smaller business, or is one growing slower. Money is used to buy growth. So companies that raise money, grow faster. But to get money, you have to sell ownership and control.

What is measured is also very important. If a company is using investor money to grow, it largely doesn’t matter if they have profits. What matters is the growth rate. But if it is a family business and there are no investors, profits are really important. Because by reinvesting profits is how the business is growing.

This distinction is frequently visible when people are debating the importance of profit to a company. For a fast growing company that funds itself with lots of investors, profit is almost unimportant. What is important is growth. If growth ever slows, then the business is in trouble. It doesn’t matter how much money is made, so long as it is growing really fast.

The bet with these types of businesses is that profits will materialise at scale and that the business model is one that is unable to be successful when not at scale. Usually this is right. In fact most types of businesses would have enormous profits at scale, but surviving until they reach scale is the problem.

But not every type of business can survive when not at scale. A search engine or social network would not be able to survive when not at scale. So what Venture Capitalists try to do is to find the businesses that can only survive at scale and then bring them there while trying to keep it from dying the entire way.

Conversely profit is very important to companies who fund themselves from revenues. These companies don’t typically have many investors and their growth rate is not important so long as profits are present to fund the operations of the business. What is left over is then used for growth. The debate between Profit VS Growth is about as old as business itself but because they both work in different circumstances, there is no broad rule.

 

 

Conclusion

 

 

There is no right or wrong for each of these businesses. They are just different types of snowflakes. And frequently when you see people debating which is right or wrong is gratuitously stupid because the answer is usually both of them or neither of them. They are more like formulas for working out certain types of equations.

To create a Facebook, you need the hyper growth silicon valley approach. To create a Pfizer, you’re better of with the generational family approach. To create a BMW, you’re better off with the Mittlestand. To create a Samsung, you’re better off with the Keiretsu. Certain kinds of companies thrive when started with the right configurations and circumstances.

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