Scaling Up Start-up Communities: Engage Risk as Your Friend, not a Foe—to Impact Investor DNA—& Raise $ for Your Venture

The most frequent complaint I hear from entrepreneurs in the emerging markets is the lack of risk capital in their country; investors willing to finance start-ups and early stage companies.  Many founders travel to America seeking money and connections in the US venture ecosystem.  While a few are able to raise cash, most don’t—and return home empty handed—to face an unknown future.

With trillions of dollars invested in food & beverage, fast moving consumer goods, retailing, wholesaling and construction to name just a few, plenty of money exists in the developing world—from Beijing to Buenos Aires to Bangalore—and from Moscow to Manila to Mexico City.  So if there is so much capital seeking opportunities, why is it such a struggle to get local investors to open their pocketbooks and finance technology, 1st time entrepreneurs and early stage SMEs? And what actions can entrepreneurs implement to ‘shape’ their business models to the risk attitudes and behaviors of investors + learn to ‘sell risk, then opportunity’—to raise $ for their ventures?

I spoke on these subjects to entrepreneurs, investors and government officials from East Europe as the invited guest of US Ambassador to Croatia, Mr. Kenneth Merten and his economic section chief Thomas Johnston at the Brown Forum. This event commemorates former US Secretary of Commerce Ron Brown’s (Clinton Administration) efforts over 20 years ago to initiate trade between states of the former Yugoslavia—after years of war and conflict—and the United States.  The theme of 2013’s event was ‘Entrepreneurship & Venture Capital in South East Europe.’

Topics in my 16 minute video talk include:

  1. Investor behavior is driven by the cultures of risk:  What it is, how it differs in the emerging markets vs. Silicon Valley and actions to make risk your friend—not your foe
  2. Debunking myths—what investors (do/will) finance in emerging markets. Risks ‘bought’ by investors in the developing world & risks which scare them (beginning with slide #39)
  3. Business models which unlock capital—& those that don’t

What I ask of you

With a deeper understanding and insight into the risk behavior of capital, entrepreneurs can create and ‘shape’ business models to unlock the wallets of customers and investors. So please write me with the solutions and strategies you used to overcome the cultures of risk and raise $ for your venture.  I’ll share your stories here.

Part V: Scaling Up Investment—Finance the Startup of Start-up Communities

In Part V, subjects discussed:

1.)   For Entrepreneurs—What are You Selling to Investors?

2.)   For Investors—Let’s Be Realistic

3.)   For Governments/Development Finance Institutions—Atypical Leadership Needed

4.)   Concluding Remarks

5.)   My Next Blog Series—Mobilize Local Capital to Finance Your Dreams

6.)   About Me

7.)   Links: Evolution of Runet (Russia Internet) & the Russia Tech Scene

Last time in Part IV, the Quest for Growth, I discussed:

1.)   Clonentrepreneurship or Alternative Paths to the Start-up of Start-up Communities?

2.)   Change the Culture & Amazing Things Happen

Read Part IV here.

The ‘take-away from Part IV.

Clonentrepreneurs sensitize local investors to the rewards of investing in technology since clones match the behavior of local investors to risk. As results are achieved and money is made by all, investors open up to new investment opportunities a bit more adventuresome and innovative—disruptive vs. cloning.

Cloning and Clonentrepreneurship is one strategy to impact the DNA of local investors in emerging countries to spark the startup of start-up communities, but of course others exist.

What are the other actions which each you can take to achieve your objectives and fuel the startup of start-up communities?

For Entrepreneurs—What Are You Selling to Investors?

Entrepreneurs raising money too often attempt to shape investor risk behavior to their investment opportunity. Instead, shape your business model to match the needs of not only your customers but investors too.  Think creatively to find the solution which your customers will pay for—no matter how little the revenue is per customer—to craft your business model to match investors’ DNA to risk.  Design your business model and its execution to systematically attack each of their fears to early stage tech deals.

Once you have this business model executed with paying customers, approach investors by ‘selling risk, then opportunity,’ i.e., demonstrate how you’ve eliminated risk in each of the four categories to prove your great investment opportunity. Once you raise money, execute yes but also pay forward in your start-up community; be the role model to other entrepreneurs, teach/mentor them in the solutions which you executed to overcome the fears of local investors in emerging markets.

For Local Investors—Let’s Be Realistic

Rarely will Western clones match the big returns as your investments in telecomm, real estate, construction, food/beverages, fast moving consumer goods, wholesaling and retailing have performed.  Yet as the economy in your country progresses and incomes grow, populations and enterprises open their pocketbooks to products and services which better match changing needs. 

In the Chinese online travel industry for example, Ctrip and eLong have millions of registered users. Entrepreneurs seeking money to compete against them is risky and uncertain; however opportunities exist for unorthodox business models. For example, Chinese company Qunar is a travel search engine for online travel services. It aggregates travel information like air tickets, hotels and holiday offerings so Chinese consumers can make better and more informed travel decisions. Qunar serves the evolving needs of consumers and achieves success by approaching the market differently by making competitors—its partners.

Tell entrepreneurs your needs for business models which generate revenues in the immediate term; postpone your demands for immediate profits and cash distributions. Be creative in deal structuring and flexible to valuations since tech business models scale better across customers and geographies to justify higher prices paid vs. investments in brick and mortar.

Structure the investment agreement to align and incentivize entrepreneurs to your attitudes and behaviors to risk.  Oh, how does that work? An example:

American investor financings typically include an equity option plan for founders and employees.  In some emerging countries, legislation permits the issuing of equity options to management of start-ups. When permissible, distribute equity shares based on revenues realized vs. traditional metrics like length of time served in the company or # of users engaged. If legislation does not permit this action, structure the investment agreement as equity earn-ins held in escrow with shares issued when agreed-upon metrics are achieved.

For Governments/Development Finance Institutions—Atypical Leadership Needed

Governments and their finance institutions conceive venture initiatives to catalyze venture funds, to finance the startup of start-up communities.  Frequently these funds are modeled to the program called Yozma, the Israel Government’s fund-of?funds.

Yozma was capitalized with $100 million; $80 million which financed new VC funds with $20 million for direct investment into Israeli tech SMEs.  It invested $8 million into a private VC fund with a minimum of $12 million/fund invested by Israeli and foreign venture capitalists. Yozma financed ten VC funds with a total capitalization exceeding $200 million. These funds went on to finance innovative companies and spur the development of the high tech SME and VC industry in Israel, where one did not exist before. Fast forward 10 years and the 10 funds supported by Yozma were managing over $3+billion with the VC industry in Israel managing $10+billion.

Yozma-type schemes offer economic incentives to induce investment and build learning experiences in seed and early stage tech investing such as:

1.)   Commit up to 49% of the capital to the creation of a new VC fund

2.)   Offer preferential returns to investors

3.)   Take 1st losses on failed investments

4.)   Cap financial returns to the Government so as to boost profits to investors

5.)   Subsidize management fees &/or pay the costs of investment due diligence

6.)   Allow private investors to ‘buy-out’ the Government’s equity, usually within the 1st five years of fund operation, at cost + a bank interest rate of return

Yozma worked exceedingly well in Israel and a few industrial nations.[1]  But results in China, Russia, Chile, and other emerging countries has not been so spectacular; local investors didn’t respond in the #s or volume of investments in the seed and early stage sector as expected and targeted by sponsoring governments.[2] 

Hmmmm. Reality sets-in as staffers scramble for new solutions and a chair before the music stops.  “Let’s try something different.”

When domestic capital does not change its risk behavior to seed/early stage tech, government staffers work vigorously to create a new class of investor—angels—since their risk behavior better matches the profile of entrepreneurial ventures. While angel investors are welcome in all countries, developing this community takes years to accomplish with multiple false starts and entrepreneurs seeking money now going unfunded.

Hmmmm—let’s rethink what the initiatives should be.”

Plenty of money exists in the pocketbooks of local investors in emerging markets to finance start-ups for a start-up community to emerge.  What’s required is the unlocking and mobilizing of local capital for investment in technology, 1st time entrepreneurs and early stage tech SMEs. Certainly encouraging a cloning strategy in the entrepreneurial community is one solution to unleashing local capital as the successes of Russian clonentrepreneurs proved. 

Another solution is to think forward—design venture schemes which better match local investors’ behavior to risk and the mentoring of local investors in early stage tech investment. Include in this mentoring ‘show & tell’ sessions of other financing solutions: royalty based or technology performance financing schemes, i.e., capital invested in technology SMEs with investment returns generated from the cost savings and/or revenue enhancement earned by customers.

What else might you do, say with founders and management teams?

Organize a mentoring program; get them the mentors they need to ‘shape’ early stage tech business models to the risk attitudes & behaviors of local investors + ‘sell risk, then opportunity.’ Until investors can understand and ‘buy’ the risk in start-ups & early stage SMEs in the emerging markets, little capital will flow to them.

But what can you do if you seek to do something more ambitious, i.e., generate knowledge creation to disrupt industries and attract local investors for the needed finance?  Deal flow funds are one solution to attack both needs.

Deal flow funds finance entrepreneurs and SMEs executing to a single technology, product or service platform, technical challenges that require new thinking in science and engineering to accomplish.  What might be an example of technical challenges in need of solutions?  Take a look at these slides which tell this story.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

A ‘deal flow’ fund finances technology development and commercialization.  And in Russia for example, development of the Shtokman field is a national priority of the Russian Government, not only because of its wealth potential but also the promise of new economic prosperity to the Russia Far North.  The linking of technology to a country’s national priority helps assure local financiers that innovators deploying the tech have a market and paying customers.  It’s this matching of tech solutions to customers which harmonize the risk behavior of local investors to the risks of start-ups and early stage SMEs.

 

Concluding Remarks

Emerging markets face huge obstacles in finding talent, capital, knowledge, and yes, the business models which match the risk appetite of local investors.

Clones are one solution to spark the startup of a start-up community since they generate the revenues which local investors demand as a precondition for investment.  As Clonentrepreneurs achieve success, it encourages others to try entrepreneurship too.  Some are a bit more venturesome and launch improvements to models cloned from the West.  Others do something different and inject their own notions of creativity by innovating new solutions layered on top of Western platforms like Russian beta-stage start-up ClipClock is doing to YouTube or IVI.ru is doing in the Russian video streaming industry.

And isn’t that what we want?

More entrepreneurs driving business and economic growth, irrespective of the business model or the platform technology. We all want more investment, more initiative and more conversation with more saying “I can do that” and “I can invest too.” Such actions generate the growth, the economic opportunities for citizens, and the prosperity that all countries, regions, cities and towns desperately seek.

A Future Blog Series: Mobilize Local Capital to Finance Your Dreams

This is one of the topics I mentored 80 entrepreneurs from 36 countries—at Singularity University, located in the heart of Silicon Valley.  These entrepreneurs learned about exponential technologies to solve global challenges, and my job was to work with them—selecting ideas, developing and shaping business models to investors’ behavior to risk.

I was one of approximately 16 or so team project advisors selected from around the world to mentor these entrepreneurs at Singularity University, created by x-Prize Foundation founder/CEO Peter Diamandis and inventor, entrepreneur and futurist Ray Kurzweil.

Till then, be well and be lucky


[1] For explanation why Yozma worked great in Israel and not so well in emerging countries, see ‘The GoForward Plan to Scaling Up Innovation, page 4 (English). For my Russian readers, go to ‘The GoForward Plan to Scaling Up Innovation,’ by Thomas D. Nastas, June/July 2007, Russian edition, Harvard Business Review.  Hungarian readers go to October 2007 ‘Scaling-Up the Innovation Ecosystem,’ Hungarian edition, Harvard Business Review; Sept. 200. Spanish readers go to ‘Innovation for Growth,’ Latin America edition, Harvard Business Review

[2] For explanation, how local investors in emerging market typically behave-invest, when managing Yozma-type schemes, see slides 50-68, ‘Bridging the Valley of Death,’ presentation of Thomas Nastas to staff of the World Bank & IFC, 29 November 2011

About Me

I am a venture and private equity investor since 1986, financing university tech in Michigan with liquidity events including Neogen (NEOG: NASDAQ), AISI Inc. (acquired by ESI, ESIO: NASDAQ, USA) & Personal Bibliographic Systems (acquired by Thompson Financial, NYSE: TRI) as examples.  An entrepreneur myself, I left Michigan in 1992, created int’l and emerging market funds in Africa, Canada, Europe, Kazakhstan and Russia, for ROI & economic development, i.e., >$300 million invested to advance entrepreneurship, innovation and growth in int’l and emerging market countries.  I am past/current Independent Director, Board of Directors of eighteen (18) companies over the past 25 years, USA & international enterprises.

I can work with you in four ways.

1. As an investor advising LPs and GPs in your country for emerging market investment, create venture initiatives (+ raise capital). I invested my own capital + established and managed cash flow, venture, private equity and fund-of-funds as shown in the1st picture below. The 2nd picture shows the deal structures and strategies executed to localize money for investment in each country and to match local investors’ behavior to risk.

2.  As an advisor to Governments & development finance institutions.

  • Design & execute venture initiatives: My clients include Development Bank of Canada, European Commission, European Bank of Reconstruction & Development, IFC/World Bank, Russian Venture Company, Govts of Slovakia, Croatia and the US Govt’s USAID—create, startup, finance & execute:
    • Venture capital funds
    • Venture lending funds
    • Private equity funds
    • Royalty based & cash flow funds
    • Fund-of-funds
  • Design & execute grant schemes—to advance tech dev. thru commercialization:  With six other directors, I manage the $85 million technology commercialization project in Kazakhstan, making grants to finance and advance science from proof-of-concept thru 1stcommercialization.
    • We established the policies/procedures for grant investment, criteria, tender & selection process including all documentation for program execution
    • Selected & committed $22.5 million to 21 development stage SMEs and R&D groups in 2011 & 2012, average grant ?$1MM
    • I lead the creation of 1st technology commercialization office in Kazakhstan, to transfer Kazakhstan tech to market.  I established strategy, programs, key performance metrics, deliverables and all tasks for commercialization & execution-budget is $2.8 million, staffing of four international experts + five Kazaks.
  • Design & execute int’l—cross border tech transfer & commercialization initiatives:  Conceive programs and connect—Russian Corporation of Nanotechnology (Rusnano)—& int’l organizations
    • Created project to establish technology proof-of-concept tech dev. & commercialization program between Rusnano & tech transfer offices of US universities (e.g., Colorado, Utah & Michigan). I established the trust and confidence in the parties to negotiate & secure signed agreements

3.  As an entrepreneur mentoring founders & entrepreneurs as an Independent Director, member of the Board of Directors or member of the Advisory Committee.  I established legal entities, hired & managed staff in Africa, Canada, Europe, Kazakhstan and Russia, all costs of market entry and operation financed by me. Living, working and      investing in these counties—paying the bills too—developed in me the experiences to counsel:

  • Founders of mid-size companies, revenues to $100 million, solutions to integrate their firms into global markets, harmonize products/services & the organization for this global expansion, raise int’l capital and build the 2nd tier layer of management for execution
  • Entrepreneurs of early stage companies, my contributions include conceive/negotiate partnerships for 1st commercialization, raise 2nd round VC financing, ‘shape’ business models to the risk profile and behavior of local money in the country, mentor/counsel management team in growth & development

My other contributions to global entrepreneurship:

4.  As a thought leader & advocate of VC, entrepreneurship and innovation to solve global challenges, I conceive and deliver keynote talks and Master Classes to engage stakeholders with the ability, interest and resources to finance technology commercialization and early stage venture capital.  View my publictions which spread ideas—solutions to create more investment, innovation and entrepreneurship.

Let’s engage, how make an impact, make money and have fun. Contact me at Tom@IVIpe.com. Learn more at Scaling Up Innovation.

Links: Evolution of Runet (Russia Internet) & the Russia Tech Scene

Top 10 Web Start-up CEOs in Russia, 2011

Top 10 Russian Web Startups of 2011

Top 30 Russian Internet Companies (Forbes, 2011)

Top 10 start-ups of 2009

Top 10 Internet Entrepreneurs, 2009

Top 10 Internet CEOs in Russia

Top 10 Russian Venture Capital Internet Investors 2009

Top 10 Russian Web Startups, 2008

Top 10 Russian Web Apps & Sites, 2007

http://www.eddy.lt/2011/12/10-must-know-facts-about-russian.html#!/2011/12/10-must-know-facts-about-russian.html

http://goaleurope.com/2012/04/21/eastern-europe-weekly-news-from-eastern-europe-baltics-russia-ukraine-and-poland/

http://thenextweb.com/russia/2012/04/19/skolkovo-stimulating-russias-it-industry-by-spending-stupid-money-smartly/

http://thenextweb.com/russia/2012/04/20/already-europes-largest-internet-market-and-still-growing-astoundingly-fast-russia-by-the-numbers/

http://thenextweb.com/russia/

http://www.marchmontnews.com/Archive/News/18636.html

 

 

 

 

 

 

 

 

Part III: The Power of Clones to Startup—Start-up Communities

Subjects in this post include:

1.)   Drive Growth and Innovation in the Supply Chain

2.)   Sidestep the Obstacles that Impede Scaling Up—Investor Attitudes to Risk & Failure

3.)   Controversy of Clonentrepreneurship: Cloning the Idea or Hatching a Start-Up?

4.)   The Spread of Clonentrepreneurship

Last time in Part II, Cultures of Risk—Financing the Startup of Start-up Communities, I discussed:

1.)   The Cultural Divide:  What Investors ‘Buy’

2.)   What Investors Fear

3.)   The Culture of Venture Capital:  Friend or Foe?

Read Part II

Read Part I

Read Introduction (to the series)

The ‘take-away from Part II. Local investors in the emerging markets ‘buy’ risk by investing in the known and understandable. This explains why they finance business models of fast moving consumer goods, food and beverage, supermarkets, telecoms, light manufacturing and automotive components as examples.  Investors finance such business models even at the seed and early stage of company development.

The reason investors invest as they do; markets and customers are a 100% guarantee in these sectors, even in greenfield projects, with the risks of investment in execution, not the risks of market existence and the uncertainties if the tech will work, will customers come and pay.

Clones copied, localized and pasted into emerging economies impact the DNA of investors to risk since many generate revenue quickly—overcoming the fears that investors have for early stage tech.  But impacting the behavior of investors to risk is not the only contribution of clones to the start-up of start-up communities.

Drive Growth and Innovation in the Supply Chain

Although clones look the same on the surface, one country to the next, there are multiple differences in execution.  Many clones require supply chain partners for them to work, yet many of these companies do not exist in emerging countries.  While outsourcing from delivery to call centers are common services for hire in the US and Europe, clones frequently build them themselves, in what I call ‘self-sourcing.’  In other cases, new supply chain entrepreneurs emerge to offer the services to make clones work.

Let’s examine three such innovations.

Logistics and delivery

Lack of effective and efficient delivery companies forced Ozon, the Russian clone of Amazon, to organize its own logistics operation for door-to-door delivery of goods to their customers in Moscow and St Petersburg plus the delivery to more than 2,000 pick-up points across the Russia Federation.  With this asset in place, Ozon offers delivery services to others as the market for online businesses grows in Russia.  Like Ozon, the discount shopping club KupiVIP delivers product with its self-owned fleet of 100 vans; it leases extra vans when capacity is short. Yes FedEx and DHL exist in Russia, but the cost for local delivery approaches $100, too expensive for a book costing $15 or a $40 pair of shoes.

Getting paid

65% of all transactions in Russia are paid for in cash.  Almost 90% of Ozon revenues ($300 million) are cash.  ATM’s that accept cash for payment are widely used in Russia, made by QIWI, a Russian innovator.  But a new complication develops in a cash economy. In Russia for example, customers regularly inspect the goods to confirm that what was ordered is actually in the box. 25% of all online orders are rejected by the buyer with no money trading hands in cash transactions, or a credit has to be made if payment was made through a QIWI terminal, another snag that required innovation for e-commerce clones to work in Russia (and other emerging market economies based on cash vs. credit or debit card transactions).

Call centers required to reassure online buyers

50% of Ctrip (Chinese online travel company) customers purchase tickets by phone as do large numbers of Russian customers of Ostrovok, a Russian online travel company.  Both Ctrip and Ostrovok operate self-owned call centers staffed with real live persons to reassure customers that their on-line orders are placed, accurate and confirmed.

Clearly what emerging markets lack in the sophistication of online shopping in the United States creates a sea of supply chain opportunities for more start-ups to service clones in the developing world.

Sidestep the Obstacles that Impede Scaling Up—Investor Attitudes to Risk & Failure

It’s great to talk about the need for failure, how great business models evolve from failed attempts and the need to encourage more failure. The question is who pays for this learning, and how recover from it? Investors not only in Russia, but other emerging markets label a failed entrepreneur a loser for life, never to raise money again with failure an embarrassment that frequently spills onto her or his family; such shame creates an environment where entrepreneurship is discouraged as a career path vs. a ‘safe’ job, e.g., working for Government, a state-owned enterprise or a multinational corporation.

Even more troublesome is another deep seated cultural attitude to failure in emerging market countries.

Failure = Fraud: we know this is not true, but that’s the verdict when entrepreneurs fail in emerging markets.

The attitude that failure equals fraud stems from ‘who pays for the cost of failure’ as failure in emerging markets means the promoter, the entrepreneur, and the team did not possess the competencies to overcome the challenges of development, or did not really understand all the requirements needed (or did not do all) for success. Yet we know that experimentation, trial and error, failure and pivoting are necessary to define the requirements for business model creation, making the path to progress unlikely in developing countries.

In the former Soviet republics, East Europe too, entrepreneurs and scientists have financial responsibility to repay money under failure; prosecution and jail-time are real possibilities.  Even more chilling are the threats of investors to entrepreneurs “You lost my money (equity), now you must pay the money back (i.e., the investment is equity if achieve success, debt if the venture fails!).”

The fears of investors, attitudes to failure and who pays for failure create a culture that makes early stage venture capital dicey in the emerging markets.  Such behavior discourages risk taking and incentivizes entrepreneurial commitments to proven business models for proven markets like fast moving consumer goods, retailing, wholesaling, telecoms, and yes, clones from Clonentrepreneurs.

But given the successes of clones to start an entrepreneurial revolution in a country, they are not without their critics.

The Controversy of Clonentrepreneurship: Cloning the Idea or Hatching a Start-Up?

Given the successes of clones to satisfy the appetites of domestic customers and local money, they have their critics when taken to the extreme.  Sarah Lacy wrote an upbeat article in TechCrunch about copy-cat business models in China yet almost three years later levied stinging criticism at the Samwer Brothers with their rip-off of Fab.com called Bamarang.

Their newest clone for the Middle East Lazada is especially bold: I thought I had inadvertently landed on Amazon, that’s how closely Lazada resembles it.

Even Union Square venture capitalist and blogger Fred Wilson jumped into the frying pan with his opt on cloning start-ups.

Condemnation aside, one can’t argue with the quick and profitable financial successes of cloning.

Controversy intensifies when founders clone not just the idea, but every pixel of the start-up to make the clone an almost exact duplicate of the original as the Samwer Brothers did.

In Russia there are multiple groups creating and financing clones.  One of the most aggressive is Fast Lane Ventures which cloned Pinterest (PinMe), Quora (OdinOvet), Eventbrite (Eventmag), Airbnb (RentHome.ru) to name a few; their Zappos clone Sapato was acquired in 1Q2012, 18 months after launch for an approximately 2x return for investors including Fast Lane (plus Intel Capital, eVenture Capital, Kinnevik and Direct Group too).  

The Spread of Clonentrepreneurship

Clonentrepreneurship is sweeping not only Russia, but all of Planet Earth.

Cloning has become a trusted way for more entrepreneurs to raise more money from more investors, thereby financing the future of their start-up communities, not only in the emerging world, but developed countries too as the explosion of car sharing clones demonstrates.

Zipcar was one of the first to execute Internet business models for the sharing of cars.  Zipcar was not the innovator, but the imitator with Vancouver’s co-op called Modo operating for more than 15 years and the catalyst that helped communities and non-profits get car sharing started in several continents.  While it may not have started in the Internet space, Modo was one of the first to institutionalize collaborative sharing in the community.

So what is really being cloned, who is cloning what and to whom?

Is it car sharing or the collaboratively sharing of underused assets and transforming them into new business opportunities? If the later, clonentrepreneurs are hard at work around the world creating the next set of companies in the sharing space to take advantage of this social movement as these examples demonstrate:

  • ParkAtMyHouse.com—shared parking spaces
  • SkillShare.com & TaskRabbit.com—sharing of skills and chores
  • Murfie.com & Swap.com—collaboratively sharing of DVDs, books & video games
  • Snapgoods.com & Neighborhoods.net—sharing of ‘stuff’
  • I-Ella.com & Thredup.com—sharing of clothes & wearables
  • Sharedearth.com & Yardshare.com—the sharing of land for gardeners & land owners with capacity
  • Freecycle.com & ILoveFreegle.org—sharing of ‘stuff’ people no longer want/need

Given the contributions of clones to spark the startup of start-up communities, are they a panacea to growth? Do alternatives exist in the quest for growth? And what can actors in the start-up community do to impact investor DNA for more seed and early stage investment?

For Next Time—Part IV: The Quest for Growth

In Part IV, subjects I’ll discuss:

1.)   Clonentrepreneurship or Alternative Paths to the Start-up of Start-up Communities?

2.)   Change the Culture and Amazing Things Happen

Comments, opinions and questions are welcome here or send directly to me at Tom@IVIpe.com

Be well and be lucky.

Tom Nastas

 

 

 

 

 

Part II: The Cultures of Risk—Financing the Startup of Start-up Communities

Subjects in this post:

1.)   The Cultural Divide:  What Investors ‘Buy’

2.)   What Investors Fear

3.)   The Culture of Venture Capital:  Friend or Foe?

Last time in Part I, I discussed:

1.)   First, Three Definitions

2.)   The Russia Tech Scene

3.)   Growth in Russia

4.)   What Changed for Growth to Emerge

5.)   The Spark that Ignited the Start-up of Russia

Read Part I.

Read the Introduction to the series.

Summary from Part I:  Beginning about 2006, innovation became a priority of the Russian Government to diversify its economy from oil/gas with its multi-billion dollar investments in the Russian Venture Company and the Russian Corporation of Nanotechnology. Even with these investments, the needle of tech investment crept up ever so slowly in venture stage companies.

But everything changed beginning in the 2nd half of 2010; Russian entrepreneurs cloned US business models in Internet e-commerce, social and mobile with 20+ startups attracting more than $400 million in less than eighteen months through 2011.  For 2012 investment in start-ups and venture stage companies is estimated at between $800 million to $1 billion.

The ‘take-away. Russian entrepreneurs demonstrated that cloning established Western Internet business models and localizing them for the domestic market captures growth.  This was what domestic investors needed to open up their pocketbooks and spark the startup of Russia.

Ok, so, uhm—what’s so revolutionary about entrepreneurs cloning the ideas of others and investors financing start-up clones?

To answer this question, I discuss the culture of risk in the developing countries and how it impacts the behavior of local investors and their willingness to finance seed and early stage tech business models.  Then I contrast how their investment behavior differs from investors in the developed countries.

The Cultural Divide:  What Investors ‘Buy’

American tech and start-up entrepreneurs ‘sell opportunity’ to raise money. This works great in the United States since angel investors and venture capitalists are comfortable with risk, ambiguity and uncertainty, and willingly pay the costs of failure when business models don’t work, founders pivot and start-ups evolve into something different from entrepreneurs’ initial intentions.

Except for the very few, most local investors from Manila to Moscow and from Shanghai to San Paulo approach risk differently. Sure, opportunity is required for the financing of ventures.  But the risks of execution are more importance as the deciding factor since emerging market countries are opaque and with their lack of transparency—invisible risks and obstacles can cause even the most experienced investors to lose their entire investment:  Capital preservation drives financing decisions.

Consequently they buy ‘risk’ by investing in the known and understandable;  businesses and projects with markets and customers a 100% guarantee, where the risks of the investment are in the execution of building a factory or constructing a warehouse, creating a bank, establishing a chain of shops or restaurants as examples. These are the uncertainties they have dealt with as businessmen and investors, and have the experience to help entrepreneurs solve—avoid.

What Investors Fear

The risks of financing innovative firms, i.e., does a market exist, will customers buy, achieve promised performance—often technology based—are uncertainties too great for domestic investors in emerging markets since they add additional layers of risks to those of execution and involve a different sort of risk assessment—skills and experiences they frequently lack.

Clones overcome these fears since many generate revenues immediately, some from day #1, demonstrating that a market exists, the tech works, customers show up and pay.  With these risks behind the venture, the way forward is managing execution—risks that local money in emerging markets ‘buy:’  the tolerance of emerging markets investors for the US model of entrepreneurial experimentation, trial and error and the funding of pivots is zero.

Why is this so?  And how do we use this culture of investor risk-taking as our ally, to make amazing things happen; more entrepreneurship, more innovation and more investment for the start-up of start-up communities not only in Russia but throughout the emerging world from Chile to China, Kazakhstan to Kenya, India to Indonesia?

The Culture of Venture Capital:  Friend or Foe?

To obtain a deeper understanding why entrepreneurs and investors behave as they do in the emerging markets, we must look at an unlikely place to frame this discussion:  Silicon Valley.

 “Silicon Valley is the only place on Earth not trying to figure out how to become Silicon Valley.[1]

Silicon Valley’s greatest attribute is not its ability to finance the future and failure, but investors’ attitude to risk which shapes their risk taking, their acceptance of ambiguity and uncertainty to early stage tech deals, thereby attracting entrepreneurs with the wildest (and craziest) ideas.

This behavior to risk is exemplified by the 2-6-2 distribution of returns rule.[2]

For every ten investments made by investors, two fail with all money lost, six return the original investment + a low to modest rate of return, with the remaining two generating breathtaking profits (Facebook, Google, Apple, Cisco, Oracle, Instagram and Microsoft as examples). These ‘superwinners’ as they are called, produce the superior rates of financial return that compensate for losing investments and slightly profitable ones.[3]

Of course one never knows in advance which investments will be superwinners or also-rans. Since Silicon Valley investors know that statistically they’ll invest in their fair share of superwinners, they have the confidence to finance the wild and crazy, a few which become successes. Superwinners breed or attract others to launch start-ups.  As more entrepreneurs enter the market, the number of new companies financed increases with less time required by investors to make the investment decision. More choice is what investors need since for every one investment, 99 are rejected;[4]  to consummate ten investments (the 2-6-2) an investor needs to see 1000 opportunities.  More choice attracts more capital to the start-up community as other investors jump in to finance the next set of superwinners.  The start-up community prospects and perpetuates to a thriving ecosystem.

Many superwinners did not start on the path to greatness, and they only found it after experimenting with different business models until they hit the bulls-eye;  others started down a path only to change direction—pivot—to find what the market and customers would accept.  Silicon Valley investors willingly finance early failures since they know statistically, many pivot to success as Google, Instagram, Facebook, YouTube, PayPal and others did to achieve superwinning status. While it may seem counterintuitive, investors must finance failure since without them they are not taking enough risk.[5]

It’s this willingness to finance ambiguity and uncertainty that makes Silicon Valley—uhm—Silicon Valley.

The National Venture Capital Association (USA) estimates that in 2010 the US venture industry invested the equivalent of $3,945 per person living in the Silicon Valley area vs. $43 per person in the rest of the US, including other start-up communities like Boston and New York. That’s a 91:1 ratio.[6]

Go to my home state of Michigan and the number falls to $15 per person, a ratio of 263:1.[7] So the likelihood of a Detroit startup raising venture capital in Michigan is more difficult vs. Silicon Valley.

In Russia and other emerging market countries the amount of capital invested/population is even less than Michigan;  these regions lack the quality and quantity of deal flow that typifies the Valley and local investors are unwilling to fund experimentation, pivoting, trial and error in business model creation.  Since domestic investors buy the ‘risks’ of execution by investing in the known and understandable—businesses and projects with markets and customers a 100% guarantee (experimentation/pivoting not necessary)—the chances of superwinners being created and financed is remote:  Yet an increasing flow of future ‘superwinners’ is what’s required for local investors to invest in, and for a start-up community to crystalize.

That is until an event or series of events breaks this cycle to change the trajectory of the market.  In Russia it was the early and fast liquidity from the Groupon clone that demonstrated the merit of cloning Western business models plus the IPO of Mail.ru that minted the money for clone investment.  With the United States as the engine of start-up creation in the world, it was natural for Russians to copy, localize and paste clones into Russia, to capture the eyeballs and wallets of the Russian consumer. And then—the pocketbooks of investors too.

The chasm between the cultures of risk-taking by local investors in Russia and the risk of start-ups was crossed. Foes became friends. The start-up of Russia began. 

“But this is not the only contribution of clones to the startup of start-up communities.”

For Next Time—Part III:  The Power of Clones

In Part III, I discuss the multiplier effect in start-up creation that clones have in local market.  Clones do more than just build a local network of supply chain partners thereby increasing the # of startups for a startup community to emerge.  Their successes impact the DNA culture of investors to risk as they build new experiences in seed and early stage risk.  And they do so without taking the risks of opportunity that is normally associated with early stage companies since clones[8] demonstrate that a market exists, the tech works, customers ‘get it’ and pay.

Subjects in Part III:

1.)   Drive Growth and Innovation in the Supply Chain

2.)   Sidestep the Obstacles that Impede Scaling Up

3.)   Controversy of Clonentrepreneurship: Cloning the Idea or Hatching a Start-Up?

4.)   Spread of Clonentrepreneurship

Comments, opinions and questions are welcome here or send directly to me at Tom@IVIpe.com.

Be well and be lucky.

Tom Nastas


[1]Quote from Robert Metcalfe, father of Ethernet, founder of 3Com, author, pundit & conference host

[2] Author’s note:  The 2-6-2 distribution of returns rule is a term to describe the distribution of investment returns in a venture capital or private equity portfolio. The 2-6-2 rule comes from data collected and reported on the industry’s financial performance over a 40 year period from Cambridge Associates, the National Venture Capital Association and the Small Business Administration (which tracks investments made through the Small Business Investment Corporation program of the US Government).

[3] Author’s note:  While the 2-6-2 distribution of returns is an industry average, individual funds will have a different distribution of financial performance, e.g., some might have a result of 4-4-2, others a 1-9-0, others a 0-7-3, etc. Approximately 2% of investments since the 1980s have produced 98% of the financial returns realized in the venture capital industry (USA)

[4] Author’s note:  A rule of thumb in the industry.  Naturally some firms will be in the flow of ‘better’ investment opportunities and able to transact the necessary number of investments with a lessor number of total deals evaluated

[7] Source: Ibid

[8] Certainly all clones are not alike.  Prudent, wisdom and understanding of the local market is required in the selection of which business models to copy, localize and paste into an emerging market

 

 

Michigan State Univ., Silicon Valley, Hungary & Emerging Markets

 

On 2 February I spoke to graduate and undergraduate students of Dr. Zsuzsanna Fluck at Michigan State University (MSU).  Zsuzsanna teaches graduate and undergraduate courses in private equity and venture capital at the Eli Broad Graduate School of Business.  Zsuzsanna is also the director of MSU’s Center for Venture Capital, Private Equity & Entrepreneurial Finance.  A few weeks ago I delivered this same lecture to graduate students enrolled in the private equity class of Dr. David Brophy, Ross Graduate School of Business at the University of Michigan.

 

 

 

 

 

MSU is on an ambitious journey to build a more vibrant entrepreneurial community in mid-Michigan.  MSU has new programs and new money commitments to encourage start-ups from university technology, under the leadership of Charles Hasemann and Ian Gray, VP of Research.  All the best to them in this endeavor.

Zsuzsanna was born and raised in Hungary. As an economist she worked on international joint ventures and then moved to the US to pursue doctoral studies in economics and finance. She and I talked extensively about the parallels of entrepreneurship between Hungary and Michigan, the perils that entrepreneurs from both face in capitalizing their businesses, and lessons they can learn from one another to do more-faster.

Silicon Valley’s greatest strengths are its comfort with risk, ambiguity and uncertainty; Valley investors willingly pay the costs of failure when business models don’t work, founders pivot & models evolve into something different from entrepreneurs’ initial intentions. This willingness to finance the wild and crazy is what attracts entrepreneurs to the Valley with gamechanging ideas that develop into businesses that truly change the world. These successes draw more investors and their money to these entrepreneurs, and the cycle repeats. As this happens over and over, the ecosystem lives, breathes and renews itself from one economic cycle to another.

Michigan entrepreneurs and its venture investors are more conservative, due to the culture that developed around the auto industry and its supply chain.  Ways of doing business that flow from one industry that dominate a region or country’s economy often leads to an investment culture that rejects early stage innovation, the untested and undeveloped ideas of innovators and entrepreneurs that makes Silicon Valley, uhm, Silicon Valley.

Decades ago I worked in engineering at Ford Motor Company, and new innovation had to be well proven before it worked its way into cars and trucks. If technology failed on the road, people can get hurt or die, risk unacceptable to all; in such circumstances the risks of failure are logical and understandable.  While times are changing, such thinking created a culture and way of doing business and investing directly opposite to the risk appetite in Silicon Valley. Conservatism to risk does not make Michigan and like-minded Rust Belt states bad, just different.

Except for the very few, most investors in developing countries approach risk differently than Silicon Valley. They invest in known and understandable risks, mainly the risks of execution. These are the uncertainties they have dealt with as businessmen and investors, and have the experience to help entrepreneurs solve—avoid. The risks of financing innovative firms, i.e., will customers buy, are profits possible, achieve promised performance from new ideas – often technology based – is simply too much for them. While the risk appetite of Midwest investors is greater than their counterparts in emerging markets, they share more commonalities than differences due to shared values toward uncertainty, ambiguity and failure.

So specifically, what actions can entrepreneurs and participants in the local ecosystem execute to create a more risk friendly venture community?  Let me suggest two:

  1. Mentor entrepreneurs to ‘Sell Risk, then Opportunity.’ The prelude to this is of course the building of business models that sell risk and opportunity by incorporating cultural attitudes to risk and failure since they drive investment decisions & the entrepreneurial process in the local community.
  1. Entrepreneurial ventures need ‘spark points’ to capture the attention of the market, users, and investors.  While spark points are easy to see in hindsight vs. foresight, they frequently result when overcoming the friction that exists in commercialization, leading to minor revenue, but huge leaps in confidence.  Keep the eyes of your entrepreneurs open to these accomplishments and transform them into events that are publicized to the market.

I’ll be writing about these subjects in future posts so stay tuned for more.

In my next posting I’ll comment on the Kauffman Foundation proposal (taxes & capital gains) as a solution to finance the ‘Valley of Death.’

Comments, opinions welcome here or send directly to me at Tom@IVIpe.com.

Be well and be lucky.