Two Risk Profiles of Entrepreneurs

Posted by: John Tozzi on September 1, 2009

Following up on yesterday’s post about how entrepreneurs approach risk, I spoke with Steve King today about two different types of small business owners with different risk profiles.

On one side are conventional small businesses, which are risk-averse. The owner’s personal wealth is tied up in the business. It’s probably her most valuable asset (or second to her home) and she’s faces big downside risk if the business fails.

On the other side are investor-backed start-ups — companies aiming for high growth and playing with other people’s money. This is key. Once entrepreneurs sell a significant amount of equity to venture capitalists or angels, the investors have taken on a lot of the downside risk. The VC model lets start-ups swing for the fences, with the understanding that a lot of times they’ll strike out, but that won’t leave the founder flat broke. Entrepreneurs can even benefit financially if the venture fails. “A lot of people have gotten rich building businesses that failed,” King says.

But I’m also interested in the people in between: Entrepreneurs bootstrapping growth ventures on their own dime. They’re often risking their personal wealth like Main Street small business owners to try to build Silicon Valley-style enterprises that scale. “Those people tend to fall into the more traditional small business risk profile, because they are putting their money on the line,” King says.

Jonathan Fields also brings up a good point in the comments on yesterday’s post: Small businesses are learning how to scale with minimal risk.

Some models require substantial investment of money and ramping up of overhead and complexity. More and more, though, freelancers and small businesses are discovering ways to scale that reduces risk and complexity by commoditizing and distributing knowledge.

Examples include copywriters and marketers who develop niche specific campaigns, test them, then license their use, instead of selling it one time. Or designers who create and distribute DIY branding information for small businesses.

SO, I agree, the massive scale homeruns tend to require more cowboy-oriented risk, but increasingly, most small business people can scale to a very satisfying level without the exposure and complexity that was required just a few years ago.

This goes back to the earlier discussion of microenterprise as a safety net. It’s possible to support yourself and grow at a respectable rate (if not a “home-run” pace) without taking on the kind of financial risk that investor-backed companies do.

I also love this anecdote from Barbara Winter:

I once got a call from an investment broker. When I told him my primary investment was my own business, he sounded shocked and said, “Isn’t that risky?” I replied, “Not as risky as giving my money to a stranger over the phone.” What others perceive as risk doesn’t feel like it to people who understand creative problem-solving and are flexible and willing to change as situations warrant. And small businesses can adjust more quickly than big dinosaur organizations.

Please keep the stories coming. How much of your personal wealth do you risk in your business? How do you minimize risk in your venture? For entrepreneurs who both bootstrapped and raised money, do you approach risk differently in an investor-backed company? Has your approach to business risk changed in this recession?

Reader Comments

Gail Nichols

September 1, 2009 7:08 PM

Having evolved from investment broker to bootstrapping entrepreneur in several companies that also attracted VC and Angel investors, I can identify with Barbara Winter completely. By personally pledging every dime (and then some) into these enterprises with no guarantee of success...but with complete confidence that they would, has been (and continues to be) the most fulfilling way to be in business IMHO. Napoleon Hill's "Law Of Success" is very inspirational as he documented how entrepreneurs can and do succeed.

Ky Ekinci - Office Divvy

September 1, 2009 8:57 PM

What a terrific article!

The statement by Steve King: “A lot of people have gotten rich building businesses that failed...” really stands out especially with the memories of the dot-com boom still fresh in my mind.

In this new era and the business environment, it is the actual business success that will yield bigger returns than any other form of investment. And that means: the investment made through intelligence, hard-work, smart-work, offering a service or product that has value, and sweat equity.

Obviously 'stick-to-it-ness' is harder in the absence of comfortable financing, but isn't true that that's when "pacing yourself" comes into play.

The company I co-founded, Office Divvy, just about one-and-a-half year old at this point, has gone through the evolution of achieving the initial business plan and goals, to now finding other verticals to be added to the core-business offering.

Capitalized by the co-founders exclusively, could we use more cash to take the business to the next level, faster? Absolutely! But at this point we're focused on organic growth through investment through client equity and outside strategic relationships.

Thank you for making these good points and asking these good questions... We will share this article with our clients, and our twitter following.

A tip of the hat to all the Entrepreneurs who are 'bootstrapping' not only on their own dime, but also their own precious time...

Ky Ekinci
Co-Founder
Office Divvy
____________
on the web: http://OfficeDivvy.com
on twitter: http://twitter.com/OfficeDivvy

Alex Hawkinson

September 1, 2009 9:13 PM

At www.CloudProfile.com we fall somewhere in the middle of your range. Heart and soul poured in with some personal capital but also heavy workload supporting synergistic activities through www.muralconsulting.com that has enabled us to bootstrap without outside investment to date. The combo has made it possible to build an innovative product that has high growth potential, but the long days and nights of consulting to drive cash flow definitely cause soul searching about raising equity capital.

Very interested to engage and listen as any dialogue unfolds around this post.

MikeyCee

September 2, 2009 8:49 AM

I've approached building a business much like I do when I buy a classic car that needs a mild restoration. Some I even do a custom job on. My money is made in the beginning even before I own it by fast calculating what I'll invest in the resto to make money when I sell. Of course I have the skills to do most of the work on the car and outsource what I don't to a pro and reap the rewards when I sell it. I move up and down the ladder on vehicle values. On some I reap higher rewards than others. In 30 years and 350 vehicles, I've made money on 90% of them. I'm always on the prowl for good deals I know I can make money on. Even though I sell most of my classics, that doesn't mean I do not love the cars. I do but the fun is in the hunt, building it and the deal. Same goes in the businesses I buy or start. I put my own money in it, do some restoration or even major improvments and when everything is running smoothly it's time to sell. If you start a business, always do it with the intention of selling. You can either borrow or use your own cash. But always remember this- starting or buying a biz is like buying one of those classics, the money is made in the beginning. Same with your choice of business and how you do things from the start. And if you do sell it for a profit, you can always buy or build another.
www.theAcquisitioner.com

Steve King

September 2, 2009 12:31 PM

John: By coincidence I attended a panel discussion last night on angel and seed investing. It was hosted by seed VC First Round Capital.

The room was full of bootstrapping entrepreneurs mostly building Internet or software companies. They were there looking for their first seed round (generally between $25k and $500k).

Almost everyone I talked to is foregoing salaries and/or living off of savings to start their companies. A few were keeping their day jobs and working on their business on the side.

Echoing Jonathan Fields, the seed investor panelists stressed the importance of capital efficiency and bootstrapped operations. They aren't interested in companies that are going to require a lot of capital.

The panelists also talked about a new model for building tech businesses - less capital, fewer employees, outsourced everything, bootstrapped operations and smaller exits.

I think this model makes sense. I also think it means a lot more personal financial risk for the entrepreneur than the traditional VC model.

And I think it means we will be seeing a lot more entrepreneurs that fit into your middle category.

Carol Cross

September 3, 2009 6:03 PM

The Small Business Startup person is, of course, risk averse when using their own assets or taking out a loan to start a small business in which he/she has expertise and great interest.

In Small Business Trends, Professor Shane a researcher, provided a graph that indicated that 50% of small startup businesses will have failed by the fifth year, and only 29% are still standing at the end of ten years. This would apply to independents, franchisors, and franchisees of franchisors.

The INDEPENDENT small business person has generally thoroughly researched the business and the demographics, etc.. and has hired professional help to prepare a business plan to show the bank or the lender, or the angel. The independent business person is most often familiar with the odds as stated above and believe he/she can overcome them and is a real entrepreneur.

On the other hand, a FRANCHISOR can be a small business startup, as well, who has one or no actual businesses up and running, but a startup franchisor can avoid most of the risk of building and growing a branded chain because it is the franchisee of the franchisor who assumes the risk of building and operating the physical unit, and who bears the risk and consequences of failure of the branded unit.

It is franchisees of franchisors, most of whom are looking for a job and profits in a recession, who provide the venture capital for franchisors to test their concepts in the marketplace. It is the franchisees cheap labor and cheap VENTURE capital that enables franchisors to grow the chain systems rapidly with little risk.

Franchisors can pass off the risk of rapidly growing a chain operation to the franchisees who finance and own the physical units that produce the gross sales upon which the franchisor takes his royalties from the first day the frnchisee opens his business.

Franchisors can often churn their failed founding franchisees who fail and the business continues to serve the franchisor. Thus, a franchisor can somewhat beat the odds of failure as indicated in the paragraph, above. Obviously, this is why franchising is encouraged with ineffective regulation of franchisors, in my opinion.

Unfortunately, franchisees of franchisors have to personally guarantee the franchise and the lease, and put too much at risk not knowing the odds of failure, and not being informed of the odds of failure or lack of profitability by the franchisor, the seller of the franchise who profits from the sale of the franchise.

While franchising has always grown in past recessions, because of the lack of good jobs, this time things may be different because those thousands of franchisees who are just teetering at break even may go under and be driven into personal bankruptcy ---even some of the multi-unit franchisees who have spread their risk.

The model of franchising must be looked at more closely by those with the money to invest in themselves who will do extensive research on the Internet concerning franchise fraud and churning and ineffective regulation of the industry.

Maybe a newer and fairer model will arise out of the ashes.

Marjorie Bostwick

September 21, 2009 10:51 AM

Boot-strapping is in my opinion the slowest, but safest route. My vision may be larger than my bank account at this time, but I have more flexibility and control.
For the new entrepreneur, with no history, it will be difficult to find investors (unless family or friends)but with the economy the way it is, believe it or not, there are folks still "skiddish" about starting a business in this climate.
Some of us must work, to fund our dream.

Carol Cross

September 21, 2009 4:28 PM

It is the entrepreneur franchisor who needs to find venture capital to "bootstrap" his dream of a chain store that will grow rapidly through his marketing efforts.

Marketing takes money and even while the franchisor entrepreneur passes off the risk of financing and building and operating the physical units that will wear the brand name, the new franchisors are probably having difficulty in getting marketing and "startup" funds in this economy to market their concepts to prospective franchisees. Prospective franchisees grow in numbers during recessions where self-employment seems like the answer to a need for a job and income.

While the banks and lenders know that franchisees and their families and friends guarantee the franchise agreement and the lease, etc.. with their personal assets, many of the banks and lenders may have been burned by the current state of affairs in franchising. They may have made loans on home equities, perhaps, to both franchisors and franchisees and many of these commercial loans to franchisees, and franchisors, may be currently failing. The Banks and lenders may want to wait until the full impact of the commercial meltdown is known to
them.

What is the point of pushing small business lending to the retail sector of the economy when so many Malls and Shopping Centers and franchisees within them are failing?

Mature franchisors, however, still sell franchises in recessions because, of course, the visibility of the franchise to the prospective buyer looks like viability to new buyers.

The new buyers of mature and very visible franchises are not given the UNIT performance statistics of the systems by the big franchisors, and mature franchisors do survive recessions because of their ability to sell their franchises based upon their visibility in the economy.

Franchisees are merely recources for franchisors in some highly visible systems who can be churned to perpetuate the franchisors.

Let the Buyer Beware!

http://thegreatfranchisingrobbery.blogspot.com

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About

What's it like to run your own company today? Entrepreneurs face multiple hurdles new and old, from raising capital and managing employees to keeping up with technology and competing in a global marketplace. In this blog, the Small Business channel's John Tozzi and Nick Leiber discuss the news, trends, and ideas that matter to small business owners. Follow them on Twitter @newentrepreneur.

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