Understanding different types of startups
The term “startup” most commonly invokes the image of a high-risk, high-growth, venture funded technology firm. This image is not entirely accurate – while some startups do fit this profile, they are a small minority. The vast majority of startups do not originate in Silicon Valley and do not end-up with billion dollar IPOs. Startups can be classified into different types based on their growth prospects, capital requirements, and the lifestyle demands they impose on their founders. It is important for an entrepreneur to understand these different types. This article will help you determine the type of startup that you are planning to pursue so that you can evaluate various decisions related to it through an appropriate analytical frame.
A startup can be a barber shop or a high-flying AI company — and everything in between. Most startups do not require VC-funding or a team of MIT-trained engineers and Harvard MBAs. The popular notion of a startup as a venture funded high-growth business is grossly misplaced. In fact, the vast majority of successful startups do not get external funding and grow at a steady but slow pace. There are several other types of startups. If you are considering starting your own business, it is essential for you to know about the different types of startups and understand the differences in their investment needs, risk profiles, lifestyle implications and upside potential before you decide which type best matches with your business idea, your personality and your lifestyle desires.
Key Questions
Answers to these will determine the type of your startup
The answers the following two questions will have the most impact on determining the type of your startup:
POTENTIAL SIZE AND GROWTH
Will your business grow very fast to a large size or will it grow at a slow but steady pace? High growth businesses share the following characteristics:
A large potential addressable market; for example smartphones or search engines.
A novel technology or business model that will result in fast adoption by your customers.
Extreme scalability in the business model. Often technology is the enabler of such scalability hence most fast growth startups are tech firms.
Need for very quick execution due to the likelihood of entrance by competitors.
FUNDING REQUIREMENTS
What is the amount of external financing that you will need to launch your business and who will provide it to you? The answer to this question will have the most consequential impact on the type of your startup. Startups that requires a large amount of outside financing share the following characteristics:
Their large capital requirements are often driven by the need to a) execute quickly ahead of any competitors or b) to build assets (IP, market share, patents, etc.) that will discourage competitors from entering the market.
In order to entice external funders, such a business must have a clearly articulated exit strategy upfront.
The founder(s) will likely have to share control of the business with external sources (such as venture capital firms or private equity firms) who will exert influence and control over the future course of the businesses.
The financing and corporate structure of the business will inevitably mean that such a startup can not be run as a “mom and pop” or “lifestyle” business.
Note that there is a strong correlation in the answers to the two above questions; high growth businesses with large potential markets often require large external investments upfront and are therefore venture funded.
Types of Startups
Five types of startups
Startups can be classified into the following five categories. Note that this list is not exhaustive, but it provides an analytical framework through which you can evaluate your startup and the associated decisions that you will have to make as you launch and grow it.
LIFESTYLE BUSINESS
A lifestyle business allows you to work on your own terms (you determine the working hours and location of work) yet pays you sufficiently that you find the work rewarding. A lifestyle business may leverage the prior experience or knowledge of the founder and is often started by a well-networked person who has retired from a high-profile job or profession. They do not depend on a brick-and-mortar location and can often be conducted virtually (i.e. using internet based collaboration and communication technologies) by the founder. Business consulting, financial advice, are some examples of such businesses.
Alternatively, a lifestyle business can be based on a hobby or passion; such an entrepreneur loves the work she does while being her own boss. A professional photographer, a surfing coach, a journeyman web-designer are examples of such hobby-based lifestyle businesses. Most often, such a business employs no or very few support staff apart from the founder.
Such lifestyle businesses are unlikely to become fast growth companies with many employees but nevertheless they can provide a very good and rewarding lifestyle to the entrepreneur.
Most startups in US do not receive any external funding.
US Small Business Administration
TRADITIONAL SMALL BUSINESSES
The overwhelming number of entrepreneurs in the world today are involved in what can be best be described as a traditional small business. This category consists of businesses that are well-recognized as providing a stable but slow growth profile. Grocery stores, hairdressers, consultants, IT consulting firms, insurance agents, Internet commerce storefronts, carpenters, plumbers, electricians, etc. are all examples of such businesses.
Another common example of this type is a franchise business. A franchise provides a stable business framework to the entrepreneur who seeks structure, guidance and marketing support. A franchise can require a significant initial investment as well as ongoing royalty payments to the Franchisor. Yet a franchise can be an excellent alternative for the entrepreneur who has little experience in startups but who has the funds available to dedicate to the franchise startup costs.
Most small businesses are not designed for scale — the owners want to own their business and support their family. Such businesses are not excessively profitable, particularly if the founders pay themselves market rate salaries. Their only available capital is their own savings, what they can borrow from relatives and banks. Small-business entrepreneurs don’t become billionaires and don’t make splashy appearances in the press . But in sheer number, they are vastly more representative of “entrepreneurship” than entrepreneurs in other categories—and their enterprises create the vast majority of local jobs in most economies.
SELF FUNDED GROWTH BUSINESS
A business that is started with the explicit intention of growing into a large enterprise but without seeking outside funding would fall in this category. In such a business, you are funding the startup costs your own assets or credit. In order to retain control of your business, you avoid external equity financing. This type of business is usually started by someone who is either independently wealthy, or been successful with other startups and wants to pursue the next idea.
Note that a business in this category may seek external financing in future once the business has developed to a point where it can command a good valuation. But the critical distinction is that such a business is not dependent on external financing to get launched; the entrepreneur is able to launch the startup with her own funds.
EXTERNALLY FUNDED SCALABLE STARTUP BUSINESS
This is the category that best describes Silicon Valley technology startups; Facebook, Uber, Cloudera are examples of this category. The founders believe that they have an idea that will “change the world”. They want to execute it quickly and need significant external capital for it. Unlike small-business entrepreneurs, these founders are not interested in merely earning a living but rather in creating a significant equity position in a company that eventually will become publicly traded or get acquired, generating a large payoff for them and their investors.
Scalable startups require risk capital to fund their search for a business model. They hire the best and the brightest employees. When they find it, their focus on scale requires even more venture capital to fuel rapid expansion. Such ventures either succeed spectacularly or fail with a lot of capital down the drain.
Some characteristics that startups of this category share are the following:
Large size of potential target market
Novel idea or business model
Extremely scalable business model
Ability to execute very fast to stay ahead of competitors. This requires top quality talent acquisition and R&D.
Large outside funding.
Complex capital structures through multiple rounds of funding.
Loss of control by founders.
Extreme success or failure, no middle ground.
“Swing for the fence” mindset in all participants, resulting in high-pressure lifestyle and sub-optimal decisions.
Need for aggressive PR operation and extensive press coverage
ACQUISITION TARGETS
These are businesses that are designed to be acquired by a larger company at a future date. These businesses share several characteristics of a the previous category (Externally Funded Scalable Startup) but with the key difference that their target market size is not as large. Often businesses in this category are trying to implement a proven globally successful business model to local or niche market.
In the past five years, the cost to build technology startups has plummeted. Many of these startups bypass traditional VCs by using crowd or angel funding. In some cases, while they might be able to build a large valuation business, the lack of traditional venture-capital investors (and the concomitant large exit dynamics) takes away the pressure of the “swing for the fences” liquidity goals. This class of startup is likely to be sold to a larger company for $5 million to $50 million. The founders and investors walk away with millions but not billions.
The characteristics of this type include:
Relatively small and niche but well-defined markets; revenue in hundreds of million, instead of billions.
Complementary to other large businesses.
Sometimes act as R&D for the larger acquirer. While the large acquiring companies execute known business models, such startups act as temporary organizations designed to search for a scalable and repeatable business model without introducing risk for the acquirer. For instance, medical drug discovery startups.
An Externally Funded Scalable Startup can end up in this category once the parties realize that the potential market for the startup is not as large or lucrative as they originally thought.
Your Startup
Align your skill set and motivations with the type of your startup
As the previous discussion alludes to, these startup types make different demands on the skill set of the founders and have vastly differing implications for their lifestyle. While financial gain is a common factor behind the decision of many people who go into business for themselves, money is certainly not the only motivator for starting a new company. Whether you are looking for flexibility in your schedule, freedom to make your own business decisions, fame or a bigger paycheck, it is critical to understand a) why you want to start a business and b) if the type of startup you are considering matches your expectations and capabilities.
Before spending the time, effort and cash required to develop a new business, take stock of your skillset. Do you work well with other people? Do you handle uncertainty well? Are you a good public speaker? Do you understand accounting? Are you an extrovert with an enormous network of business contacts? Make a list of the skills, knowledge and assets you already possess but also make one of those you do not. In the areas where you are deficient , you will need to get help. This help can come in the form of co-founders or employees. Honesty at this stage of the process will save you from embarrassment, debts and failure later on. Knowing what you don’t know and being secure enough to ask for help when you don’t know is essential for the success of your business.
No matter the type of startup you are considering, you should realize that only thing all startups have in common is that they are risky. In fact, nine out of ten startup do, primarily because they create a product that nobody wants. Can you accept this high level of risk that you will walk away with nothing to show for your stress and sacrifice? Even worse, the dissolution of your business might have enormous personal consequences, such as bankruptcy, losing your home, divorce and losing your reputation.
The ability to accept setbacks and failure is essential when it comes to starting a new business. If you are the type of person who becomes frustrated, upset or simply shuts down when things don’t go your way, starting your own company may not be a suitable path.
Conclusion
Startups can be classified into different types. Each type requires different level of commitment and skills, presents different levels of complexity, and offers different financial rewards. An entrepreneur should have a clear understanding of this dynamic and ensure that the type of startup she is planning to launch matches her abilities, and personal goals.
