Customer-Funded Growth
I have a limit to the amount of bad news that I am willing to absorb before I am compelled to do something about it. There is a point at which additional disruption, confusion, and shifting circumstances begin to blend into a sort of white noise that tells me it is time to start identifying the things that I can control and the resources that I need to make things happen. Over the years I have learned one very important fact about this tendency of mine: I am not alone.
I have spoken with other leaders and self-described optimists that experience this tipping point as well. It compels us to start building toward the future we want to see rather than continuing to accept our current reality. I have a pet theory that this is why so many of the largest companies in the US today got their start during recessions, depressions, and economic downturns. It was in this frame of mind that I had the opportunity to explore the California Entrepreneurship Educator’s Conference (CEEC) online through the Fowler College of Business at San Diego State University.
As I perused the various session recordings, one stood out to me: The Customer Funded Business featuring Dr. John Mullins. If you are an optimist like me who is looking to respond to the challenge of 2020 by finding ways to grow your business, then I encourage you to invest 40 minutes to watch the session via YouTube below and to explore Dr. Mullins' books (see resource links). Here are a few of the insights from the CEEC session that I found most valuable:
There is a strategic and operational downside to seeking outside funding too early:
Fund raising itself is a full-time job that takes time and capacity away from the work of running & building the business.
Seeking funding too early is a tactical mistake. Outside investors typically want the business to execute on the plan that was included in the investment pitch. However successful businesses typically evolve their business model over time as they learn how to connect with their customers, find ways to solve their problems, and profitably create value. There is a fundamental tension between the firm’s need to innovate and the equity holder’s demand for execution and immediate returns.
Seeking funding too early may therefore hamper growth, and ultimately cause a firm to fail that would otherwise have gone on to succeed.
There is more to building a business than private equity and business loans:
While business publications regularly wax eloquent on the latest record-breaking venture capital campaign, our obsession with private equity misses an important reality: venture capital and angel investors combined, typically fund less than 1% of startup businesses each year.
With bank loans funding another 1.43% of startups, its clear that the VAST majority of businesses are not funded by investors or banks
Other than personal assets and credit, there are five basic alternatives to outside funding that you can use to build your business.
Pay-in-advance:
When firms collect full or partial payment before they incur meaningful costs to supply their product, they are using a pay-in-advance funding model.
In its early days, Dell famously used this model. It set up its supply chain to deliver so quickly that they were able collect payment before they built their finished product. Holding customer payments for 30, 60, or even 90 days before having to pay their suppliers gave them ready access to working capital to build the business.
It is also common for service businesses to work this way. If you have ever been asked to pay a deposit to a contractor, lawyer, architect, or other professional before work began, you were engaged with a business using at least a partial pay-in-advance approach.
There are many variations of the model and its use is not limited to technology companies or service firms. The model can typically be applied to any product or service sold directly to customers where the supply chain is able to deliver the final product quickly enough after payment is received to meet customer expectations.
Crowd funding is a relatively new variant of this model that is particularly effective at setting customer expectations. Backers typically pay far in advance and may even pay a premium because they desire to help a new firm bring their product to market.
Matchmakers:
Matchmakers typically do not own or manufacture the products or services that they sell. They focus instead on bringing buyers and sellers together on a platform that facilitates transactions and eliminates friction in the market for those goods and services.
Airbnb, Uber, and Lyft are well known matchmakers. These companies have little to no inventory for the vacation rental, transportation, and delivery services they sell. Instead they bring buyers and sellers together at a large scale and seek to monetizes the business via transaction fees or commissions.
Amazon is an example of a partial matchmaker where the firm may own some inventory and participate as a seller on its own platform while also serving as a platform for outside sellers. While Amazon has received recent criticism over its competitive practices related to outside sellers, there are still vastly more goods and services sold on the platform than are provided by Amazon itself.
Subscriptions:
Subscription services are nothing new. Gyms, newspapers, and periodicals successfully used subscriptions to grow their business long before Netflix, Hulu, and Disney+ jumped on the bandwagon. What is new is how good companies are getting at selling such services and how many companies are adopting the model. Particularly in the software industry, companies are converting large customer bases from buyers that purchase a product for a one-time fee into service-subscribers that pay continuously.
Consumers get access to products at a much lower initial cost than the traditional sales model. They are also often able to customize their subscription level to pay for only the features and functions that meet their needs.
Businesses typically benefit when smaller payments allow more customers to afford their services. In addition, most subscription models are priced so that customers end up paying more over the life of their subscription than they would under a point of sale arrangement. These additional funds add directly to the firm’s bottom line (so long as customers avoid subscription fatigue and are not annoyed into cancelling their subscription).
The business benefits by having access to cash up front and is also able to use the number of subscriptions as a leading indicator to forecast demand. These demand-forecast calculations play a critical role in customer retention. No one likes working out in a crowded gym where they must wait to use equipment. Likewise, few businesses are willing to tolerate web-hosting services with frequent breakdowns due to high traffic. Customer retention depends on the firm maintaining enough capacity to deliver on both the functionality and the customer experience promised by their product or service.
Subscriptions can work well for almost any product or service that is consumed over time and that can be turned off or made unusable by the firm at little to no cost.
Scarcity:
Almost everyone loves a treasure hunt. You can feel the rush of dopamine and other feel-good chemicals in your body when you find that unique item or diamond in the rough! Firms can use that element of human nature to build a fantastic customer-funded business.
Two great examples are Zara (fast fashion) and Costco (warehouse retail). Both firms make a habit of rotating stock in scarce quantities. These small quantities keep the need for capital low as large inventory orders are not necessary. For example, by turning over their inventory 12 times per year, Zara is able to contract with suppliers for 30 days’ worth of inventory with 60 days to pay. Sales from previous inventory turnover provide funding to pay for new inventory, and small quantities incentivize customers to “buy it while they can.” Costco does the same thing by stocking only a fraction of the items you would find in a traditional grocery store and changing their product mix regularly.
Both Zara and Costco create experiences in which customers are excited to buy what is available and are worried about missing out if they do not buy it now. Rather than creating disappointment when a desired item is not available, customers feel rewarded when they find something they want. As items frequently sell out, this eliminates unsold goods and creates a profit-driving cycle in which customers are encouraged to buy quickly and revisit often.
Using a service to fund a product:
In a counter example to the booming subscription trend, firms can also go the other direction by moving from a service to a product model. Before Microsoft became what it is today, Bill Gates and Paul Allen offered a service writing custom operating systems for computer manufacturers. They were paid in advance to write these programs and after they wrote enough of them, they noticed that all of them were similar enough that they came up with a standardized product. This allowed them to create a solution once and sell digital copies with very low marginal unit costs. Thus, Microsoft and the Windows operating system were born.
The most important insight to be drawn from the Microsoft example is not that software is uniquely suited for explosive growth. Rather, it is the fact that Allen and Gates effectively used their service offering to fund the development of the product that they would later bring to market. That is a model that almost any service-business can use to develop new revenue sources and grow their business.
Which model is right for you? That depends. Your firm’s mission, vision, values, target market, competitive strategy, supply chain, and customer experience come together in ways that are unique. Digging into the particulars of your business and mapping them onto the best funding model to grow your business now and in the future is not easy, but it is as rewarding. Outside perspective can help.
Let’s get to work!
