Monday, June 21, 2010

What is a startup?

I think most people have a fairly specific image that gets conjured up when they hear the word startup. Maybe it’s the “two guys in a garage” made famous by HP, or the idea of Jobs and Wozniack walking barefoot and shaggy through the Homebrew Computer Club. Maybe it’s the more recent wunderkinds like Zuckerberg or Brin and Page. What all of these pictures have in common is a narrative that goes something like this: scrappy outsiders, possessed of a unique genius, took outrageous risks and worked incomprehensible hours to beat the odds.

But this cinematic view of entrepreneurs is flawed in many ways. Let’s start with the most basic. It leads people to mistakenly believe that any time they see two guys in a garage attempting the impossible, that’s a startup. Wrong. It also causes them to miss the numerous other kinds of startups that appear in less-glamorous settings: inside enterprises, non-profits, and even governments. And because both small businesses and startups have a high mortality rate, sometimes these images lead us to believe that any small business is a startup. Wrong again.

So let’s begin with a definition of a startup that captures its essential nature, and tries to leave behind the specific associations of the most famous startups.

A startup is a human institution designed to deliver a new product or service under conditions of extreme uncertainty.

Let’s take each of these pieces in turn. First, I want to emphasize the human institution aspect, because this is completely lost in the “two guys in a garage” story. The word institution connotes bureaucracy, process, even lethargy. How can that be part of a startup? Yet, the real stories of successful startups are full of activities that can rightly be called institution-building: hiring creative employees, coordinating their activities, and creating a company culture that delivers results. Although some startups may approach these activities in radical ways, they are nonetheless key ingredients in their success.

Isn’t the word human redundant in this definition? What other kinds of institutions are there, anyway? And yet, we so often loose sight of the fact that startups are not their products, their technological breakthroughs, or even their data. Even for companies that essentially have only one product, the value the company creates is located not in the product itself but with the people and their organization who built it. To see proof of this, simply observe the results of the large majorities of corporate acquisitions of startups. In most cases, essential aspects of the startup are lost, even when the product, its brand, and even its employment contracts are preserved. A startup is greater than the sum of its parts; it is an acutely human enterprise.

And yet the newness of a startup’s product or service is also a key part of the definition. This is a tricky part of the definition, too. I prefer to take the most expansive possible definition of product, one that encompasses any source of value for a set of people who voluntarily choose to become customers. This is equally true of a packaged good in a grocery store, an ecommerce website, a non-profit social service or a variety of government programs. In every case, the organization is dedicated to uncovering a new source of value for customers, and cares about the actual impact of its work on those customers (by contrast, a monopoly or true bureaucracy generally doesn’t care and only seeks to perpetuate itself).

It’s also important that we’re talking innovation, but this should also be understood broadly. Even the most radical new inventions always build upon previous technology. Many startups don’t innovate at all in the product dimension, but use other kinds of innovation: repurposing an existing technology for a new use, devising a new business model that unlocks value that was previously hidden, or even simply bringing a product or service to a new location or set of customers previously underserved. In all of these cases, innovation is at the heart of the company’s success.

Because innovation is inherently risky, there may be outsized economic returns for startups that are able to harness the risk in a new way – but this is not an essential part of the startup character. The real question is: “what is the degree of innovation that this business proposes to accomplish?”

There is one last important part of this definition: the context in which the innovation happens. Most businesses – large and small alike – are typically excluded by this context. Startups are designed to confront situations of extreme uncertainty. To open up a new business that is an exact clone of an existing business, all the way down to the business model, pricing, target customer, and specific product may, under many circumstances, be an attractive economic investment. But it is not a startup, because its success depends only on decent execution – so much so that this success can be modeled with high accuracy. This is why so many small businesses can be financed with simple bank loans; the level of risk and uncertainty is well enough understood that a reasonably intelligent loan officer can assess its prospects.

Thus, the land of startups is a unique place, where the risks themselves are unknown. Contrast this with other high-risk situations, like buying a high-risk stock. Although the specific payoff of a specific risky stock is not known, investing in many such stocks can be modeled accurately. Thus a decent financial advisor can give you a reasonably accurate long-term expected return for a set of risky stocks. When the “risk premium” is known, we are not in startup land. In fact, when viewed in retrospect, most startups appear like no-brainers. Probably the most famous example today is Google: how did we ever live without it? Building that particular product was not nearly has risky as it seemed at the time; in fact, I think it is a reasonable inference to say that it was almost guaranteed to succeed. It just wasn’t possible for anyone to know that ahead of time.

Startups are designed for the situations that cannot be modeled, are not clear-cut, and where the risk is not necessarily large – it’s just not yet known. I emphasize this point because it is necessary to motivate large amounts of the theory of the lean startup. Fundamentally, the lean startup is a methodology for coping with uncertainty and unknowns with agility, poise, and ruthless efficiency. It is a completely different experience from the equally hard job of executing in a traditional kind of business, and my goal is not to disparage those other practitioners – after all, most startups aspire to become non-startups someday.

Still, these differences matter, because the “best practices” that are learned in other contexts do not transplant well into the startup soil. In fact the most spectacular startup failures result when people were in a startup situation but failed to recognize it, or failed to recognize what it meant for their behavior.

This definition is also important for what it excludes. Notice that it says nothing about the size of the company involved. Big companies often fail because they find themselves in a startup situation but are unable to reorient in time to cope with this situation; this specific pathology is explored in The Innovator’s Dilemma. This kind of crisis can be precipitated by many external factors: macroeconomic changes, trade policy, technological change, or even cultural shifts. But most often, the entrant of a startup into a previously calm market precipitates this kind of crisis. This has significant implications for general managers in enterprise, about which you can read more at HBR: Is Entrepreneurship a Management Science?
blog comments powered by Disqus