Part Two: Myths and Misconceptions About Entrepreneurial Growth Companies

Risk is an intrinsic part of any business venture. Starting a company of any type places tremendous strain on the founders' personal lives. The cost of the uncertainty that comes with a new venture can be staggering in terms of stress on family relationships, self-image, and personal bank accounts.

But according to Bhidé and others, the highest measurable levels of risk to the founder of the EGC – financially and professionally – come much later in the development of the business and not at the start, as is commonly thought. At this earliest stage of development, the founders of entrepreneurial growth companies do not take on the majority of the risks that are associated with the company. They find others to take on these risks.

However counterintuitive it may seem, a close look at growth companies in their earlier stages of development shows that founders do not assume all of the risks of the venture. In terms of professional risks, the founders of most successful growth companies are usually not well established in the field in which they're starting the new venture – a phenomenon described in greater detail in following sections. In terms of financial risks, most entrepreneurs starting out have little by way of financial assets or protected intellectual property to offer, and so their financial contribution – in absolute dollars – is limited. Successful entrepreneurs are surprisingly effective at spreading the risk around to others.

Given that an even greater set of risks is shouldered by those who work for an entrepreneur, sell supplies to an entrepreneur, or agree to buy whatever the entrepreneur is selling, the ability to persuade others to take on risks is key to the early success of entrepreneurs. Without it, little progress can be made.

Successful entrepreneurs rely on a range of tactics to overcome these hurdles, according to Bhidé. They learn to target resource providers who have limited alternatives, short-term needs, and a personal or psychological preference for working with new companies. They attempt to mimic the appearance of established companies. Entrepreneurs offer extra services and special deals to prospective customers – though rarely offer to cut prices to where they can't make a profit. Above all, the founders offer various forms of equity to their employees, suppliers, and even customers. Even knowing the risks involved, lawyers, accountants, landlords, and other resource providers sometimes participate, with the hope of developing a long-term client, developing new business, or winning equity in what may become a lucrative new company.

It is only later on in the development of the company, when the business has created some real value, that entrepreneurs risk losing it all if they are to continue growing. At these later stages, the risks involved are almost unimaginably high for the founder. Here, the popular conception of risk-taking entrepreneurs is right on target. During the later stages, financial and other risks that were previously shared among a broader group now fall heavily on the company founder, who now must face the potential loss of all that has been created. And at this point, there is much more to lose. The founder has invested a tremendous amount of time, developed a successful product, invested early revenues back into the company, and has responsibilities to his or her employees. For example, if the EGC fails to make its revenue projections or delays a product introduction, the entrepreneur may be forced to seek additional capital to keep going. If the new capital investment is not forthcoming, he may have to fold the company entirely; or if he gets the money, it may be on terms that could radically reduce his ownership of the company or even strip him of all control of the company.

Further growth requires increased investments – a factory, a system of warehouses, a set of Internet servers, or a research and development unit. Outside funders often require aggressive growth trends, the hiring of experienced managers, and a commitment to a high-risk strategy as a condition of their investments. As a result, this later stages of development requires tremendous drive on the part of the entrepreneur to make the business grow into something much larger, ignoring the risks and going for broke regardless of the consequences.

Grand ambition, organizational and managerial ability, and the willingness to take significant risks become much more important at the later stages. So does the ability to trust others to make key decisions about the business and relinquish personal control. “Only a very few individuals like Sam Walton will have the ambiguity tolerance needed to start an uncertain business and the risk tolerance needed to build it,” writes Bhidé.

Going by mainstream media coverage, it would be easy to imagine that most successful EGCs are built around some sort of invention or breakthrough – probably technological in nature. But that is not the case. “Revolutionary ventures” are relatively rare among successful growth companies, according to Bhidé. He cites Federal Express, which was started in the 1970s on the then-unheard of idea of creating a worldwide system of transportation dedicated to providing overnight delivery of packages, as the exception that proves the rule. Far more common are EGCs like Jiffy Lube, which brought moderate change and certainly marketable distinctions – but not “revolution” – to the way we change our oil.

Certainly, innovation is important to successful businesses, and inventions, new processes, and proprietary knowledge are certainly an important part of long-term business development. The potential productivity benefit of a new product, service, or distribution system must lie at the core of the new business. And technological innovation and other forms of distinctiveness become particularly important during a growth company's transition out of its original form. Bhidé finds that few ongoing ventures thrive without developing distinctive products or services. Distinctiveness is also a key to securing outside venture funding, which usually requires that a company have the potential to become a leader in its field based on the productivity gain it offers, as a condition of investment. An idea that is easily imitated or lacks copyright or other protection is of little interest to a venture capital firm risking millions at a time.

Having a breakthrough invention, a unique product, or a radically new process is not a necessary element at the beginning of most successful growth companies.

Far more common are EGCs like Jiffy Lube, which brought moderate change and certainly marketable distinctions – but not “revolution” – to the way we change our oil.

However, having a breakthrough invention, a unique product, or a radically new process is not a necessary element at the beginning of most successful growth companies. In Bhidé's interviews, “exceptional execution of an ordinary idea” was cited by almost nine out of ten successful entrepreneurs as the key to their success and enough to create the needed “distinctiveness.” Or, if there is an innovation, the innovation can be small and the company can still be very successful. In some cases – take Starbucks Coffee, for example – being first or second to dominate a new market is enough of a difference. Or there might be a minor variation, or a change in packaging that makes the endeavor appear to be unique.

In many cases, entrepreneurial growth companies create distinctiveness and protect their advantage by moving quickly, upgrading frequently, and always keeping one step ahead of the competition. Massive marketing efforts are sometimes a key element. But quality implementation, flexibility, the ability to meet customers' needs, the successful delivery of the promised productivity benefit – are usually more important than whether a company provides a unique service, product, or business model, according to Bhidé and others.

There are several well-known examples of growth companies that have thrived without early reliance on inventions or proprietary processes: Charles Schwab and other discount brokers found a way to make money with a new pricing strategy that encouraged individual investors to bypass traditional money managers. By guaranteeing the uniformity of the eating experience through tightly controlled franchises, McDonalds and other fast-food restaurants found a powerful way to win market share. And Sam Walton improved on the idea of a discount retailing that had been developed by predecessor stores like Ann & Hope and used careful site selection and rigorous inventory control to help create the Wal-Mart empire.

In fact, only six of 100 successful entrepreneurs interviewed by Bhidé even claimed to have had a unique idea, and fewer than 10 percent of the Inc. 500 companies studied were based on unique ideas according to their founders. Few of these successful founders were even the first or second entrants in their markets. Instead, they based their companies on replicating existing services or products with only a marginal improvement – “slightly modifying someone else's idea,” according to Bhidé.

Even in the computer industry, the companies that thrive don't often offer a unique product or service. Bhidé cites Bill Gates as an example of a wildly successful entrepreneur who pursued “small, uncertain opportunities, without ... breakthrough technology.” Or take another example. WordPerfect dominated the word processing software sector for many years and was bought for $884 million by Novell in 1994. But at the time WordPerfect first started shipping software, Wang already offered software applications, and WordStar was on the shelves a full year before. It took WordPerfect another six years – into the mid-1980s – to produce a technically superior product and to overtake WordStar as the market leader. In the end, WordPerfect delivered higher productivity than its competitors.

It's not just that these growth companies do without inventions; most aren't even technology-based. These EGCs have found ways to deliver productivity benefits in non-technological ways. Interestingly enough, Bhidé's research shows that most entrepreneurs are not basing their business on technology-based services or products. While technology-based companies receive the lion's share of attention in the public and among venture capitalists, technology does not dominate entrepreneurial start-ups and growing companies. In fact, two out of three companies listed in the Inc. 500 – Inc. magazine's list of the 500 fastest growing companies in the U.S. – are not technology-based. As Bhidé likes to point out, “you can't get a Starbucks latte on the Internet.”

Jann Wenner started Rolling Stone magazine when he was just 21 years old and just out of college. Steve Wozniak, who helped found Apple Computers, was an “undistinguished” engineer at Hewlett-Packard when he built the first Apple computer. John Katzman was a part-time tutor at Hunter College in New York City when he founded the Princeton Review, a test-preparation and tutoring company.

Jann Wenner started Rolling Stone magazine when he was just 21 . . . Steve Wozniak was an “undistinguished” engineer at Hewlett-Packard when he built the first Apple computer.

While founders of successful companies may become knowledgeable and prominent in their field later on, it is surprising but true that early-stage growth companies are just as likely to be started by relative amateurs with little background experience in the field. A full 40 percent of Inc. 500 founders had no prior experience in the industry they were entering, according to Bhidé's research. In fact, many of them have little work experience at all. More than a third of the Inc. 500 founders interviewed by Bhidé were out of work when they started their companies. Many others had just a few years on the job. These entrepreneurs often have few if any contacts in the field that they are going to enter.

Given the uncertainty involved, it makes sense that established executives and experienced professionals might not be interested in leaving their jobs for such a slim chance. “The individuals who face high opportunity costs...usually do not start small, bootstrapped ventures,” writes Bhidé. While entrepreneurs may be intelligent and many have impressive sales skills, what makes these companies so successful is that their founders are highly responsive and adaptable. It is their personality, adaptability, and their willingness to provide specialized products or services that wins the day, rather than the traditional industry expertise that they bring. And through this unceasing attention to the needs of customers and adapting their products and services accordingly, they gradually develop a clarity of vision to make and deliver the products or services that will win market share. They may not have “years in the industry,” but they know what they are doing.

While entrepreneurs may be intelligent and many have impressive sales skills, what makes these companies so successful is that their founders are highly responsive and adaptable.

During the transition to the later stages, however, growth companies need a deep reservoir of industry expertise and specialized training in order to thrive. This process, which Bhidé calls “upgrading resources,” usually includes the acquisition of highly qualified and motivated employees who do not require training and whose skills fit the needs and direction the company has taken. Bhidé cites the case of experienced Procter & Gamble executive Steve Ballmer, who joined the fledgling Microsoft company in 1980, to show how hiring can affect company growth during this stage. Shortly after Ballmer joined Microsoft, IBM approached the company to write an operating system for its personal computer. Bhidé and others credit the presence of Ballmer as a key to that transition.

Starbucks is another example of a company whose steep growth curve Bhidé attributes in large part to hiring experienced executives in order to propel the company from a small, regional player into a worldwide behemoth. Howard Schultz's hiring of Lawrence Maltz, who had 20 years of experience in business and eight years of experience as president of a profitable public beverage company, proved a turning point in Starbucks' history.

Again, the quest for outside funding often accelerates this process, pairing inexperienced founders with experienced executives as a condition of funding. As a condition of providing investment funds, a venture capital firm will often require the hiring of an established chief operating officer.

While it might be easy to assume that most successful entrepreneurs start out with a well-considered plan of action, strategic planning and research are in fact hallmarks of the later stages of development, rather than a necessary initial ingredient.

For many start-ups, extensive research and planning are often both unnecessary and financially impossible. At the early stages, Bhidé finds that successful entrepreneurs do not necessarily have grand plans or a horizon-to-horizon vision of where they want to take their businesses. Only 4 percent of the Inc. 500 founders interviewed by Bhidé used any sort of systematic search to develop their business ideas, and fewer than one out of three had anything more than a rudimentary business plan. Another study by Bhidé found that fewer than half of the Inc. 500 founders during the 1980s even consulted with a lawyer before starting their businesses.

The process of starting a new business is like jumping from rock to rock up a stream rather than constructing the Golden Gate Bridge from a detailed blueprint.

For these reasons, the first efforts of many successful entrepreneurs are often not the product or service that eventually brings success. William Hewlett and David Packard started out selling an audio oscillator. Virgin Records founder Richard Branson's first several business ventures included a failed magazine launch.

While lack of long-term planning may seem hasty or unwise, the reasons so many successful companies go without it are clear. Bhidé comments that the process of starting a new business is like jumping from rock to rock up a stream rather than constructing the Golden Gate Bridge from a detailed blueprint. “In businesses that lack differentiating technologies or concepts,” he writes, “personal traits such as open-mindedness, the willingness to make decisions quickly, the ability to cope with setbacks and rejection, and skill in face-to-face selling help differentiate the winners from the also-rans.”

At this early stage, adaptiveness is much more important than a thorough, rationalized decisionmaking process. Through this adaptive process, an Internet business originally intended to generate revenue from its articles and analysis may evolve into a web portal that generates revenue by selling magazine subscriptions or ad placement without any original content. Only later, when the business is ready to make the transition to a later, more developed stage, do planning, strategy, and research become prime considerations.

It is during the later stages of growth that extensive research and strategic planning become essential to survival and further development of an EGC. The initial success of the company cannot be sustained by a series of improvised, unrelated decisions that might lead it to pursue too many disconnected endeavors. Initiatives that do not fit within the overall strategy of the company must be discarded, however profitable. In these ways and others, spontaneity and speedy adaptation are replaced by planning, innovation within defined constraints, and carefully coordinated decisionmaking. And the need for outside investment, usually accompanied by intense scrutiny by potential investors, only reinforces the need for a sound business plan. Strong advocates of planning and research, venture capitalists usually require a business plan with set metrics and timetables as well as seats on the board and other concessions.

Of all the myths and misunderstandings surrounding entrepreneurship, the role of venture capital is perhaps the most exaggerated. The venture capital phenomenon has received so much attention that it often appears to those looking in from the outside that most decent business ideas would receive venture backing. The media lavishes coverage on venture-backed startups, and has highlighted the massive growth in business “incubators” around the country.

In truth, venture capital is dominant in some industry sectors where capital requirements force companies to skip the early growth stages. For example, venture capital backing is a common feature among biotechnology ventures, some high-tech startups, and the Internet industry. For example, at the height of the boom, Internet startups received roughly $17 billion out of $21 billion (80 percent) in venture capital during the first quarter of 1999. But even after the “dot-com crash” (the third quarter of 2000) Internet companies still accounted for 45 percent of all venture capital investments.

And venture capital is an important part of the transition from a fledgling company to a more developed EGC. Growth companies of all types require equity financing in order to grow. At the later stages, substantial resources are needed in order to capitalize on initial successes. Started with just $5,000 of Sam Walton's money in 1945, Wal-Mart supported its own growth until 1969, when it secured a large term loan and shortly thereafter completed a $4.6 million public offering. In many cases, the search for outside funding and the conditions imposed by venture capital firms accelerate and enforce the transformation of initially successful startups into later-stage growth companies. There are data, for example, that show that venture capital-financed companies perform better through entrepreneurial growth stages than EGCs without such investors.³

However, venture capital – or any other type of formal financial support – is surprisingly uncommon among most successful EGCs at their early stages of development. In 1999, for example, fewer than 4,000 of the roughly 700,000 new businesses created were venture capital-funded. That means that less than one percent of all new businesses were backed by venture capital. In recent years, no fewer than half of all initial public offerings have involved companies without venture backing, according to the National Venture Capital Association.⁴

Cisco Systems, now one of the top providers of Internet routers and servers, was initially financed from the personal savings and borrowings of its two founders.

While high-tech startups are often the exception to this rule, it is well worth noting that even Bill Gates and Paul Allen, founders of Microsoft, failed to secure venture capital when they started their company in 1975. Hotmail.com, the popular e-mail program, thrived without venture capital before it eventually received outside backing and was bought out by Microsoft for $400 million. And Cisco Systems, now one of the top providers of Internet routers and servers, was initially financed from the personal savings and borrowings of its two founders.

In fact, most growth companies start with limited means. One reason is that the resources required to start most growth companies are remarkably small. In the world of venture capital, backing usually starts at about $3 million – far more than most early-stage growth companies need or warrant. In most cases, there is simply no need for a massive influx of cash. According to Bhidé, 26 percent of the successful businesses he studied started with less than $5,000. Two out of three on the 1996 Inc. 500 started with less than $50,000. The average funding required for these companies was just $25,000.

Rolling Stone magazine was started with just $7,500 in the bank. Waste Management, Inc., a NYSE-listed waste management leader operating in more than half of the states, started out with a single truck and revenues of $500 a month. Bob Reiss founded Valdawn, which makes fashionable, inexpensive watches, with just $1,000 of initial funding. By 1994, Valdawn was an Inc. 500 company with $7 million a year in revenue.

At these funding levels, personal savings, and money from family and friends, are usually more than enough to do the job. In some cases, individual “angel” investors become involved at this point. Angels, many of whom are former entrepreneurs with industry experience, are often the first outsiders to look critically at an EGC. Through the moderate amounts of funding they provide, angels frequently accelerate the transition between the early and later stages of entrepreneurial growth.

Moreover, venture capital is usually only awarded to initiatives that have features most EGCs lack at the start – a strong business plan, and a solid track record, experienced staff, and an innovative or proprietary idea. They may acquire some or all of these things along the way, but, lacking most of these characteristics at the outset, three out of four entrepreneurs surveyed by Bhidé didn't even attempt to secure venture capital. “More than 80 percent of the Inc. founders I studied bootstrapped their ventures with modest funds derived from personal savings, credit cards, second mortgages, and so on,” states Bhidé. “The median start-up capital was about $10,000. Only 5 percent raised their initial equity from professional venture capitalists.”