The Small Business Opportunity for VCs
I see three distinct areas of opportunity that are attractive today: Investments in technologies that enable small businesses to operate more efficiently, investments in platforms that effectively create new small businesses, and direct investments in small businesses.
Tech for Small Businesses
Most of the workforce in the United States is employed by a small business. There are about 30 million active businesses across the country. But because of this dispersion, venture investors often view tech startups who target small businesses as their primary customer as too inefficient. It is difficult to grow a profitable business when you consider the cost and time required to find and maintain many small businesses customers. Conventional wisdom suggests it’s a much better idea to target larger enterprises, like the Fortune 500 companies, who can afford to pay much more for technology and keep longer term contracts.
Despite the natural bias toward building technology that serves large enterprise, the opportunity to serve the massive small business population is clear. Hardware and software products and services that figure it out can quickly achieve massive scale. Square allowed anyone to accept credit card payments by iPhone, Zenefits made HR benefits less intimidating, Xero has made accounting more manageable, and the list goes on.
Usually the technology drastically improves at least one core function of the business such Marketing, HR, Finance, Inventory, etc. Value is derived most from the business owners who are particularly weak in one of those areas but recognize the importance of addressing it.
Platforms for Small Business Creation
By contrast to tech addressing one narrow function of a small business, Platforms that create new businesses address almost all core functions of a business and outsource only one or two. A traditional example of this would be Avon with its direct selling model. The product design, packaging, inventory, branding, customer service, finance, compensation, and almost all functions are handled by Avon, the corporation. This created a platform for individuals who were good at sales and people management to excel by only focusing only on those two functions. These individuals effectively created their own businesses by leveraging the Avon platform.
Another key aspect of Platforms is the low cost of entry. Traditional small businesses often require large upfront capital outlays that the average American doesn’t have access to. This lack of available financing is the one of the primary reasons people do not start businesses. Platforms that create new businesses address this by requiring a much smaller initial investment or no investment at all.
It should be noted that Platforms I’m describing are also quite different than many of the current “1099 economy” platforms like Uber. There the best drivers don’t generate much more money than the average driver. On the platforms I describe, performance typically follows a power law distribution where the best performers usually generate many multiples more than the average. This makes for a substantially more attractive opportunity for those with skill who are also willing to put in the work.
Direct Investment in Small Businesses
The last opportunity is to invest directly in small businesses themselves. Venture investors have avoided this due to the need to construct a portfolio of companies that each have the potential to grow to nearly a $1B in market value in a relatively short period of time. The term “lifestyle business” emerged to describe a small businesses that instead prioritized stability and survival over exponential growth.
A “lifestyle business” has a somewhat negative connotation because the size of the opportunity is typically much smaller than that of a venture backable business. But in reality this has much more to do with the way venture funds are structured than it has to do with the merits of the business. Many venture funds would be happy to produce a 20% IRR for their LPs. A 20% IRR from investing in a small business is not uncommon. Still most venture funds hold on to a strategy where the winners make up for the losers who go to zero, so the winners must be really big. A portfolio of good “lifestyle businesses” would have much lower variance in outcomes but could potentially produce similar results. Not a bad “lifestyle” — so let’s just call them traditional small businesses.
The investment opportunity is rooted in the fact that for every venture backed business created there are a thousand traditional businesses created in the US. Furthermore, for every thousand VCs there seem to be only a few funds that make equity investments in newly created traditional businesses. In other words there is a huge disconnect between the types of businesses being created and the dollars that are chasing them. This causes many traditional small business founders to try to attract capital from venture capitalists by spinning their businesses into a hyper-growth narrative they know VCs want to hear. But even if those founders do attract capital from VCs, their goals are so misaligned it often causes tension.
Though I’ve only come across a couple of funds who actively focus on early direct investment in traditional businesses, I suspect we will see more VC interest in small business in the coming years. Until that happens the market is wide open.
The opportunity to invest in small businesses generally appeals to me because it also represents a wider distribution of wealth. We are in a time where technology is displacing jobs and value is being concentrated around the top 0.1%. We’re overdue to enable more of the population outside of Silicon Valley to use their hard work and creativity for economic advancement of themselves and those around them.
My hope is that by investing in small business I would not only be able to show the strong case for good returns, but also restore the concept of the American dream for those with the will and aptitude to go after it.