Think Customer capital, Not venture capital

Mega fund-raising rounds are certainly newsworthy and can get you atop the business press. However, London Business Professor, John Mullins, gently reminds entrepreneurs, especially in new age technology-enabled sectors, about an age old concept – that of bringing in cash from customers. He suggests five models to pursue a ‘customer-funded’ business

 

DR. JOHN MULLINS, A RENOWNED ENTREPRENEURSHIP EXPERT AND PROFESSOR OF MANAGEMENT PRACTICE AT LONDON BUSINESS SCHOOL

Let me cut to the chase. India’s upcoming brigade of new age entrepreneurs is being fed with a whole lot of inspiration. From India’s leading business newspapers to several digital magazines focused on entrepreneurship, every media house is screaming loud about the entrepreneurship boom in India. The boom, so to speak, comes from the mega venture capital deals that are announced almost every single day. However, those who were around in 1999 will understand that a bust cycle is inevitable. For others, there’s certainly potential to make merry while the party lasts.

To be sure, there is probably nothing wrong with big bucks chasing Indian tech startups. From Ola Cabs and Housing.com to Zomato and LimeRoad, most of these ventures have become mainstream and often, even a daily routine of a youngster’s life. There is one name – Flipkart – that arguably played a pivotal role in shaping up this thrust for the startup ecosystem in the country. At a macro level, this is good news. However, it would be prudent for newer entrepreneurs to keep in mind that one fine day, this party is going to end. And, who’ll bail you out during those gloom days? Your customers, if you have any who pay you more cash than you spend on acquiring and serving them.


“The germ of the idea was set while I was authoring Getting to Plan B with Randy Komisar. The business model of Costco and Dow Jones particularly intrigued me, where cash from customers, not investors, predominantly funded the working capital.”


For this edition’s cover story, we interviewed and drew inspiration from research done by Dr. John Mullins, a renowned entrepreneurship expert and professor of management practice at London Business School. Mullins’ insights are drawn from several years of empirical, data-driven research, that has been captured in the form of three books he’s authored – The New Business Road Test, Getting to Plan B and his latest, The Customer-Funded Business.

In this latest book, Mullins has uncovered five fundamental models of customer-funded businesses. As he repeatedly mentions in his book, these models have existed for ages. Mullins says, “The germ of the idea was set while I was authoring Getting to Plan B with Randy Komisar. The business model of Costco and Dow Jones particularly intrigued me, where cash from customers, not investors, predominantly funded the working capital.” This led Mullins to dig deeper and uncover models where customer cash was used to start, grow and finance a startup. In accounting terms, Mullins uncovers five models where negative working capital can fund your business, at least partly.

To re-emphasize, this whole concept of being customer-funded is not to be confused with the bootstrapping model. The idea here is to nudge entrepreneurs in the direction of generating cash from customers for working capital needs irrespective of whether you are venture funded, bootstrapped, a new venture or even a large company.

Mullins believes that raking in cash from customers, especially in the early stages, and raising funds much after the business model is set, can be a good thing. He quotes the example of Airbnb, the world’s largest marketplace for connecting people who seek to rent their extra rooms or apartments with people who want accommodation. Of course, the vacation rental firm is a Silicon Valley darling today and Techcrunch recently reported that it is raising US $1 billion at a valuation of around US $20 billion. But, in the good old days when the founders had just founded the company, it was customer cash that kept the company afloat.

John Mullins narrated this story for us. Apparently, when Airbnb founders, Brian Chesky and Joe Gebbla, were just starting up, they wanted people attending a Democratic Convention in Denver (where Obama was nominated) to rent from Airbnb. The business problem they were solving was very simple – hotels were fully booked thanks to a packed convention, hence, Airbnb enabled anyone with an extra room in their house, to rent to people coming into Denver for the summit. But, that’s not all.

Chesky and Gebbla, both design graduates with creative streaks, went a step further and designed these cereal boxes that read – Obama O’s, the Cereal of Change,” and “Cap’n McCain’s, a Maverick in Every Box – and then bought a bulk supply of generic cheerios and packaged these boxes with it. They sold these for breakfast at US $40 a box, generating over US $25,000 (apparently, only the Obama O’s sold well) in funding to get started. In the book, The Customer Funded Business, Paul Graham of Silicon Valley incubator, Y-Combinator, explains that this story of how the entrepreneurs got creative to rake in cash from customers was a key reason why they invested in Airbnb.

The whole concept of customer cash, or negative working capital, is not new to India. Several businesses including the likes of Zoho and Naukri.com in the early days adopted this strategy. In one of his interviews with The Smart CEO, Sanjeev Bikhchandani of Naukri touched upon how the company conceptualized a plan to sell its database of resumes to small recruitment services firms across the country, collecting cash upfront through an annual subscription model. The whole IT Services industry adopted this model, thanks to advance paid by their enterprise customers.

One of the companies we feature in this edition, RateGain, remained self-funded for years, thanks to its ability to make cash from customers. This model of enticing customers to pay upfront goes beyond the monthly subscription model. Mullins took us through five models he uncovered, thanks to in-depth research he conducted with over 40 companies from around the world.

He puts in a caveat that these models may not work in your business’ context. However, he believes it is worthwhile to explore if there is anyway you can tweak your business to have negative working capital. Of course, some businesses, like the flash sales model adopted by companies like 99Labels have gone under for several reasons. Mullins says, “The primary reason why so many flash sales businesses went down is that while they could bring in customer cash, they were profit poor.”

Similarly, your business might be operating in a sector where it is impossible to work on any of the following models. However, the purpose of this cover story is to give you a perspective on how global firms – in spite of being venture funded – are pursing interesting strategies to fund their working capital and, in the process, becoming market leaders.

The Matchmaker model 

For several new age, Internet-based startups, the matchmaker model (or market place as it is called today) used to be a good way to get started without too much capital. The classic global example is that of eBay, which pretty much tied up buyers and sellers of goods through a marketplace and arguably pioneered this “no inventory” model. In the early days, eBay made a commission on sale value, and its only costs were technology and people. Its gross margin was 100 per cent simply because it didn’t own any of the goods. In India, Naukri, MakeMyTrip, Shaadi.com and Bharatmatrimony.com pioneered this model.

Of course, this is also the most prominent model in the Indian startup world today. Flipkart (minus WS Retail), Snapdeal, Ola Cabs and Uber, to name a few are designed as marketplaces. However, the typical challenge in this model is that it is a ‘winner takes all’ game. This means you can prove your model without external funding, but once it’s proven, raising capital in large amounts is crucial to win the battle.

The key metrics to measure here are the number of buyers and sellers, cost of acquiring members on both sides and the ability to maintain balance between demand and supply. For example, the key for Ola Cabs, is to ensure that there is very little demand-supply gap between drivers and customers, and scaling up both its driver network and customer network.

In his research, Mullins also observed that one of the biggest challenges in the marketplace model is the role played by ‘bad actors’. What happened with the Uber driver in Delhi is a classic example of the same, and entrepreneurs would do well to predict such pitfalls and setup processes to avoid or tackle the same.

In short, if you’re new entrepreneur pursuing a marketplace model, these are some questions you should ask yourself. Is there under-utilized supply that has demand? Just like eBay or Airbnb did, can I prove my model works before raising capital? Most importantly, is my space unique enough that I can scale up sizably to compete in a ‘winner takes all’ sector? Finally, is my idea suitable for a marketplace or matchmaker model?

It is crucial to think few steps ahead, predict what your competition will do and most importantly, stay nimble enough to tweak a model if it does not work.

Pay-in-advance model 

The B2B services sector has pursued this model for decades. Legal firms, architects, IT services firms and ad agencies have managed to build sizable companies with no external funding. Firms like Infosys and Wipro didn’t raise capital from outside till their IPOs, and if you can manage scaling linearly by adding people, nothing like it.

Among new-age sectors, companies like MuSigma and Fractal Analytics (another company we have featured this edition) have built scalable models around big data services.

Mullins believes that one of the biggest challenges in scaling up B2B services is adding people and managing extremely large organizations. However, companies like MuSigma have proved that it can work, and there is no reason why one should not attempt it.

One thing is clear though – services models find it tough to raise venture funding, unless you have a proven management team (like Ashok Soota did with Happiest Minds) and it takes a patient entrepreneur with strong people-orientation to build one.

In the Internet space, one company that has managed to have a reasonable pay-in-advance model is Urban Ladder, the online furniture retailer. Unless you pick the cash-on-delivery option, you pay cash upfront and your furniture is then made and delivered. However, this model is not universally applicable and it is tough to predict whether a customer will opt for the cash-on-delivery option.

Mullins says, “Customers pay-in-advance only if you’re solving a major pain point.” Additionally, if you want to have capacity ready to acquire clients even faster, raising venture capital will be a challenge. Several services companies today are incubating products within their venture.

Arun Jain-founded Polaris Financial Technology, for example, recently hived off its products division into a separate company called Intellect Design Arena. The Intellect suite of products targeted at the financial sector was born while Polaris was servicing its global clients in the same segment. Later in this article, we have a specific section dedicated to this model of converting from “services-to-products”.

Subscription or SaaS model 

The third customer-funded model that Mullins has researched is the subscription model. Of course, successful media companies all over the world pioneered the low-cost subscription model. Once they amassed a sizable subscriber database, advertisers started advertising in their media platform and media companies made money through advertising.

Over the last two decades, software-as-a-service companies have taken this model to another level. In India, companies like Zoho, Freshdesk, Chargebee have all built scalable businesses with a subscription model.

While cash from subscribers can help with working capital, the cost of acquiring customers has prompted these companies to raise external funding, to scale up rapidly.

Mullins says, “The two key metrics here are cost of customer acquisition and customer lifetime value. Some entrepreneurs overestimate the customer lifetime value and this often leads to challenges.”

A common pitfall in this business model is the risk associated with payback. The number of subscribers needed to breakeven can vary depending on the product and the value proposition to customers is crucial. The other challenge here is that the pricing and revenue strategies of competitors can vary. For example, Freshdesk initially was founded because Girish Mathrubootham thought there was potential to beat its larger rival Zendesk both in terms of product and pricing.

Also, for technically savvy founders with deep domain expertise, barriers to entry into starting a SaaS venture are fairly low and you never know when a new innovative product will come and suddenly you’re competing against a startup, as Salesforce found out with Zoho. Of course, the B2B SaaS sector has room for multiple players, each with a unique advantage of its own.

The other common worry for founders of SaaS companies is to decide whether to do the ‘freemium’ model, wherein the basic product is free and customer start paying for the upgraded version. However, if very few people switch from the basic version, you’re in trouble. Some entrepreneurs have gone to offer a one-month free trial, after which only the paid option is available.

The Scarcity Model 

Globally, the classic example of a company that has thrived in this model is Zara, known for its “fast fashion” approach. Thanks to a robust supply chain with extremely efficient turnaround times, Zara is able to attract its fashion conscious consumers with its “buy now or you won’t find it later” approach.

The Zara model works only because its manufacturing facilities are close to where its products are retailed and not outsourced to South East Asia. The company has the ability to constantly come out with new designs, an efficient supply chain and most importantly, a marketing strategy to fuel this model.

Mullins, in his research, found the company collected cash from its customer upfront and negotiated longer-term credit with all its vendors. It was a classic example of funding all its working capital through customer cash.

Inspired by the Zara model, several e-commerce companies all over the world thought they could make money off a similar approach of using scarcity of goods. The ‘flash sale’ model was born, pioneered by French e-commerce firm Vente-Privee. The idea was that there would be ‘online events’ when excess inventory of brands would go on sale at a super discount. Considering these brands were normally very expensive, the thesis was, people would buy in loads during the ‘flash sale’. Of course, just like Zara did, they negotiated better pricing and credit terms with their branded vendors.

But, there was a major glitch in the whole model for the entire industry. The reason excess inventory of brands was cheap was because there was no demand for these designs. However, with fuel from venture investors, there were many flash sale startups that offered to buy this excess inventory. Demand increased and, hence, price of this excess inventory went up. This resulted in a crash of the whole industry. While the pioneer Vente-Privee continues to operate in a few countries in Europe, it shut shop in the US.

Mullins summarises saying, “The key is to be cash rich but also profitable. Lack of profits was a key challenge in the flash sale segment.”

For entrepreneurs, the key takeaway here is that customers will come if an aspirational product is available at an attractive price. However, such a model may make more sense as a “feature” within a larger company, rather than as a standalone business. Luxury brands often launch “limited edition” products or e-commerce companies could have a one-off flash sale, and in such situations, the model works very well.

Services-to-Products model 

Did you know Microsoft started off being a services company trying to build an operating system for IBM? The MS-DOS was born, thanks to a project that Bill Gates and Paul Allen were asked to work on for IBM. Of course, Gates and Allen were smart enough to negotiate in the contract that they could license it other customers too.

The advantage with this approach of starting off with services and then moving to products is fairly straightforward – your customer funds your initial product development.

Close to home, as mentioned in this article before, Polaris, the IT services company focused on the global financial sector incubated a whole new products company within its services business. Now called Intellect Design Arena, the company is a Rs. 500 crore independent products company listed in the Indian stock market. Of course, Finacle from Infosys is the other classic example of a product that was born within a services company.

Another company in India, Congruent Solutions, an IT services company focused on the retirement financial management industry made the transition into becoming a complete products company. After being around for more than two decades in the services industry, recently, it raised money from Fulcrum Venture Partners to scale up with its products business model. It partnered with IT Services major, Cognizant Technology Solutions, to take its retirement product to global markets and aid in implementation.

On a concluding note, the five models mentioned above are several ways in which customer cash can fund working capital, at least partially. Entrepreneurs, especially in new age sectors, would do well to think of similar approaches to add to their revenue mix. At Amazon.com, the membership fee for Amazon Prime is a classic example of bringing in customer cash upfront, to offer specific perks to privileged customers. The Obama O’s cereal breakfast was a quirky way for a startup to raise much needed cash in the early days.

Indian entrepreneurs must explore such quirky, creative and unique methods, to bring in cash from customers.


A story from the early days of airbnb on raking in customer cash 

Apparently, when Airbnb founders, Brian Chesky and Joe Gebbla, were just starting up, they wanted people attending a Democratic Convention in Denver (where Obama was nominated) to rent from Airbnb. The business problem they were solving was very simple – hotels were fully booked thanks to a packed convention, hence, Airbnb enabled anyone with an extra room in their house, to rent to people coming into Denver for the summit. But, that’s not all.

Chesky and Gebbla, both design graduates with creative streaks, went a step further and designed these cereal boxes that read – Obama O’s, the Cereal of Change,” and “Cap’n McCain’s, a Maverick in Every Box – and then bought a bulk supply of generic cheerios and packaged these boxes with it. They sold these for breakfast at US $40 a box, generating over US $25,000 (apparently, only the Obama O’s sold well) in funding to get started. In the book, The Customer Funded Business, Paul Graham of Silicon Valley incubator, Y-Combinator, explains that this story of how the entrepreneurs got creative to rake in cash from customers was a key reason why they invested in Airbnb.

The Obama O’s cereal breakfast was a quirky way for a startup to raise much needed cash in the early days. India entrepreneurs must explore such quirky, creative and unique methods, to bring in cash from customers.


THE FIVE CUSTOMER-FUNDED MODELS 

Of course, these models have been around for ages. But, even today, startups are relying too much on investor funding in the early days, as opposed to using these models to bring in much needed cash. The book suggests exploring the option of using any of these five models to do so:

Marketplace model with no inventory

Classic examples: MakeMyTrip, Matrimony.com

Subscription Model

Newspapers, SaaS companies like Freshdesk and Zoho

Pay in Advance Model

Get an advance like B2B IT services companies, legal firms, KPOs

Scarcity model

Zara, the fashion retailer, does it successfully by enticing customer into buying and making sure expired designs don’t come back; Luxury limited editions of Mont Blanc pens are a classic example

Service-to-product model

Services companies build products, thanks to their domain expertise and internal skill sets. It is often easier to scale up a product venture. Classic example: Microsoft

John Mullins technology startups

Prem Sivakumaran is co-founder & CEO of Growth Mechanics, a leadership and entrepreneurship-focused business content company in India. Growth Mechanics publishes The Smart CEO, a publication focused on enabling peer-to-peer knowledge exchange among C-level executives and board members. The platform reaches over 1.2 lakh CXOs across its website, app, print publication & CEO Round Tables, and has featured on the cover India’s leading business leaders/founders from Infosys, Mindtree, Tata Sons, ICICI Bank, Biocon, Yes Bank and several others. In addition of Smart CEO, Growth Mechanics also organises the Startup50 Conference & Awards, an annual event to recognize India’s top 50 startups every year. Startup50 Alumni include Freshdesk, Oyo Rooms, Urban Ladder, Capital Float, Paperboat Beverages, among others. Growth Mechanics’ primary business model revolves around linking CXOs and Brands around engaging content and has worked with India’s leading companies including Mahindra Group, Godrej & Boyce, BASF, Airtel, Tata Docomo, Fiat, IDA Ireland, Yes Bank, Prestige Estates, Frederique Constant, Indian Terrain