Do Small Business Start-ups Have to Innovate to Succeed?

One of the questions that frequently comes up when discussing a model or plan for a new business (a start-up) is “Is it innovative?” The assumption is that innovation is good and that innovators always have an edge over those who are merely following an established business model. I completely disagree with this assumption and delve into the risky nature of small business innovation in several places in the book, especially in Chapter Four which I have entitled “Small is Beautiful.” Here is what I say in that chapter on page 175:

“Given the enormous amount of positive publicity that surrounds innovative companies, it is not surprising that many small start-up entrepreneurs believe that if they are not innovative they cannot succeed. They conclude that a brilliant new idea is the key to fortune and fame. They are wrong. Unlike big start-ups, the vast majority of successful small start-ups I have known begin with basic products and services presented to a known market in fairly traditional ways. Nothing about them would strike you as especially innovative. On the other hand, there are many instances where entrepreneurs flounder and fail as they attempt to create and then launch an innovative, sometimes wildly innovative, business model or product. Creating wealth through innovation is extremely difficult, indeed almost impossible. Statistically, you have better odds of playing in the NFL.”

The reasons I give for the difficulties that start-up innovators encounter include the amount of time and money required for innovation that could be used to assure a successful business launch (in economic terms innovation has high opportunity costs) and the potential confusion innovation can cause in the mind of customers unless it creates immediate benefits to the customer that are simple and obvious. People and markets respond slowly and skeptically to change and entrepreneurs who try to innovate can easily end up standing “Naked in Macy’s Window” (you will have to read Chapter Four to find out exactly what that means.)

Now a new study just released by Accenture (a global management consulting firm) reinforces the idea that (as Accenture puts it) “ideas are unprofitable.” For starters Accenture points out that there are 160,000 patents filed in the U.S. every year of which only about 1,600 (about 1%) ever reach the marketplace as part of a product or service. Few of of these are financial successes. Moreover the Accenture data shows that most of the “highly innovative” companies in America are really not innovative at all. They didn’t invent anything. Instead they are “scalers,” i.e, companies that have been able to take existing products, ideas and business models and make them more efficient and productive, find new applications for them and slowly make them a dominant force in the marketplace. Accenture calls this incremental improvement “renovation” (taking an existing idea and making is work better in the marketplace, examples being Dell, Apple, Wal-Mart) as opposed to “innovation” (being the first to come up with a new idea, examples being Xerox PARC’s computer mouse or Osborne Computer’s personal computing machine). This sounds a lot like the distinction I make between innovative and “replicative” businesses. What are replicative businesses? I answer that in Chapter Eight.

“(Replicative businesses are) ones that start out by providing standard goods and services in standard ways, very likely relying on a customer base in the local community perhaps supplemented by non-local customers acquired through e-commerce marketing efforts.”

But once the business becomes more successful there is ample opportunity to become a “scaler.” As I put it;

“If innovation is in your blood, keep in mind that there is no hard and fast rule that says replicative businesses cannot innovate. This is especially true for businesses that include a substantial service component. As I argue in Chapter Five, service innovation often can be achieved with little or no additional capital outlays and is far less risky and easier to implement or reverse than product innovation. Yet service innovation often has a powerful effect on customers and can take the most boring of business models to a higher level.”

Do you have to innovate to succeed? No. Innovation often fails. On the other hand, if your business lends itself to innovation, once you have successfully completed the start-up phase and are on the path to long-term success you can begin to innovate at a pace you can control and afford. As you scale up, your business just may turn out to be the next Apple or Costco.

© Ralph Blanchard 2011

Reference: Vaclav Smil, “The Myth of the Innovator Hero,” The Atlantic. http://www.theatlantic.com/business/archive/2011/11/the-myth-of-the-innovator-hero/248291/. Accessed 16 November 2011.

Do Extreme Concentrations of Wealth Create Opportunity for Entrepreneurs?

The news has been filled recently with stories about the Occupy Wall Street rallies being held in major cities around the country. To the casual observer the Occupy movement seems like a leaderless mishmash of ideas and causes ranging from the breaking up mega-banks to the legalization of marijuana. But at its core, the occupier message points (correctly in my opinion) to a dangerous and growing concentration of wealth among those earning the top 1% of incomes in the U.S. The occupiers claim (again, correctly in my opinion) that much of this concentration has occurred at the expense of the remaining 99% so that it is not only economically destabilizing but also unfair. (You may recall that similar views about taxpayer bailouts of large corporations and financial institutions under the TARP program fueled the early Tea Party movement before it was absorbed by mainstream politics.)

From a purely economic perspective, there is plenty of data that points to a substantial and growing imbalance of wealth in America. But for small business entrepreneurs this extreme concentration may present a golden opportunity. Can entrepreneurs create wealth with business models that target the wealthy? Let’s explore the idea and find out.

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When a newspaper reporter once asked Willie Sutton why he robbed banks he responded “because that’s where the money is.” What we might refer to as “Sutton’s Law” postulates that the best strategy to acquire wealth is to “go where the money is...and go there often.” This strategy is sometimes used by entrepreneurs who start businesses that target highly affluent customers. Examples include specialty boutiques for children and adults (clothes, toys, etc.), pet spas, personal shopping and errand (concierge) services, auto detailing services, landscape design services, etc.

Business models that focus on the wealthy as a target market have an understandable appeal (Chapter Five of my book talks about how to develop a business model for a product or service, the first step of which is to identify a well-defined target market.) There is an ample amount of economic data to support this strategy. Much of this data can be found in a recent report issued by the Congressional Budget Office (CBO), which has been studying the matter of wealth concentration in the U.S. Some of the CBO’s conclusions:

1. The share of after-tax household income for the top 1% of the population more than doubled, climbing to 20% of the national total in 2008 from less than 8% in 1979 (a 150% increase).

2. The most affluent 20% of the population received 53% of after-tax household income in 2007, up from 43% in 1979. In other words, the after-tax income of the most affluent 20% exceeded the total after-tax income of the other 80% of the population.

Go where the money is seems like a logical business strategy because the money is extremely concentrated.

Of greater interest to entrepreneurs looking for market opportunities are studies that focus on actual consumer spending as opposed to after-tax income. They show that in 2008 the top 5% of U.S. earners accounted for 37% of total consumer expenditures. Since consumer spending as a whole accounts for about 70% of the total U.S. economy, the top 5% accounts for 26% of the total U.S. economy, about $3.5 trillion annually. Within this 5% cohort is an even smaller group called the “x-fluents,” roughly the top 1% of all consumers. X-fluent income in 2010 averaged $410,000 per person before taxes. Not surprisingly, with annual incomes this high these people are truly high volume spenders. Data from Unity Marketing Inc., a consulting firm that tracks luxury retailing, show that x-fluents spent an average of $25,800 per person for the three month period ending June 30, 2011 This averages out to about $8600 per person per month (annualized this is over $100,000 per person). This was all luxury consumption (Chanel purses, Oscar de la Renta gowns, Brioni suits, Roche Bobois furniture, Manolo Blahnik shoes, Tiffany jewelry, Ritz-Carlton spa treatments, exotic vacations, etc.) Everyday expenditures on items such as such as food, transportation and shelter are not included in the $8600. This may seem like a lot of money and it is, but 2011 luxury expenditures were actually about 18% less than for the same period in 2010. Even in a down year, however, this seems like way too much retail opportunity for entrepreneurs to ignore. As Willie would say, that’s where the money is.

Is this target market as lucrative for entrepreneurs as it appears? Do wealthy people really spend this lavishly on haute couture fashion and vacations to far-off places while their purebred dogs and cats relax in luxury pet hotels and college-trained horticulturalists tweeze dandelions from their otherwise immaculate lawns? The answer is…….sometimes they do, but sometimes they don’t. A new book by Robert Frank of The Wall Street Journal (the latest of several books he has published on the spending habits of the highly affluent) explores the spending patterns and cycles of affluent consumers and concludes that the amount of wealth available for the wealthy to spend on non-essential consumption fluctuates greatly as the economy rises and falls. They adjust their spending patterns accordingly. He calls these consumers “hi-betas,” a term borrowed from the equities market to describe a stock whose share price gains much more than the average when the market is on an upswing but loses substantially more than the average when the market declines. In other words, hi-beta stock prices swing wildly from the highest highs to the lowest lows. Hi-beta spenders follow the same pattern and so are neither consistent nor even predictable in their consumption expenditures over any given period of time. This is a potentially fatal problem for businesses that cater to them.

What is the problem with these rich people? Gee whiz, if someone has a net worth (on paper) of, say, $25 million what could possible cause that person to periodically cut back on a level of luxury spending that, although high compared with the average person, is only a small fraction of their total wealth?? There are two parts to the answer. One has to do with how wealthy people acquire the high net worth that makes them look (and act) rich. The other has to do with the alternating euphoria and anxiety caused by making and losing large amounts of money.

Wealthy individuals do not hide their money in a can buried in the back yard. Nor do they keep much of it in low yield money market funds or checking accounts. Instead they invest it in equities, sometimes using traditional stock portfolios but often through hedge funds or other high risk, high return investment vehicles (think Bernie Madoff-like investment opportunities). As a result, much of their “wealth” is on paper (unrealized capital gains), not in actual cash. They often take great gambles in their investment strategies (I am speaking about the average hi-beta; there are exceptions) and can make or lose large amounts of money literally overnight. The stock market crash of 2008 (caused by the near-collapse of the financial system which in turn caused the Great Recession) could easily have cost a hi-beta $10 million of his/her $25 million.

Hi-betas also typically have another substantial chunk of their wealth invested in real estate (multiple homes, partnerships in shopping malls, etc.) These assets are often highly leveraged (acquired with borrowed money.) When times are good, banks and private lenders are happy to loan money to their wealthy clients hoping that, because of their high net worth, they are immune to the normal ebb and flow of the economy. Wealthy people are often assumed to have “deep pockets” and the financial capacity to weather short-term economic downturns. But real estate is highly illiquid (slow to sell to convert the value into cash). The collapse of the housing bubble and a paralysis of the commercial real estate sector such as we have experienced during the Great Recession and its New Normal aftermath can put tremendous strain on the cash flow of even very affluent borrowers. Rich people have to make mortgage payments just like everyone else and lenders want those monthly or quarterly payments made in a timely manner. Otherwise, they foreclose. Other “safe” investments made by rich people as a hedge against a temporary downturn may also be illiquid. As a result of all of these illiquid investments, a wealthy person with a net worth of $25 million may only have easy access to $1 million or so in cash at any given moment. This sounds like a lot of money to the average person but not to someone who is accustomed to thinking of him/herself as “rich.” Discretionary expenditures (non-essential things like a new Louis Vuitton travel bag to replace the one that got scuffed up on the last trip to Monte Carlo) are postponed. Hi-beta consumption plummets and the merchants and entrepreneurs who cater to their every whim find that their showrooms are suddenly silent.

The second part of the explanation as to why wealthy people periodically curtail their consumer spending has to do with the psychology of gaining or losing large amounts of money as the financial (and real estate) markets rise and fall. Imagine what probably went through the mind of a typical hi-beta investor on May 6, 2010 when the Dow Jones Industrial Average (DJIA) dropped 9% in less than five minutes. The 9% was an overall average. Each individual stock reacted differently so that Accenture, CenterPoint Energy and Exelon dropped to one cent (a single penny) per share while other stocks, including Sotheby's, Apple, and Hewlett-Packard, increased in value to a per-share price of over $100,000. Bellweather stocks consider “safe” collapsed right along with the more volatile issues. Proctor & Gamble, for example, a favorite of conservative investors, dropped 37% in value in only a few minutes. The net effect was a loss of over $1 trillion in market value, all in less than 9 minutes! Of course the collapse of the Dow (dubbed the “flash crash”) proved temporary and per-share prices soon returned to more normal levels. But it took several days to sort out all of the automated buy/sell transactions that were triggered by the sudden crash (high frequency computerized trading is thought to have played a major role in the speed with which share prices fell) so that even after the market rebounded many wealthy investors endured days of uncertainty about the actual value of their portfolios. You would have to be brain dead not to suffer a severe anxiety attack under these circumstances.

In the aftermath of the flash crash stock market volatility is much more common (or at least it seems more volatile to skittish investors) and even more attention is paid to the minute-by-minute rise and fall of the DJIA and other stock indexes which are a prominent feature of virtually all radio, TV and web news programs. On a day when the DJIA rises, the whole population (not just the hi-beta segment) feels better and consumer spending tends to increase. The reverse occurs when the index drops. This happens regularly and is referred to by economists as the “wealth effect.” The 18% decline in x-fluent spending during the first half of 2011 (previously mentioned) was very likely caused by the extreme volatility and overall decline in the DJIA during the same period. This explains why the government and the Federal Reserve (FED) have worked so hard to pump up stock market values and even out volatility during the New Normal. They do this even at the expense of savers (who suffer from lower interest rates) because they know that as the market rises the wealth effect creates activity in the economy which in turn creates jobs. Oftentimes the FED’s only priority seems to be to keep those x-fluents spending even if it means risking an increase in inflation. None of this is expected to change much in the decade of the 2010s and Robert Frank warns that the extreme swings in consumption expenditures by hi-betas and x-fluents pose a serious threat to the long-term stability of the U.S. and perhaps even the entire global economy.

So was Willie right? Does Sutton’s Law point to a sound strategy for a fledgling entrepreneur? Perhaps, but be careful, especially if you don’t have the deep pockets that enable you to survive during periodic consumption dry spells. Here are some suggestions:

1. Diversify your customer base. Less affluent people spend money too and, influenced by advertising, TV and social media often aspire to own at least some of the things that the highly affluent own. If you have a retail presence make sure it is welcoming to the less affluent and don’t be a snob when interacting with them. I did an experiment of sorts a few years back in which I went into a high-end retail store (OK, I’ll name names – it was a St. Johns, a well-known women’s fashion label) to buy my wife something for Christmas. I deliberately dressed down by wearing blue jeans and a very casual shirt open at the neck. I hadn’t shaved (interpreted by many as a sign of lower class status). Every clerk in the store averted her eyes and made me feel extremely uncomfortable by leaving me standing there unattended. I am sure they snickered among themselves after I left the store. A couple of weeks later I returned to the same store only this time I made a point of shaving and wearing an expensive suit and tie. The same sales clerks fell all over me to make a sale (I left without buying anything.) I didn’t have more money the second time I visited. I only looked like I had more money. The clerks completely misread the situation. St. Johns survived the loss of my business but a small business entrepreneur cannot afford to make the same mistake. (I write about diversification of customer base within your total sales volume in Chapter Four of my book.)

2. Diversify your product line. Not everyone can afford the most expensive items but are often willing to settling for lower-priced substitutes. Haute couture brands know this and offer relatively low-priced items (sunglasses or perfumes) that nevertheless feature the couture label. Second and third tier designers are far less expensive at retail but often offer great value in their product lines. High-end department stores such as Neiman Marcus, Saks and Nordstrom have all introduced lower-priced “store brands” to cater to the less than super-rich. Whether you offer clothing, spa services or lawn maintenance, you should do the same so that what you offer your clients is spread across the price spectrum.

3. E-commerce is essential if your business is going to serve affluent customers. For example, while approximately 50% of all shoppers (i.e., all income levels) will do at least some shopping online for the upcoming holidays, a recent study by consulting firm Deloitte indicates that people with incomes exceeding $100,000 are expected to do almost 40% of their total spending online. Your web presence must be attractive and easy-to-use, and your order fulfillment (packing, shipping, billing, etc.) has to be quick and accurate. There are also many e-commerce issues that are not as difficult to deal with when sales are transacted face-to-face. Examples are collecting sales taxes and allocating shipping costs. Good e-commerce can be costly to a small business both in terms of expense and management time. Without it, however, it is difficult to capitalize on opportunities to sell to upscale shoppers.

4. Learn from the mistakes of others. After you have created wealth for yourself and your family think long and hard before you decide to emulate the boom and bust lifestyle and spending habits of the hi-betas. As Robert Frank makes clear in his book, it is easy for even the most affluent among us to crash and burn with little or no warning. And when that happens, no one ends up as a winner.

© Ralph Blanchard 2011

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References:

“Trends in the Distribution of Household Income Between 1979 and 2007,” Congressional Budget Office, October 2011. http://cbo.gov/ftpdocs/124xx/doc12485/10-25-HouseholdIncome.pdf. Accessed 02 November 2011.

Robert Frank, The High-Beta Rich: How the Manic Wealthy Will Take Us to the Next Boom, Bubble and Bust (New York: Crown Publishing Group, 2011).

Latest Kauffman Foundation Report: New Business Startups Are Not Hiring Workers

In Chapter One of “Creating Wealth…” I draw on data from Kauffman Foundation studies on the formation of new businesses. (The Kauffman Foundation is a non-profit dedicated to business education and the encouragement of entrepreneurship.) A series of studies conducted by their researchers have consistently shown that past recession have not markedly reduced the enthusiasm of entrepreneurs for starting new businesses or hiring workers. On page 6 of my book I quote a recent Kauffman report, as follows:

“Firm formation in the United States is remarkably constant over time, with the number of new companies varying little from year to year. This remains true despite sharp changes in economic conditions and markets, and longer-cycle changes in population and education. Such constancy possibly reflects the nature of the United States economy, employment churn, and demographics. A steady level of firm formation implies that relatively few factors, such as entrepreneurship education and venture capital, influence the pace of startups…”

My point in citing these studies was that even in a depressed economy the spirit of entrepreneurism burns bright and opportunities to create wealth by starting new businesses are plentiful. A beneficial side effect is the creation of large numbers of new jobs by small, startup firms.

Unfortunately a new study released by the Kauffman Foundation in July of 2011 has concluded that the most recent recession – which economists have come to refer to as the “Great Recession” – has seen a 27% decline in new businesses that have at least one employee besides the owner, what are referred to as “employer businesses” as opposed to “non-employer businesses” in which only the owner is employed. The total number of new business startups has not declined, only those that create jobs for people other than the owner. To quote the Kauffman report summary:

“The study draws on data sources indicating a decline in the number of new "employer businesses," those startups that create jobs for workers other than the owner. Citing data from the U.S. Census Bureau, the study found that the number of new employer businesses has fallen 27 percent since 2006. When including new employer businesses and newly self-employed workers, the level of startups has held steady or even edged up since the recession, according to the Kauffman Index of Entrepreneurial Activity. But that encouraging sign is somewhat misleading because firms that support only the self-employed owner do not scale to generate the new jobs needed to support overall economic growth.”

This trend, if permanent, has significant consequences for future job growth in the U.S. The total number of jobs created by small businesses in 2009 was approximately 2.3 million as compared with an average annual job creation of 3.0 million by startups over the past two decades. This is a “loss” of 700,000 jobs per year at a time when the economy has been struggling to produce new jobs for a growing number of unemployed workers. Worse, the Kauffman study indicates that the decline in job creation by new businesses can be traced back to 2006, that is, it predates the onset of the Great Recession. These losses may therefore be caused by structural problems in the economy and not recovered even if the economy returns to normal levels of growth. Once again quoting the Kauffman report:

"While the recession certainly deepened the jobs deficit, the U.S. economy stopped producing enough new jobs well before the downturn," said Robert Litan, Kauffman Foundation vice president of research and policy and study co-author. "Historically, startups are the key to long-term employment growth, and they have been hiring fewer people for the last several years. We won’t fix our core unemployment problem in the United States until young businesses get back on track."

This is not good news for the U.S. economy but may serve as yet another wakeup call for those seeking greater personal opportunity or a higher level of economic security for themselves and their family. Jobs will be harder to find for the foreseeable future. Business owners will have greater control over their professional career and their financial security.

© Ralph Blanchard 2011

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Reference: “New Firms are Generating and Holding onto Substantially Fewer Jobs in the U.S.; Kauffman Foundation Study Finds that U.S. Jobs Problem Pre-dates Great Recession,” Ewing Marion Kauffman Foundation. http://www.kauffman.org/newsroom/new-firms-are-generating-and-holding-onto-substantially-fewer-jobs.aspx. Accessed 22 September 2011.