A friend of mine pointed me to an interesting blog posting titled “Why Angels Chase Electrons” by Christopher Mirabile, Managing Director of Launchpad Venture Group, a venture investment group focused on seed and early-stage investments in technology-oriented companies. The posting was in response to a question an entrepreneur had asked Mr. Mirabile: “Why do angel investors (and to some extent, VCs) turn up their noses at real, down-to-earth physical product companies and instead chase ethereal Web and process flow services businesses?”
The short answer: supply chain costs and risks.
Here are a couple of excerpts from Mr. Mirabile’s response:
Since every company makes lots of mistakes in the early days and inevitably takes more time than expected to achieve their forecasts, the basic and fundamental nature of the business they are pursuing has a lot to do with how much cash they consume while they thrash and iterate. If you build a web-based business and you don’t quite get the product right, it takes two pizzas, a six pack of beer, and a weekend to modify it. If the business you are in requires you to build a factory and a supply chain and crank out enough widgets to fill a distribution chain before you can discover the error of your ways, you have burned a lot more money in the process.
Companies [that] manufacture products…contain some scary aspects. They need to put together longer and more complex supply and manufacturing chains. They have to carry inventory which has high costs and huge risks of obsolescence in the event of a necessary pivot, and they have to figure out and pay for distribution, which further erodes margins. Web services and software products, in contrast, cost relatively little [to] get started. And then once you produce the first “copy” of your product, or service your first customer through the site, the second and subsequent copies and customers are so much less expensive as to be virtually free.
Overall, Mr. Mirabile raises some valid points about why angel investors view companies that produce Web-based products and services as being more attractive (less risky, more capital efficient) than companies that produce and distribute physical products. But I would argue that the risk and capital efficiency gap between the two models is narrower today than just a few years ago, and getting narrower by the day. Here are some reasons why:
More than ever before, entrepreneurs have access to a diverse, global, and sophisticated base of contract manufacturers and logistics service providers. Simply put, entrepreneurs don’t have to build their own factories and distribution centers; they can outsource it (see “Fulfillment by Amazon” as an example). Outsourcing also enables companies to adapt their supply chain and distribution networks more quickly and cost effectively to changes in product demand or supply, which further reduces risks. And I believe there is still a tremendous opportunity for service providers to innovate their business/contracting models to minimize the upfront costs and risks for entrepreneurs, while maximizing their longer term profit potential (see Vested Outsourcing).
Thanks to software-as-a-service and cloud computing, entrepreneurs no longer have to pay millions of dollars upfront for IT solutions to power their businesses. Software has gone from being a large, upfront capital expense to a much smaller, recurring operating expense — and implementations are generally faster and less risky than traditional “behind-the-firewall” installations. Plus, when it comes to warehouse management systems, transportation management systems, network design, business intelligence, and other types of supply chain software, entrepreneurs don’t even have to invest in these solutions directly because 3PLs provide these solutions to customers as part of their service.
“Crowdsourcing” is transforming the way entrepreneurs (as well as established companies) develop new products. P&G’s Connect + Develop, IdeaConnection, and Quirky are just a few examples of crowdsourcing in action. Advancements in product lifecycle management (PLM) software and rapid prototyping are also pushing the envelope in new product development (see recent USA Today article, “More design hobbyists, entrepreneurs use 3D printing”). The main objective is to accelerate and scale the process of generating, testing, and iterating new product ideas — faster, cheaper, and with a higher probability for market success.
When it came to marketing and advertising, entrepreneurs had no chance of competing with the budgets of large competitors — until social media came along, which is making it much easier and cheaper for entrepreneurs to market their products to millions of prospective customers around the world at a fraction of the cost of traditional advertising mediums like television. The current buzz around the launch video for Dollar Shave Club, which I have shared with countless friends on Facebook, is a perfect example (4.3 million viewers since March 6, 2012).
Of course, not all products are created equal. An entrepreneur looking to bring a new car to market faces very different costs, risks, and challenges than one looking to market a new toy or household item. My point, however, is that entrepreneurs have more options and tools available to them today (thanks to outsourcing and trends in software and social media) to create supply chains that are more flexible, less risky, and more capital efficient than ever before, and investors need to update their thinking and understanding of how supply chains work as they evaluate investment opportunities.
I’ll end on a point I made earlier. I believe 3PLs have a tremendous opportunity to help entrepreneurs bring their products to market. And a tremendous incentive too: If investors only put money into Web-based business like Instagram (bought by Facebook for a jaw-dropping $1,000,000,000), what will fill your warehouses and trucks in the future?
Here’s what I’m suggesting to entrepreneurs: Before meeting with an angel investor, meet with a forward-thinking 3PL first. If you can get the 3PL to effectively invest its time, resources, and assets in your business (via a Vested Outsourcing agreement, for example, where the risks the 3PL takes upfront are balanced with the rewards later on), then you have a partner at your side that can address whatever supply chain and logistics related concerns an angel investor might have.
And here’s what I’m suggesting to 3PLs: Be forward thinking if an entrepreneur knocks on your door. If an opportunity looks promising, find a creative way to partner with the entrepreneur, where you minimize the upfront costs and risks for him (or her), while maximizing your longer term profit potential.
That’s my idea for kick-starting the Make Economy. What’s yours?