Five Types of Customer-Funded Models
Craving Crowd-Funding? Pandering to VCs? Groveling to Your CFO? The Magic of Traction and the Customer-Funded Revolution
Imagine this. It was 1995, and the Coca-Cola Company had just re-entered India after an aborted earlier effort, this time by acquiring the maker of Thums Up, India’s leading cola. Along with the deal came a thick book describing each of the Thums Up bottlers’ territories in plenty of legal jargon, but without a single map. Coke needed a way to find and understand its newly acquired territories.
Alas, no one had maps that could show Coke where its bottlers were located. Until the mid-1960s, maps had been largely unavailable in India, at least for anyone not in the military. Even 30 years later, a mapping culture and map-reading ethos simply did not exist, perhaps in part because there were very few accurate Indian maps.
Into the breach stepped Rakesh and Rashmi Verma, who had started a small IT training business in India, CE Info Systems, serving blue-chip clients like IBM. Their company also licensed American digital mapping software to aid India’s nascent mapmaking industry.1 Saying to Coke, “We can give you the maps you need” (even though they had not actually ever produced a single map!), the Vermas began to build a digital mapping business. First, they bought an ordinary office scanner and took out the kitchen scissors. Next, using their native Indian ingenuity, they began cutting what rudimentary paper maps they could find into A4 size and scanning them to make them “digital.” Using Rashmi’s software and programming skills together with the American software they had been licensing to others, they then overlaid demographic and other data to enable Coke—and soon other commercial customers—to do in India what they took for granted in other parts of the world.
CellularOne, entering India in a joint venture with Essar as the Indian telecommunications industry was liberalized, was their next client. “Where should we put our mobile phone towers?” CellularOne asked, from both a technical perspective (Where is the high ground? How do we achieve uncluttered line-of-sight coverage in Bombay, a city of high rises?) and a marketing perspective (Where are there sufficiently dense concentrations of customers with the right demographics whom we can economically serve?). Once again, the Vermas delivered.
A Customer-Funded Model
So, did the Vermas need venture capital to start, finance, and grow their business? No. Instead, they identified customer after customer— even the Indian Navy—who could benefit from digital maps, charging the customers fees to cover most of the development costs of creating additional maps or applying additional demographic or other information to maps they had already created. Over the next 10 years, their mapping business grew slowly but steadily, funded by one customer assignment after another, and they became the dominant digital mapmaker in India. And they did so without raising a single rupee of venture capital.
Customer Funding: The Vermas Are Not Alone
What the Vermas accomplished with customer funding is neither unique to India nor to the 1990s. Anyone who has booked a hotel room on Expedia.com, for example, might be surprised at the role they were playing in funding Expedia’s operations and growth. Not only didn’t Expedia pay the hotel for your stay until after you arrived—despite the fact that you probably paid Expedia when you booked the room—but in many cases they paid the hotel as many as six weeks after your stay. What is Expedia doing with your money—their customers’ money—for all those weeks, or sometimes months? Running and growing their business, of course! “Sitting on the float” with the customer’s money is a time-honored principle that runs throughout this book.
As we’ll see in Chapter 2, starting, financing, or growing your business with your customers’ cash isn’t novel. It’s a fundamental principle—a mind-set, really—by which many entrepreneurs live. It’s how Michael Dell created one of the twentieth century’s most prominent success stories and how Mel and Patricia Ziegler created Banana Republic, another customer-funded phenomenon. In the five chapters that then follow, equally remarkable are the stories, all customer funded, of Airbnb (Chapter 3), Threadless (Chapter 4), India’s TutorVista (Chapter 5), Gilt Group (Chapter 6), Denmark’s GoViral (Chapter 7), and nearly a dozen other inspiring companies—plus some failures as well— and the entrepreneurs who created and drove them. Whether you’re an entrepreneur or a leader in an established business that wants to grow faster, you get the drift: The customer-funded business has been a widely practiced phenomenon, but has been underobserved and underdiscussed. But not any more!
A Problem: Financing Your Startup
Later in this chapter, I’ll explore in some depth why I believe raising equity at the outset of a new venture’s journey is, at least most of the time, an exceedingly bad idea—for both entrepreneurs and investors alike. For now, though, think of it this way:
- Most of the time, the Plan A that you have so lovingly conceived is unlikely to work, as most any experienced early-stage investor, whether a VC or a business angel, will tell you. Do you look forward to explaining to your investors why your Plan A didn’t work, as you ask them for more money for your newer, brighter, and inevitably still-optimistic Plan B? I don’t think so! As Peter Drucker, arguably the leading management thinker of the twentieth century, observed, “If a new venture does succeed, more often than not it is
- in a market other than the one it was originally intended to serve
- with products and services not quite those with which it had set out
- bought in large part by customers it did not even think of when it started
- and used for a host of purposes besides the ones for which the products were first designed.”
- There are material drawbacks to raising capital too early. Among the most daunting of them is that raising capital— whether by pandering to VCs or groveling to your CFO, if you’re seeking to start something inside an established company—is a full-time job. Getting your venture underway is a full-time job, too. If you try to do both, one of them will inevitably suffer.
- As you’ll see later in this chapter, the evidence is compelling that the odds of success for VC-backed companies are far worse than most entrepreneurs realize. Is joining tomorrow’s failure statistics what you had in mind in pursuing your venture? Definitely not!
A Solution: The Magic of Traction
Fortunately, with the cost of technology declining ever more rapidly, it’s easier and cheaper to get into a customer-funded business than ever before. As this book will make clear through the companies whose stories it tells, there are numerous benefits that all five customer-funded models provide, to entrepreneurs and their backers alike.
- First, waiting to raise capital forces the entrepreneur’s attention toward his or her customers, where it should be in the first place. Customers matter, and as Peter Drucker also noted, if there’s no paying customer— at least eventually— there’s no business, either (the protestations of some dot-com entrepreneurs to the contrary).
- Second, winning customer orders often gives your customer a vested interest in your success. If they are happy to buy from you, they’ll want you to stick around, either so they can buy again later, or so you will service what you’ve sold. For an entrepreneur, having your customers on your side is a good place to be. For angels, having customers rave about the company in which you are thinking of investing is a very good sign!
- Third, making do with the probably modest amounts of cash your customers will give you enforces frugality, rather than waste. Having too much money can make you stupid and lets you ignore your customer! Having less money will make you smarter, and will force you to run your business better, too.
- Fourth, when venture capital is raised later, once customer traction is proven, the investor’s risk is lower, meaning the terms and valuation are better, and making the founder’s stake—and perhaps control—more substantial, too. For angels, investing later reduces the number of eventual “lemons” in the portfolio and is likely to improve returns.
- Fifth, focusing your efforts to raise cash from customers who are willing and eager to buy from your yet-unproven company is likely to mercifully put to rest a half-baked or notquite- right idea that requires more development—a pivot, in today’s entrepreneurial lexicon—in order to hit the mark.
- Finally, there’s freedom! Gaining one’s freedom is high on every entrepreneur’s priority list, and the best source of freedom—even better than cash in the bank—is positive cash flow! And with the magic of customer traction and the cash flow it brings, you’ll sleep better, too!
Customer Funding Helps Ryzex Thrive, Then Survive
In its early days, Ryzex bought decommissioned mobile computing equipment that was sitting in warehouses gathering dust and sold it to business users who needed to expand their existing fleets. When users added another few trucks or new stores, they generally wanted to buy exactly the kind of mobile devices they already were using, around which their systems had been built. Often, however, the exact such devices were no longer being made. Ryzex would find them used and—because they were gathering dust anyway— buy them, generally on 90-day terms. Ryzex then refurbished and sold them, with the customer paying in
advance, or worst case, in cash on delivery.
Thanks to the 90 days or more of customer cash these buying and selling practices provided and its attractive gross margins (from buying used equipment for a song and selling it dear to customers who sorely needed it), Ryzex grew from a standing start in a tiny apartment in Vancouver, British Columbia in 1989 to $75 million in sales in 2007, with 360 people in offices spread across five countries. The arrival of the Internet was putting pressure on margins, however, and migration to larger corporate customers and the sale of new equipment, too, had put pressure on Ryzex’s pay-in-advance terms. So in early 2008,Ryzex found itself with plummeting sales, declining margins, and $3 million in debt. The global financial crisis was, for Ryzex, a crisis indeed.
Ryzex founder and CEO Rud Browne went into high gear. Personally training each and every one of his 360 employees on the importance of cash flow, Ryzex made managing cash everybody’s job, whether that meant getting longer payment terms from its vendors or faster payment from its customers. “On the customer side, there was no single bullet,” recalls Browne. But there were several customer funding strategies that dramatically improved his company’s cash flow:
- When customers wanted extra discounts (which they almost always did), granting discounts was tied to payin-advance or seven-day terms. “We would have had to go to the lower price anyway,” Browne recalls. “So we made sure we got something for it—better terms.”
- Ryzex ramped up its sales of one-year service and maintenance contracts paid in advance, instead of monthly in arrears. It also ramped up sales of vendor-provided service contracts, for which Ryzex needed no investment in parts—inventory that may take 12 months to turn, thereby further conserving precious cash.
- While everyone in the industry felt tremendous pressure to accept every purchase order, Ryzex remained disciplined and simply refused to extend credit to customers it deemed financially risky. “We’d rather take a hit to our sales than have them go belly-up,” says Browne. Internal resistance to this policy evaporated when, after having insisted on prepayment, Ryzex avoided losing $1.5 million when one customer went bankrupt a week after the goods were delivered.
Customer-Funded Models: The Five Types
In an effort to better understand customer-funded models, the circumstances and ways in which today’s entrepreneurs can best put them to use, and the challenges entailed in implementing them, my research uncovered five different types of models—each surprisingly familiar when you think about them carefully— through which founders have convinced their customers to fund their companies, particularly at startup (see Table 1.1).
Table 1.1 Customer-Funded Models: The Five Types
|TYPE||Category-Defining Examples||Twenty-First Century Examples|
|Matchmaker Models||Real estate broker, eBay, Expedia.com||Airbnb, DogVacay, Profounder|
|Pay-in-advance models||Consultants, architects, Dell, Banana Republic||Via.com, Threadless, The Loot|
|Subscription models||Wall Street Journal, Financial Times, Showtime, Netflix||TutorVista, H.Bloom|
|Scarcity-based models||Zara||vente-privee, Gilt Groupe, Lot18|
|Service-to-product models||Microsoft||MapmyIndia, Rock Solid Technologies, GoViral|
What is most striking about these models is that each of them gives the company what accountants call negative—or very nearly negative—working capital: that is, the company has the customer’s cash in hand before having to produce or pay for the good (or service) it sells. In exploring these models, I found that most of them—perhaps surprisingly—work for selling both goods and services. Let’s define the five models.
Some companies are in the business of matching up buyers and sellers, such as your local real estate broker, eBay, or Expedia. Because they simply take the order, but never own the goods (somebody’s home or junk from your attic) or services (airline tickets or hotel rooms) that are sold, there’s no need to tie up cash in inventory. The fees or commissions they earn from customers—whether from buyers, or more typically, sellers—provide most or all of the cash required to launch the business and grow it enough to prove the concept, and sometimes take it much further. Thus, matchmaker models are those in which the business, with no or limited investment up front, brings together buyers and sellers—without actually owning what is bought and sold—and completes the transaction, earning fees or commissions for doing so.
We examine matchmaker models in Chapter 3. Perhaps the most inspiring of our case histories that bring matchmaker models to life is that of Airbnb, which has grown from its 2007 start—on a couple of airbeds on the floor of founders Joe Gebbia and Brian Chesky’s San Francisco apartment4— to a global booking system that monetizes people’s extra space. As I write in late 2013, Airbnb offers more than half a million properties in 34,000 towns and cities in 192 countries.
In some industries, customers traditionally pay the supplier in advance for at least part of the price of goods or services before receiving anything. Consultants, architects, and many kinds of other services firms are good examples. Thus, pay-in-advance models are those in which the business asks (and convinces!) the customer to pay something up front—perhaps a deposit, perhaps something structured in another way, perhaps the full price—as a requirement to get started on building or procuring whatever it is that the customer has agreed to buy.
There’s nothing new about subscription models, of course, wherein a subscriber pays for something—the New York Times or Showtime, for example—and the goods or services are then delivered over an ensuing period of weeks, months, or years. Sometimes the subscription fee is paid entirely up front, as I do with my subscriptions to various periodicals and journals, and sometimes they are paid on a recurring basis—typically the case with cable TV. Thus, subscription models are those in which the customer agrees to buy something that is delivered repeatedly over an extended period of time—perhaps a product, like newspapers or a box of organic veggies delivered weekly straight to your door—or a service like a cable TV subscription or your monthly Netflix fix. Or, as we saw in the Ryzex story, even a maintenance contract to make sure Ryzex customers’ mobile devices—or our laptops or fridges—will be fixed at no cost if they fail.
We examine subscription models in Chapter 5. Perhaps the closest to home (literally!) of the case histories in the book is that of India’s TutorVista, which helps more than 10,000 students per month around the world with their homework in their own homes. Starting with three Indian tutors and an online erasable whiteboard over a VoIP connection in 2005, Krishnan Ganesh built a company that was sold to Pearson PLC, the world’s largest largest education company, at a $213 million valuation in 2011.7 From zero to $200-plus million in six years: a testament to the remarkable value creation potential of companies built on customer-funded foundations.
These days, innovative specialty retailers of various kinds are using scarcity models to achieve rapid inventory turnover that gives them negative working capital: that is, the customers buy the goods before the retailers’ vendors are paid. In effect, the retailer finances its business using your and my money. Thus, scarcity models are those in which what’s for sale is severely restricted by the seller to a limited quantity for a limited time period, with the seller’s supplier being paid after the sale is made. When the goods are gone, they’re gone, and there will be no more! In scarcity models, the scarcity is typically reflected in both the paucity of units offered for sale, typically with no reorders, and in the brief time period during which those units are available.
We examine scarcity models in Chapter 6. Imagine selling high-fashion but overstocked Parisian apparel that people didn’t want and turning the business into one of France’s best-known brands. That’s exactly what Jacques-Anton Granjon and his founding team did with vente-privee, the originator of the flash sales concept for moving surplus fashion merchandise. Connecting the dots in 2001 between the founders’ prior experience of discreetly moving unwanted inventory for high-profile brands, and the Internet’s ability to create a virtual store that could move volumes of discounted merchandise without disrupting the brands’ carefully honed images, Granjon and his team pioneered a new industry—flash sales—and grew vente-privee into a business selling more than 200,000 items each day to its more than 18 million members across eight European countries by 2013. Alas, as we shall see in Chapter 6, not all of vente-privee’s flash sales imitators have fared very well.
At the dawn of the personal-computing age, Bill Gates and Paul Allen won a contract from IBM to provide an operating system for its new personal computer. Their company, Microsoft, also won similar contracts to develop and deliver operating systems for other PC makers as that market exploded in the 1980s. Eventually, Microsoft began delivering software-in-a-box—the now ubiquitous Word, Excel, and other Microsoft products—thereby transforming its services business into one that shipped “products” that were ready to use. Thus service-to-product models are those in which businesses begin their lives by providing customized services and eventually draw on their accumulated expertise to deliver packaged solutions that stand on their own.
Sometimes the products are delivered in physical containers, sometimes as software-as-a-service (SaaS) digitally downloaded to our PCs, iPads, or mobile phones—ready to be used or consumed by the customer largely without seller support.
What Customer-Funded Models Have in Common
Regardless of their type or the eventual size to which they have grown—some incredibly large, some not so large; some successful, others not—our examples of companies using customer-funded models share three attributes:
- They required little or no external capital to get started.
- At founding, most were what in today’s entrepreneurial parlance would be called lean startups.
- Most of them raised institutional capital eventually, and did so once the concept had been proven.
Further, we observed that, in almost every case, there was at some point a queue of VCs lined up, eager to invest. Contrast that with the length of the typical queue that early-stage entrepreneurs find at their door: nil. Or, if they’re really lucky and some investor shares their vision, one. Unfortunately for the entrepreneur, when there’s a queue of one, it’s the investor who calls the shots on the deal. Since the successful application of any of the five customer-funded models always results in customer traction, there’s a far higher likelihood of eventually having a queue of VCs at your door if, at some point, you decide to raise capital to grow your then-proven venture faster.
This post is an excerpt from John Mullins’s newest book The Customer Funded Business.