When entrepreneurs dream about running successful companies, they picture themselves building companies like Amazon or Google or Facebook or Tesla. After all, those are what successful startups “look like.” However, while those companies were, at some point, startups, the youngest of the four — Facebook — was founded in 2004, making it old enough to legally drive in most parts of the world. In other words, none of those companies are new or startups.
Entrepreneurs often forget this important piece of temporal context. As a result, when dreaming of entrepreneurial conquest, they usually overlook an important detail: The successful companies they so desperately want to emulate didn’t look the same when they were a few years into their respective startup journeys. Instead, the corporate behemoths, industry titans, and stock market darlings of today looked very different when they were startups. They were struggling, ugly companies trying to survive the first few tumultuous years of existence. What factors would have helped you — or anyone — predict how successful they would become?
Businesses and butterflies
I was reminded of the differences between startups and businesses the other day while I was out for a walk with my 4-year-old. She spotted a caterpillar inching its way across the sidewalk. “Eww Daddy!” she exclaimed, “look at that gross worm. Can I step on it?” She raised her foot above the caterpillar’s suddenly-frozen body.
“You can,” I said, “But you’ll be killing a butterfly.”
“That’s not a butterfly, Daddy,” she replied as she balanced her foot above her victim in the precarious way only a 4-year-old can. “You’re silly. That’s a yucky worm!”
“It’s not a worm,” I explained. “It’s a caterpillar. It might not look like much now, but, if you let it live, one day it will grow into a beautiful butterfly.” I knew that would stop her from stomping. In her mind, the only sin more unforgivable than killing a butterfly would be killing a unicorn, and we weren’t likely to see one of those on our walk.
She uncocked her homicidal leg, knelt down beside the caterpillar, and began to study it. After a few moments, she asked, “Are you sure, Daddy? I don’t see how something that ugly could become something so beautiful.”
I crouched down beside her. “Lots of things that become beautiful don’t start off looking very pretty,” I explained. “Butterflies are beautiful, but they’re also incredibly complex and sophisticated creatures. The form of a caterpillar is a more efficient way for baby butterflies to develop all the resources they need to reach adulthood. It’s kind of like how a startup doesn’t look at all like a mature business it might eventually become.”
OK… I didn’t really say that last part about startups and businesses. My 4-year-old already describes my work as, “the thing Daddy always does instead of playing with me.” No reason to ruin her passion for butterflies by connecting them with my job.
However, the moment did make me think about the odd similarity between businesses and butterflies. Compare them with, say, puppies. Puppies look like adorable little dogs. Kittens are cute, tiny cats. Human babies are pudgy, miniature humans. And so on. But “baby” butterflies are caterpillars. They’re ugly worm-like creatures that crawl around slowly, desperately hunting for food, and hoping to not get eaten. How strange is it that something recognized as a universal symbol for grace and beauty — the butterfly — begins life looking so different? If you didn’t know better, you’d never guess one was set to become the other.
How successful companies look as startups
Just like caterpillars don’t look capable of becoming butterflies, startups don’t look capable of becoming enormous businesses. Instead, they begin their lives as ugly little startups struggling to feed themselves and survive. They take huge losses. They have high employee turnover. They fight to get customers. Their competitors are constantly trying to swallow them or destroy them. And those are just some of the challenges they face. Sure, If they somehow mature to adulthood, they’ll be praised as symbols of success, ingenuity, persistence, and corporate beauty. But they have to get there, and — as with caterpillars — relatively few make it.
I’m pointing out this otherwise superficial similarity between businesses and butterflies because it offers a helpful way of viewing and evaluating startups. Specifically, in the case of caterpillars, the qualities that make caterpillars successful look nothing like the qualities that make butterflies successful. For example, caterpillars have to eat lots of food and get fat. They convert all that food into the energy they’ll need during the metamorphosis phase that transforms them into butterflies. So we might evaluate a caterpillar’s chance at becoming a butterfly by judging its girth and weight. Conversely, those qualities wouldn’t be ideal for a butterfly.
The same is true for startups and businesses. We can’t evaluate the potential success of startups using the same criteria we might use to judge the businesses they’ll ultimately become. Instead, here are three “good-ugly” qualities to look for in a startup that you’d never want to see from a mature company.
1) Lots of revenue but losing money
Mature companies have stable products, established customers, and consistent market share. Yes, all those things continuously evolve and change even after a company has reached maturity, but most changes to products, customers, and market share are gradual and incremental. As a result, mature companies demonstrate their maturity through profitability. They can do this because the amount of money they spend to operate remains roughly fixed while they focus on growing the amount of revenue they generate. The difference between costs and revenues (hopefully) produces consistently increasing profits.
In contrast, profitability is the enemy of startups. But it doesn’t mean startups shouldn’t be generating revenue. Profits and revenues are different things. Profits come after the company has invested revenues back into the operations of the company… everything from salaries to customer acquisition to R&D. In a mature company, after investing revenues back into the company, lots of money should be left over for profit.
But a startup, by definition, hasn’t reached market saturation. That means it needs to be acquiring more customers at a faster pace. To do this, a startup must reinvest its revenues into growth by hiring more salespeople, increasing marketing budgets, opening new locations, and so on. Those rapidly increasing costs will eat away at profits, and that’s OK. If a startup has large revenues and still isn’t generating a profit, that’s usually a great sign. It means leadership is reinvesting and trying to grow as fast as possible.
2) A small market and large adjacent markets
Mature companies will serve large and diverse markets relative to their respective industries. For example, Ford has sedans and sports cars and trucks and SUVs. They also have a luxury brand — Lincoln — that allows them to sell higher ticket vehicles to more affluent consumers. In total, Ford’s customers range from, at one extreme, just-heading-to-college teens in need of a cheap, reliable set of wheels to get them around campus, to, at the other extreme, executives being chauffeured in fully-equipped luxury office suites on wheels.
Those extremes reflect an enormous market Ford is selling into. But Ford is a mature enough company — with enough resources — to be able to handle the complexity of selling to so many different consumers. It can afford the different production lines, different marketing messages, and even different sub-brands to accommodate a wide and diverse audience.
Compare that with a startup. A startup is going to struggle to support its core product. And a startup is going to struggle getting customers for that core product. As a result, all of the startup’s limited resources should be devoted to the core product and the market the product serves. The company literally can’t afford to focus on other markets.
However, if the market a startup currently serves looks similar to lots of adjacent markets, that’s a great sign. It means once the company establishes itself in its current market, it will have less friction expanding its market opportunity into related verticals.
The startup will be even more promising if the biggest differentiator between its current market and its adjacent markets is price sensitivity. Once the startup gets good traction in its target, niche market, it should be able to create similar versions of its product at higher and lower price points that can be sold into the adjacent markets with similar needs but different abilities to pay.
3) A single but highly scalable revenue stream
Think about all the different ways a company like Disney makes money: movies; theme parks; TV networks; streaming services; resorts; cruise ships; merchandise.
Then there’s Amazon: e-commerce; cloud hosting; content streaming; devices; grocery stores.
Or Microsoft: software; hardware; social media; search; video games.
You could do the same exercise for any major company and identify dozens — or, in some cases, hundreds — of different revenue streams. Each revenue stream is like its own mini-company within the larger company.
The same shouldn’t be true for a startup. Startups don’t have the resources to support multiple revenue streams because it requires targeting a different customer base with a different product and different support infrastructure. It’s like running different companies, and startups hardly have the resources to support their core business. Running multiple companies would stretch them too thin.
However, if a fledgling startup is going to become a hugely successful company, its one revenue stream needs to have significant room for growth. This growth potential is what allows the startup to expand into other revenue streams as it matures, giving them the capital to acquire other companies or make new products and operate sub-businesses.
In a way, a startup with a healthy core revenue stream is the equivalent of a fat caterpillar. Just like caterpillars use the food they eat to power their transformation into a butterfly, a startup with a robust core revenue stream is ultimately going to be able to use that healthy revenue stream to transform itself from a one-product, niche company into a suite of products and services capable of serving multiple industries.