Entrepreneurial Arbitrage

We have all heard the arbitrage business strategy: “Our goal is to develop a working product and be acquired by Company X.” In the current climate of lucrative acquisitions by Google and their competitors, it is tempting to be enticed by the fast sell.

Let’s define Entrepreneurial Arbitrage as the explicit strategy of creating firm built on replicable technology or business models whose sole essential asset is lead time. This is arbitrage to the extent that many firms create businesses around the goal of simply arriving slightly ahead of competitors in a market or while a worthy suitor, a major established company in the market, is considering entry. Development then simply becomes a make-buy decision for the acquirer. This is also a dangerous strategy for the other 99.9% of firms that aren’t going to be the subject of an intense public bidding war.

The perceived low barriers to entry and promise of network effects encourages many to enter software space with an Entrepreneurial Arbitrage approach. Web apps, portals, social networking and the like have attracted many, but this approach is starting to spread to other markets with higher entry costs and for which the network effects are less clear, such as what I call Social Acceptance Network Effects or SANE (more on that in a future blog).

In my experience, there’s two types of technology start-ups out there. Those that focus on being purchased by the Googles and Microsofts of the world and those that are focused on building products protected from the Googles and Microsofts of the world. I always advice companies to adopt the latter approach for three reasons:

1. Putting many eggs in one basket: its tempting to customize “just a little more” to cater to the suitor’s needs—if the suitor doesn’t come through, the start-up is stuck with extras that are merely distractions from a real business model.
   
2. The perceived success (likelihood of success times net cash received) is much lower than folks think: for every MySpace, there are 10 unknown failures out there.
3. Acquisitions take a long time. It is easy to think that an interested acquirer is a once-in-a-lifetime chance. You can still build your core product around sound, protected business principles, and when the time is right you can still sell your company.

There’s diet cola version of Entrepreneurial Arbitrage: building to a potential partner’s specifications. It is a fine line between being a good partner and being distracted from building that initial prototype or beta version, in the case of software.

Bottom line(s): focusing on building the first product is always first priority, and Entrepreneurial Arbitrage threatens that needed focus. Building to be bought is exciting, but its also like playing the lottery. If the company isn’t acquired, there’s little future left since little effort was put in to a sustainable business model.

The Need to Pollinate

When I began looking at entrepreneurship as an academic, I would be commonly asked by seasoned captains of industry, “How can you study entrepreneurship if you haven’t done it yourself?” My immediate response was always a dire analogy: if you had cancer, would you rather receive advice and prescriptions from a studied oncologist or a cancer-survivor?

Most people opted for the doctor, though some people stuck with the patient. I’m not sure the latter answer is often genuine. Regardless, the point was made.

My answer is “both.”

I realize that wasn’t presented as a choice. And, that’s my real point. To date, it hasn’t been offered. The vast majority of universities have supported research faculty; economic development organizations have supported Executives-in-Residence. The policy failure has been to not coordinate these two valuable groups in any truly meaningful way.

I’d like more professors armed with rigorous research methods and thinking and the experience, even if a short-lived failure, of starting a company. Entrepreneurship, like many social phenomenon, requires both the tacit knowledge and skills garnered through first hand experience, and a rigorous review of past entrepreneurial events which comes with a broad analysis… not just opinion papers based on anecdotal evidence derived from an individual’s personal experience, which often passes as research among experienced entrepreneurs. Admittedly, this leaves a small list of eligible mentors today, and we have to work harder as a society to bring these groups together.

To date, policy, business, and academia have largely failed to converge on how to encourage and train in entrepreneurship. I argue it is in large part because the marriage of research and experience has been wholly dismissed by both sides. Seasoned entrepreneurs have not sought, or even found it helpful, to conduct rigorous empirical research, and university research faculty, at least in my experience, have not deigned to get actively involved in start-ups.

Why not? Two words: incentives and gate-keeping.

Incentives: Entrepreneurs typically lack the research skills and incentives to be involved in rigorous research projects. I mean rigorous, not just simple marketing reports and white papers. And, there’s no apparatus to provide seasoned entrepreneurs such experience. A few people, like Hank Chesbrough of University of California Berkeley (full disclosure: Berkeley is my alma mater), represent a rare exception.

Gate-keeping: The tenure system rewards focused effort on publications, grant dollars, and teaching ratings. Experience and impact on the community are simply not considered. No rational faculty would engage actively while simultaneously maintaining a research agenda full-time and expect to remain clearly on the tenure track.

Bottom line: more cross-pollination is needed. We cannot expect effective entrepreneurial mentoring, training, and teaching until we take seriously the experiences and criteria necessary to train someone in this area. Effective mentoring, training, and teaching requires letting faculty both gain experience firsthand and pursue research agendas in this area, while simultaneously encouraging experienced entrepreneurs to develop research skills and be a participant in empirical research projects on entrepreneurship.

Philanthropic organizations, government agencies, and policy makers can make a difference by encouraging such joint programs. But, this burden largely falls on universities to adopt more flexible positions within their graduate schools and faculty rosters.