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.