Can Startups beat the Lobbyists ?

What the ongoing circus in our nation's capital shows us is that special interests and lobbyists still rule the day. As upstarts bring new business models in to change broken industries, they face significant hurdles by incumbents and artificial forces trying to protect existing turf. Broken laws, deep pocketed industry leaders, and politicians are at play against the upstarts - Can they ultimately survive the long and expensive battle they will endure?

Uber has faced the threat of a ban in almost every market it has entered. A hodgepodge of federal and state lawsuits as well as motions by taxi and limo lobby have essentially tried to shut them down (even the ultracool city of Austin tried to pass an ordinance during SxSW). Why are they trying to protect the revenue of the taxi oligopoly if there are cheaper, more effective alternatives? Let's not be naive to think this resistance is with consumer protection in mind - just look at who is funding the legislation. AirBnB faces similar challenges as it faces threats from hotels, realtors, and taxing authorities. The city of New York, for example, has recently requested their entire database in order to vet out long-term housing hosts. I understand the need to collect taxes if appropriate - but let's not try to save Marriott from individuals renting out their rooms.

Many incumbents try to hide behind ill-conceived laws that they try to uphold. Tesla, which has brought a step change of innovation into a slow moving industry, is surprisingly facing resistance in its market rollout. The culprit is outdated state franchise laws that mandate cars be sold through franchisees. While originally designed to protect small business franchise owners, the laws seem ridiculous nowadays. Imagine if we were forced to buy diapers or a stereo from a certified outlet? A question to the states - have you heard of ecommerce?

To be sure, bizarre regulations are nothing new. Southwest Airlines has faced an incredibly long road to unwind the "Wright" amendment which limited its flights out of Dallas. The law, designed to protect American Airlines and DFW Airport, failed to do so. American still went bankrupt while Southwest thrived since it was passed. In hindsight, the city bet on the wrong horse. Consumers have realized low fares because of Southwest(try pricing non-SW city pairs if you don't believe me) and the company is the only one in the industry to refrain from layoffs, even post 9/11. As Southwest finally can count down the days until the Wright amendment elapses, I commend its patience and high road tactics by keeping its headquarters in Dallas.

So are the new entrants winning so far? Despite some early wins, the road will be long and bumpy. While AirBnB initially won a ruling in New York, the city is going aggressively after them to collect forgone occupancy taxes. Uber seems to continue to operate in most of the markets they want, despite the political noise. The good news, particularly in the new sharing economy, is that the fight has become increasingly more public as the newbies take it to the streets (virtually). They have smartly created online petitions and other consumer-driven campaigns to forward their cause. It also helps that some of the startups are backed by huge valuations that can arm them for the legal hurdles. If the rhetoric from Uber's CEO and others is any indication, these startups will not shy away from battle anytime soon.

Artificial barriers to entry fail to protect the companies they are supposed to and usually hurt consumers in the long-run. Given the accelerating rate of change and strength of market forces, they tend to be speed bumps for entrepreneurs trying to gain market share. But as Washington shows us loud and clear is that lobbying and inertia are here to stay. Let's hope that market-based concerns such as a mobile taxi app can force trasparency and efficiencies within the system. Unfortunately, elections do not change the game - and it's a game that needs a significant makeover if the US wants to stay the center of technological and business advancement.

Can JVs work for small business?

Generally speaking, joint ventures have a finite shelf life. There are numerous examples of JV's winding down, such as Verizon's recent acquisition of Vodafone's wireless stake. Bringing two parties together with different capabilities seems to make sense on paper, but more often than not, most large ones end in failure, dispute, or a partner buyout. With a similar thesis in mind, are small businesses bound to a similar fate when attempting joint ventures? Or are entrepreneurial companies more adept in successfully navigating partnerships better than big conglomerates?

First off, small businesses have much more to lose than larger concerns. When big companies do it, they generally have limited options for that particular business. For example, an oil & gas company cannot enter a middle east country without some sort of government or local JV. In other instances, JV businesses are non-core or underperforming which makes the risk less. For smaller companies, the stakes are much greater. They don't have idle cash or business lines to throw into the mix. It's usually the entire business that would be impacted by the potential partnership. So the bar is much higher to engage in one.

A traditional JV, which may involve a merger with a similarly situated company, is hard to pull off. The required exchange of information to consummate a deal is often difficult as head to head competitors will be relunctant to disclose business secrets. And even if a deal can be completed, the operational risks are great. Cultural division, power struggle, or misalignment of goals are often hard to overcome. While there are things you can do on the front end to stave off potential conflict, the odds of a successful merger are long.

Partnering with a large industry player might be a way to mitigate some of this risk. Large companies can often provide the most sought after benefits for a small business (such as capital and distribution) with potentially less conflict of interest. They often have different goals than a small business, so the risk for overlap is less. Large suppliers, for example, are often good choices for product companies.

The downside, however, is that the terms of a proposed JV might be very expensive. If they feel they have bargaining power, they may try to extract more equity or better terms than you are willing to offer. Further, large companies tend to overestimate the amount of support they can provide as part of the JV; these companies have numerous priorities that fluctuate and can't make critical decisions as quickly as the business may require. On the other hand, if you offer something they really want (such as a new product line or channel), they will be much more willing to give you a greater piece of the pie.

Financial sponsors are another potential avenue. From a JV perspective, examples are very rare. Financial investors generally want control (or a path to control) or have too large investment hurdle rates for it to make sense to engage in a partnership. There are less synergies compared with industry players and can generally help only on the growth capital or leveraging their vast network. While possible, a financial based JV would need to have a limited scope and finite timeframe.

The irony is that despite the long odds for a successful joint venture, many businesses small and large continue to attempt them. The upside could potentially be great, especially for entrepreneurial concerns that are at an inflection point in their business. I think that more established companies may be a better fit as a JV partner, but taking control around the governance and commercial terms is paramount in the discussions. In addition to JVs, other options such as joint cooperatives may yield some results without giving up any control. In the end, it's important to keep an open mind about them but certainly tread carfefully.

The Overhyped Business Buzzwords

The business community, like most others, thrives on convenience. Complex changes in the market or new concepts get reduced to simple phrases like "big data" or "infomediary" (remember that one?) to fit into executive summary style investement theses. As with any trend, by the time it gets institutionalized, it has become overhyped, overvalued, or too late.

I recently wrote about the rise of ACOs in health care. In addition to the billions of deals done by payors and hospital systems, private equity invested nearly $4B in health care services in 2012 alone. As I surmised that if ACOs are no more than HMOs or closed payor systems of the past, then how will they ultimately prove in their current valuations? Reform has failed to make any significant changes to the health care delivery system, so how will the ACO's fair better than their predecessors? ACOs are merely a term for large future bets without a clear path to better outcomes at lower costs.

Software as a service, and offshoots such as mobile, has been flush with investment in recent years. I still can't figure it out what exactly people are investing in. The AAAS (anything as a service) model gives little regard to the underlying product by instead focusing on unproven startups in a new distribution platform. Microsoft might have missed the boat on mobile and the shift away from client-based installations, but if consumers ultimately like their spreadsheet and operating systems best, why would SaaS based competitors succeed? No question the incumbent has given rivals a huge window to catch up, but if Microsoft can maintain product superiority in the long run than it won't matter (it is Microsoft, so I won't hold my breath). The medium in which users consume software is important, but certainly the underlying products and services will be more valuable over time.

Similarly, cloud computing seems to a nascent, growing phenomenon, right? When I was in telecom ten years ago, we called them Storage Area Networks. Nowadays, any outsourced IT infrastructure is in the "cloud" and commands huge premiums. What is most perplexing to me is how the companies that are enabling the shift such as server makers and internet infrastructure are seeing their businesses squeezed, while cloud-based consumer concerns like Dropbox command billion dollar valuations. Dont get me wrong, I love Dropbox's interface and ease of use, but there is nothing groundbreaking in a modern day FTP website.

TQM was going to eliminate US auto manufacturers. Ecommerce was going to kill retail industry. The new business buzzwords have always failed to reach the levels of the initial hype. These technological shifts and efficiency gains have significantly altered distribution, democratized broken industries, and changed market leadership; but they haven't been the category killers originally thought by investment pundits. Perhaps a more realistic title to "video killed the radio star" should have been mtv took market share from unsuspecting incumbents. But then again, everyone likes the Buggles version better.

How should GPO's help small business ?

Services that help small business compete better are very important to the capitalistic ecosystem.  One of the most common is general purchase organizations (GPO's) that essentially pool purchasing power to lower costs for their members.  GPO's are broad across industries, vary in organization, and realized differing levels of success throughout the years.  I've often wondered what the optimal structure of a GPO should be to yield the largest impact for the most number of small businesses they support.

Historically, GPO's took shape in the form of cooperatives.  Each member generally paid a fee to buy an ownership stake and then paid monthly dues to support the co-op's infrastructure.  Local grocers,  distributors and other small businesses now had leverage over manufactures and other suppliers to exert lower prices, better service, and other incentives.  It also helped the small guys compete with larger, more sophisticated corporate competition.  There were limits to their success however.

The problem was that co-ops were no more than a loose associated of individually-owned businesses with no real capital or governance to change business models to adapt to market conditions.  Ace Hardware, one of the largest ever created, is now a fraction of what it once was thanks to the rise of chains like Home Depot.  Associated Press was poised to thrive during the migration to digital news consumption, but could not get their media outlet owners to move quick enough (Innovator's Dilemma at play as well).  For an individual member who might have lost their small ownership stake in a declining cooperative, the real impact was on its underlying business that could not successfully compete.

Not all of them have been failures.  REI, which did close to $2B in revenue in 2012, has thrived as a member-owned coop.  REI is unique in that it operates similar to a public company with a board and governance provisions similar to larger concerns. Other successes can be seen in the meteoric rise of hospital system GPO's that address rising healthcare costs. The top six GPO's alone account for almost $750M in aggregate purchases serving close to 14,000 hospitals.  As the GPO's act as separate entities from their members, they are able to move quicker and focus better on its business objectives. 

There is a continuum of needs being addressed ranging from small discount plans to full service GPOs.  On the one hand, while the historic cooperatives may have be limited in their reach, they provided benefits with little commitment or loss of control from their members.  Large, successful GPOs offer a wider array of services, but take a larger cut of the pie (MedAssets, for example, operate at 30% EBITDA margins).  The risk in a broad shift to for-profit concerns is that the central focus turns away from member needs and towards padding individual bottom lines.

Small businesses have a hard time reacting to macro trends in their industry given their general internal focus and lack of resources required.  GPO's fill some this void but often come at a heavy price tag.  While this is probably no different from MSO or franchise organizations, the notion of a highly effective industry cooperative seems appealing.  Imagine if an entity like Associated Grocers was able to build a world-class distribution system to thwart the massive Walmart market share grab starting in the late 1990s.  It could've provided competitive equalization and perhaps kept more of the value chain with small businesses.  Or perhaps this is just summer nostalgia kicking in longing for childhood walks to Piggly Wiggly.

The Real Power of Pricing

One of Warren Buffett's key investment tenets relies on identifying companies that have an ability raise prices.   Certainly pricing power is a characteristic of quality earnings potential, it may also go deeper into the DNA of a firm as well.  Something as seemingly mundane as a company's pricing philosophy may indicate whether it has the vision, culture, and business model to become a long-term success.  And more importantly, whether or not it is good for investors and consumers alike.

A few years ago, I was at Southwest Airlines' headquarters for a talk led by Herb Kelleher.  When he founded the company, his goal was lofty but simple:  he wanted to democratize air travel and bring it to the masses.  As a result, Southwest built the most low-cost, efficient business model in the industry to profitably support their low fares.  They priced based on cost and could care less what others were doing.  And to this day, they continue along the same path.  Still no bag fees.  Have you ever compared fares between Southwest served cities and non-Southwest cities? Every industry needs a Southwest Airlines.

Similarly, Walmart continues to bring low prices through efficient operations and a singularly focused mission.  It has resisted the temptation to boost margins despite its size with tactics such loss-leading prices common in the industry (have you ever wondered why a gallon of milk costs so much more at Walmart?).   I was at a meeting recently with a mid level executive who proudly explained that Walmart would rather sell "10,000 items for $1 than 1 item for $10,000."  Certainly Sam Walton’s motto continues to ring true deep into the heart of the organization. 

Cheaper, however, is not always best.  The first dot com bust was a disaster and probably set internet commerce back several years.  Remember the days of CDNow and Pets.Com that would sell anything for a loss in order to build traffic and chase lofty valuations?  Amazon, in certain respects, still subscribes to this notion (see Amazon's Strategy Problem).  Diapers.com may have been forced to sell to Amazon a few years ago because of its predatory pricing tactics.  It seems the industry is still evolving as there has yet to emerge an industry leader to rationalize the marketplace. 

What is more interesting of a topic is those areas that affect us in an important way.  For example, how much should big pharma companies be allowed to charge for new blockbuster drugs?  On the one hand, the absurd prices during the patent years encourages investment in R&D, but on the other, shuts out many of the most needy patients who cannot afford to use them.  It's a good thing generic firms are gaining more market share to counterbalance the incumbents. 

Principle-based companies generally employ clear pricing tactics and the highly successful ones use their power to generate profits, sustain the industry, and solve a real need for consumers.  Industries that lack these quality leaders tend to face erratic pricing and significant turnover in the players.  There are many industries that have yet to be rationalized like our healthcare system that still lack the visionary leaders to effect cost structures and outcomes in the long run. But for now, at least we can enjoy an Abilene to Houston flight for $99.

Are HMOs back?

As the ramifications of the Affordable Care Act comes more into focus, I can’t help but wonder if the days of the HMOs are back.  As I wrote in a recent piece on the rise of ACO's, closed medical network systems are expanding at rapid rates.  What is different this time around is that the payors aren't the only ones leading the charge -  hospital systems, universities, and provider networks are all scrambling to acquire assets, build paywalls around services, and capture consumer lives.  And they are doing so at a very local level.  It was bad enough that we had few insurance companies attempt to rationalize medicine during the HMO days; are we now hoping that hundreds of localized efforts will be successful this time around?

A physician employed by a regional medical hospital system recently told me that their employee benefits changed such that visit to any provider or facility outside their controlled system would now be charged out-of network rates.  It took me by surprise not only because of the overtly limited directive, but also the fact that this system doesn't administer an insurance plan per se.  To be sure, this system has been heavily acquisitive and expansive lately (surgical facilities, urgent care, providers), but the reach is still limited.  Certainly they are testing this option with their employees first, but no doubt they plan to roll this out through the health exchanges.  I'm no expert, but this seems to be one of the smallest network footprints I have ever seen.  At least in HMO world, you couldn’t see every doctor, but had many more choices. 

The argument for closed networks is that it facilitates better outcomes and lower costs.  In other words, if a medical system keeps care within their system, they can leverage knowledge, IT, and service offerings to maximize quality and minimize cost. A patient can be guided more efficiently and effectively, focus more on prevention, and limit extraneous testing and procedures.  This theory is great on paper, but the premise relies on inefficient, for-profit entities to lead the transformation.  Remember – some of these hospital systems, for example, are the same ones that operate under the guise of a “non-profit” banner have played a leading role in our current state of out of control health care costs.

Also, how much influence can an individual ACO have? Kaiser might be the perfect model, but how scalable is it?  It has been around for years and has had little reach outside California.  And where is the optimal tradeoff between choice and cost?  These local systems may provide an option for many specialties, but how can that be enough to adequately serve individual needs of all patients?  Wouldn’t we almost be better off with a national led system with a larger reach and ability to protect choice?  These microcosms of local ACOs all seem to come at it differently with different capabilities -  there is no focus on common efficiencies or even offerings to impact the system at large.  

It’s certainly too early to tell where we're headed as implementation doesn’t really hit until 2014.  However, I don't think ownership of small health care systems are the way to cut costs and improve outcomes, rather it might merely shift market share to bigger hands at a local level.  I would rather see better use of technology and new approaches such as telemed, EMR based efforts, and home health that actually expands coverage and availability of health care.   Almost all experts agree that optimal reform would find the right balance between costs, profit, and choice that can be scaled on a national basis.  I worry, however, whether the consolidation trend at a local level is leading us astray out of the gates.  Perhaps out of this local competition will emerge better models that can be used on a more national basis.  But let's hope that the result won't leave us longing for the days of the Aetna HMO plan. 

Should You Take the Money Now?

With the reported record $100B of dry powder that private equity funds must deploy in 2013, it seems logical for a growing company to partner with a financial investor right now.  While the surplus cash can lead to favorable terms,  is it better for an entrepreneur to wait ?   Or does the current frothy investment appetite make it an ideal time take the private equity plunge?

Generally speaking, delaying a sale is better.  From a financial standpoint, valuations tend to accelerate as a company grows.  In a good market, a $1M bottom line may yield a $4M valuation (4x); but doubling the bottom line might yield a three times better valuation ($12M).  Thanks to "multiple expansion," a dollar of cash flow is worth more as an enterprise grows.  There are many factors as to why, but the primary reason is an increased supply of money available for larger deals.  There are also other critical factors that tend to work in your favor as a bigger concern, such as negotiations around corporate governance and control issues.

However, outside of price, there might be business reasons why it's better to bring in financial sponsors now.  PE firms are very well connected and good at scaling businesses.   They also can help mitigate risks such as competitive threats or large capital investments that an entrepreneur may not want stomach on his or her own.  PE shops are also good at building seasoned management teams and helping to grow company infrastructure.  If any of these areas are critical to the success in the near term, than it might be the right time for a partnership.

Of course, the timing alone is not the only consideration for taking institutional equity.  According to that same Bloomberg article, over 1/4 of PE firms are expected to fail.  Diligence around the track record of a firm is key; If the firm is not around for the second bite of the apple, then the lofty valuation on the front end doesn't mean as much.  Also, goal alignment is also important.  For example, private equity is not "patient capital."  Your business will be sold to the highest bidder at some point in time.  There's no emotional ties to the business and the clock starts on day one.

Current private equity valuations certainly offer an attractive way to deepen your company's coffers (and your personal one).  But an entrepreneur must balance taking chips off the table with avoiding giving too much away too soon.  Working from the perspective of the long-term needs of the business is probably the best thing an entrepreneur can do to decide.  It's more important to gauge whether a financial partner can help grow the your business rather than whether or not you are getting a great price.  Even though the macro environment may change, a good business will always have a buyer.  But then again, if November rolls around and there's still money on the sidelines, they may just force the island vacation on you.