Startups vs Local Businesses

I've noticed lately that when people use the term "startup", that they are increasingly referring to a totally different type of business: local businesses.

This is dangerous because there are major differences between starting a startup and starting a local business. Startup culture can backfire when used in local businesses, so it's important to separate the two out.

So, what are the differences between the two?

• a startup is an organization designed to scale globally through finding a repeatable high-growth model.
• a local business is an organization designed to expand organically through executing a known business model.

When most people around the world think about starting a business, they usually think about businesses with physical presences. Businesses like restaurants and barber shops. These are local businesses. They compete locally (with other similar businesses nearby) and execute a known business model.

Restaurants make money by selling food and dining experiences to local customers. Barber shops make money by selling haircut services to men nearby. Their models are known and competitive, so they compete on efficiency with similar businesses their local area.

Specifically, there’s just 3 numbers that local businesses compete on.

1. Getting new customers.
2. Maximizing customer lifetime value.
3. Reducing their cost to operate, or to offer each incremental service.

Nothing outside of those categories matters. Of course, customer experience matters, but only as far as it contributes to getting new customers (referrals) or maximizing the amount that that customer spends over their lifetime (retention + upsells).

A great team also matters, but it matters because it contributes to those three categories.

In years of working with thousands of local businesses, the highest leverage way to become the market leader is clearly maximizing customer lifetime value. This is because the business that can afford to spend the most to acquire each new customer ends up winning the game of customer acquisition. While reducing costs can help some, the returns are nowhere near as exponential as making each customer spend more and last for a longer period of time.

So local businesses are a contest that takes place near you, and whose winner is determined by each of those 3 rules. If you can be more efficient in these 3 categories than others near you (especially in maximizing how much you make per customer), you win.

A restaurant in West Hollywood doesn’t have to compete with a restaurant in New York City. Instead, they compete with other nearby restaurants in a contest for the prize of surviving using a known business model.

And the prizes for these contests is where things get interesting. The top grossing pizzeria in Milwaukee generates $5,500,000 in annual sales and 15% of that is profit ($825,000).

That could be a good living for each of the partners that own it, considering it cost them an estimated $1,000,000 and a year of time to get it going.

But the average pizzeria owner in Milwaukee generates $445,721 in annual sales and 7% of that is profit ($31,200) even though it cost over $200,000 to initially open. Those economics make it a bad investment of time and money for the owners.

So there’s some deep inequality in local business outcomes. They all have to work really hard and some achieve these efficiencies better than others. But the majority survive, and survive for years, even if they’re just barely limping along.

Anecdotally, I've seen that the #1 player in most categories of local businesses clears around $500,000 in annual profits in each market. They tend to have around 20% net margins.

Some scale their model by expanding to multiple locations, but that almost always happens over the course of decades. Not years. Interestingly, the efficiency of each additional location tends to go way down (not up) because the ability of the owner to assure quality of service and pay careful attention to each customer relationship is diluted across locations.

So, how does this compare to startups?

First, they're cheaper to start. Most software startups can be seeded and validated with less than $200,000 today. Then the best among them raise a lot more money from there.

But startups have a different challenge. Instead of competing on operational efficiencies, they compete on finding and scaling a brand new business model from scratch initially.

In startups, everything is unknown. They start with a vision and assemble a team of people crazy enough to materialize it. Maybe there’s some ideas on how to execute, but those almost always change when they meet the real world.

The product is unknown. The customer is unknown. The business model is unknown.

But if they can figure these hard problems out and make something better then the reward can be outsized.

Airbnb, for example, got started in 2007 with $30,000 that the founders got from selling artsy cereal boxes. That is less than half of what the average pizzeria gets started on.

At the time, they were a marketplace for people to rent air beds in strangers’ homes generating $200 a week.

In 2008 they then got funded by Y Combinator with another $20,000 in funding for a grand total of $50,000. But they kept talking to their users and persisted in searching for a working business model. By 2009, they grew to serve over 10,000 registered people and in 2010 were able to raise $7,200,000 to take the concept global due to their growth rate.

Now, AirBNB is worth $31 billion dollars. That’s more than Domino’s Pizza – which was founded in 1960 and had a 48 year head start.

The company is worth 238% more in 500% less time.

Of course, AirBNB is not alone. This is how all of the most successful startups compare relatively to all of the most successful businesses. The best ones make the founders much more wealthy in a lot less time. There’s a catch, though.

Even though the best startups way outperform the best local businesses, on average, starting a startup is even riskier than starting a local business.

The vast majority of startups actually lose money, whereas the majority of local businesses turn some profit – despite it being mostly low profit. In other words, the average startup loses money, despite taking years of time to figure out, but the average local business makes at least some money. It’s in the winners that the biggest difference becomes clear.

The top 1% of startups make the owners way more money than the top 1% of local businesses.

If you can get a lot wealthier from starting a startup, then why does anyone start local businesses instead of startups?

1) More probable (modest) success

Most local businesses generate modest incomes for the owners. They then use those profits over years to add more locations and expand their operation. Some outright fail but most actually turn a profit continuously, even at a modest level.

This is because they’re based on tried and true business models. Known customers, known offerings, known products, known services, known price points – that do something people want.

In startups, almost all founders fail. Most never even raise venture backing and deplete the time and savings of the founders. They either get really big, or (like most) die trying. Most startups die before reaching “product market fit” which means that they never made something people want and never found a repeatable business model. Local businesses start with that model.

So, for people looking for less risky and modest success – and to slowly grow their businesses through organic profit and small business loans – local businesses make a lot more sense.

2) Faster social status

Interestingly, local businesses give their owners social respect and praise far faster than startups. A restaurant with 100 customers inside draws admiration and praise because it clearly looks successful. Friends and family get a visualization of its success and can’t help but imagine how much money it’s making in there. It visually represents success.

Whereas a startup with 100 customers registered doesn’t seem successful to the outside world at all. It’s probably still in some dinghy office space with a tiny team and little external recognition. Nobody can visualize their success, few understand what they’re doing, and ultimately they receive less external validations of success from others.

3) Easier to understand

In addition to giving the owners faster social status, local businesses help the owners feel a faster sense of connection because what they’re doing is easy for others to grasp. People know what a restaurant does and what a successful restaurant looks like. The owners’ friends and families can feel like they’re a part of the success and suggest ideas as a result of their understanding, giving the owners another sense of validation and connection.

Whereas the best startups are often misunderstood in the beginning. In 1994, a place on the Internet where you could buy books probably didn’t seem to most like it could be a big business. Many refused to invest in it or join the company as employees.

That company became Amazon.

4) Complete passion

Another reason why local businesses get started so much more frequently than startups is because of their owners’ passion for that industry. Whether it’s making people feel great through providing haircuts or amazing dining experiences, the owners’ identities become wrapped up in the art of what they do and their natural endgame becomes to own their own business someday. It's not a calculated financial decision

People assume that their love for practicing their craft will help them build a business where they can do it all day long. Ironically, though, they lose the ability to practice that craft all day long when they start the business. They instead must focus on finances and marketing and planning and administrative tasks to keep the place running.

Starting any business is really hard and requires persistence so loving what you’re doing is definitely an advantage, but it often comes at the cost of doing that thing all the time.

Conclusion

Startups are for entrepreneurs with crazy global ambitions, who are willing to embrace complete uncertainty to solve hard problems with potential for outsized rewards at the end. Even though the average startup fails more frequently than local businesses, the top startups make thousands of times more than the top local businesses. They succeed on their mission to realize a grand vision of the world.

Local businesses, by contrast, are for entrepreneurs with moderate personal ambitions –who are willing to take great risks and work long hours to continually grow their income and build their version of the American dream. Most local business owners start in entry level positions of the business type that they start, and over the course of years save up enough to become their own business by starting their own business.

They are easier to make profitable and fundamentally provide something people want from the beginning, with a lower death rate and a slower expansion timeline. Their purpose is to build personal assets for their owners.