Startups vs Local Businesses

Some people use the term "startup" to refer to a totally different type of business: local businesses.

But starting a startup is different from starting a local business. Startup culture can backfire when used in local businesses. That's why it's important to know the difference.

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

When most people around the world think about starting a business, they imagine a business with a physical presence. Restaurants. Barber shops. These are local businesses. They compete locally with nearby businesses. A restaurant in West Hollywood doesn’t have to compete with a restaurant in New York City. Startups, by contrast, compete globally.

Local businesses also 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. These models are known and competitive. Startups, by contrast, don't know initially which business model they'll execute.

Local businesses compete on efficiency with similar businesses the area. When I say "compete on efficiency," I'm thinking about 3 activities:

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

Nothing matters outside of those activities. Of course, customer experience matters—because it contributes to both (1) and (2). A great customer experience can help the business get new customers (referrals). It can also maximize how much each customer spends (retention + upselling).

A great team also matters, and also because it contributes to those three activities.

I've learned to prioritize LTV after years of working with thousands of local businesses. Maximizing LTV is the highest-leverage way to become the market leader. That's because your business will win when you can afford to spend more to acquire each new customer. Cost-cutting can help too. But there are exponential returns in getting each customer to spend more and stay around longer.

What are the prizes in this local contest?

The top-grossing pizzeria in Milwaukee generates $5,500,000 in annual sales and 15% of that is profit ($825,000).

That could earn a good living for each of the partners who own it, considering it cost them ~$1,000,000 and 1 year to get started.

But the average pizzeria owner in Milwaukee generates $445,721 in annual sales. Only 7% is profit ($31,200), even though it cost ~$200,000 to get started. Those economics make it a bad investment for the owners.

So there’s some deep inequality in local business outcomes. They all have to work really hard. Some achieve the 3 efficiencies better than others. But the majority survive for years, even if they’re just barely limping along.

Anecdotally, it looks like the #1 player in most categories of local businesses clears around $500,000 in annual profits. They tend to have 20% net margins.

Some scale their model by expanding to multiple locations. But that almost always takes decades, not years. Interestingly, the efficiency of each additional location tends to go way down (not up). That's because the owners struggle to maintain a high standard of service. Their personal touch in customer relationships gets diluted as they open more locations.

How do startups compare?

First, they're cheaper to start. Most software startups can be seeded and validated with less than $200,000 today. The best among them raise much more money afterwards.

But startups have a different challenge. They aren't competing on operational efficiencies. They compete on finding and scaling a brand-new business model from scratch.

In startups, everything is unknown. They start with a vision and assemble a team of people crazy enough to materialize it. They might have some ideas about 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 solve these hard problems, then the reward can be outsized.

Airbnb, for example, got started in 2007 with $30,000 that the founders earned by selling artsy cereal boxes. That's less than half of what it takes to start an average pizzeria.

Airbnb started as a marketplace for renting an air mattress in a stranger's home. They initially generated $200 per week.

In 2008 they then got funded by Y Combinator. That was another $20,000 in funding, for a grand total of $50,000. But they kept talking to their users. They persisted in searching for a working business model. By 2009, they had grown to serve 10,000+ registered people and. In 2010 they raised $7,200,000 to take the concept global, thanks to their growth rate.

Now, Airbnb is worth $31 billion. That’s more than Domino’s Pizza. Domino's 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 successful startups compare with successful local businesses. The best startups make the founders much wealther in much less time. The top 1% of startups enrich their owners far more than even the top 1% of local businesses.

If you can get so much richer by starting a startup, then why would anyone start a local business?

Because there's a catch. Starting a startup is much riskier than starting a local business (which is also risky). The vast majority of startups lose money. But the average local business makes money. The majority of local businesses turn some profit.

Here are four big reasons many people choose to start a local business instead of a startup:

1) Probable (modest) success

Most local businesses generate modest incomes for the owners. The owners can use those profits to add more locations and expand their operation. Some outright fail. But most actually turn some profit continually.

That's because they're executing tried-and-true business models. Known customers, known offerings, known products, known services, known price points. And they sell something people want.

In startups, almost all founders fail. Most never even raise venture backing, depleting their own savings and time. Startups can get huge, but most die trying. Most startups die before reaching “product/market fit.” That means that they never made something people wanted, and they never found a repeatable business model. Local businesses don't face these hurdles.

Local businesses offer a higher chance of slower growth, through organic profit and small business loans.

2) Faster social status

Interestingly, local businesses gain social status faster than startup founders. A restaurant with 100 customers inside draws admiration and praise. It looks simply and obviously successful. People can’t help but see a full restaurant as a success.

In contrast, a startup with 100 customers doesn’t seem successful to the outside world. It’s probably in some dingy office/garage with a tiny team. Nobody can visualize its success. Few understand what it even does. Ultimately, startup founders don't get much external validation until a late stage.

3) Easier to understand

People know what a restaurant does and what its success looks like. Many benefits stem from having an understandable business. For example, the owners’ friends and families can suggest ideas, and those ideas might actually help.

In contrast, the best startups are often misunderstood in the beginning. Most people in 1994 didn't think "a place to buy books on the internet" would be a great business. Many refused to invest or join. That company became Amazon.

4) Complete passion

Most local business owners start in entry level positions of the business type that they start. Over years, they save up enough to start their own business. Sheer passion drives this behavior. Some people love making people feel great by providing great haircuts. They start barber shops and salons. Other people are deeply passionate about food. They start restaurants.

The owners’ identities become wrapped up in the art of what they do. They naturally aspire to live a life that's focused on their passion. There's an intangible reward and sense of freedom there, which might matter more than money.

The irony of local businesses is that they often restrict the owners' freedom to practice their craft. When they start the business, the owners must focus on finances, marketing, and planning. Some succeed in transforming their passion for their craft into a passion for business-building.

Conclusion

Startups are for entrepreneurs with crazy global ambitions. Startup founders must embrace utter uncertainty to solve hard problems with outsized rewards. The average startup fails. But 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, on the other hand, are for entrepreneurs with moderate personal ambitions. Local entrepreneurs still take great risks and work long hours. They do it to build their version of the American dream. They have a type of head-start compared to startups—they're already selling something people want. It's easier for them to become profitable and moderately enrich their owners.

Now you see the advantages of both.