Bhide’s research showed that virtually all startups fall into two categories: marginal startups (e.g., hair salons, lawn care, etc.) and promising startups (e.g., Microsoft, HP, etc.). Marginal startups have low uncertainty, low investment requirements and low likely profit. Promising startups have high uncertainty, low investment requirements and low likely profit. However, both types have two things in common: they are low risk and arbitrage oriented. This is contrary to the myth that entrepreneurs are risk takers. When Gates dropped out of Harvard and started Microsoft, his opportunity cost was very low. He was not worth much in the job market. But, had Microsoft failed, he could have simply returned to Harvard to finish his degree. He faced uncertainty and ambiguity, but not risk (see figure 1).

Risk Reward Equation

Consider the example of a skilled hairdresser who notices that there are no salons within a 24-mile radius of her town. She scrounges up her savings and opens a little salon with very basic infrastructure. Her risk of failure is quite low because people need to get their hair cut and they are driving at least 24 miles.

Because of the compelling proposition, she soon gets a steady and growing clientele. She has virtually no risk because, if the venture fails, she simply goes back to working at another salon. The upside is better than working at another salon, but it’s unlikely that she’ll end up on the Forbes 400 as a result. Essentially, she’s engaged in arbitrage. The arbitrage “spread” is the 24 miles between her and the next salon. As she gets busy, another venturesome hairdresser leaves her job and opens a salon 12 miles away. Then another opens three miles away, and so on. Eventually, the market becomes efficient and net changes in salon chairs match population changes.

When Gates and Allen launched Microsoft in 1975, their only product was an 8080 BASIC compiler that ran only on an Altair computer. At the time, they were the only ones serving this small niche. Similarly, HP started with an audio oscillator for which there was very limited demand. Both companies essentially were acting as arbitrageurs in their respective markets. They were collecting the “spread” until other entrants show up. Neither had a grand plan to get them to where they are today. They simply were trying to be resourceful and survive.

Arbitrage by definition is low risk and typically a return slightly higher than the risk. If gold is quoted in London at $275/ounce and $280/ounce in Frankfurt, arbitrage players quickly jump in buying in London and selling in Frankfurt till the spread eventually equals transaction costs.

But an astute investor — whether looking to invest in Microsoft in 1975 or in our salon when it still enjoys the 24-mile advantage — is not usually looking for an arbitrage spread. Buffett succinctly says: “The key to investing is … determining the competitive advantage of any given company and the durability of that advantage.” Our salon has a wonderful competitive advantage when it starts, but that advantage is not durable. Hence it would make a poor investment. Similarly, the barriers to entry for others to create a BASIC compiler for the Altair were essentially nonexistent (see figure 2).

The good news for entrepreneurs and investors is that the arbitrage spread can occasionally last for years. Given enough time, some durable barriers to entry may be created such as brand, scale or a loyal customer base. Nonetheless, Bhide’s research clearly shows that the business model of the overwhelming number of startups is straight arbitrage. Any sustainable competitive advantage is nonexistent at the time of startup.

Both Microsoft and HP would have failed Buffett’s durable competitive advantage test in their early days. To scale, both jumped from one niche to the next without much planning or analysis. Any one wrong jump would have done them in.

Who Fails?

Most companies, however, are unable to keep successfully jumping from one arbitrage opportunity to the next and thus wither away. The ones that choose not to jump (like our salon) remain small. U. S. government data indicates that 60 percent of the million annual startups fail in the first six years. More importantly, the overwhelming number of survivors remain small.

Durable competitive advantage is usually the result of unpredictable and rare random events, like IBM’s call to Microsoft to sell them a PC operating system when Microsoft had never built an operating system before and did not have one to sell. These events have no pattern and cannot be forecast when a startup is being formed. They happen to a very small minority. Once a startup has acquired a durable competitive advantage, and investors get an opportunity to buy in well below intrinsic value, backup the truck.

Because entrepreneurs are arbitrageurs, they constantly watch companies with durable advantages. They then try to find a way to carve off a piece of that advantage for themselves. Durable competitive advantage is an anomaly and quite rare. When the Coca Cola Company started it had a unique product that delivered high value to its customers. The drink was wildly popular.Concocting Coca Cola was not rocket science and soon enough numerous other “colas” emerged. These new arbitrage players offered lower prices or entered markets that Coke had not yet entered. In time, hundreds of “cola companies” with names similar to Coca Cola had popped up. Most folks would ask for Coca Cola and vendors would freely serve any other brand they were selling. Coke was in a fix until its brilliant lawyers sued all the competitors and their vendors — driving them out of business. Pepsi, based in Canada, escaped and today is Coca Cola’s primary competitor.

Thus, the Coca Colas and the Microsofts of the world are under constant attack by thousands of entrepreneurs trying to make inroads.

In another fascinating book, “The Living Company,” Arie de Geus noted that the average life of a Fortune 500 company is less than 50 years from birth to death. The Fortune 500 represents the businesses that are able to take advantage of some aberration and build durable competitive advantage.

Investing in most startups is akin to gambling. The odds do not favor the investor. Hence it is necessary invest in them at substantial discounts to intrinsic value with a Ben Graham “margin of safety” to realize a good return within the first few years.

Mohnish Pabrai is managing partner of The Pabrai Investment Funds. Write to him at mohnish@corp.siliconindia.com
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