Thursday, February 26, 2015

Derivative Startups: Building Ecosystems of Innovation

We hear more and more about the success stories of Uber (or Lyft) and Airbnb.  I can personally vouch for both the nice ride and the nice lodging.    What is also happening, on the side, is that a new #DerivativeStartup business model has sprung up.  In a “derivative startup,”  entrepreneurs are building  new businesses  that are ancillary to another startup’s business.   For example, while Uber and Lyft offer rides to passengers, Breeze and HyreCar offer car leasing to drivers who want to provide such rides under an Uber or Lyft mobile platform.  And Guesty helps Airbnb manage its real estate properties. 

This piggybacking approach reflects the development of add-ins or complementary, non-competing technologies and services in support of a “host” successful startup.   Thus, #DerivativeStartups are second-generation startups that provide goods and services to larger startups. (“Piggybacks”, Wall St. Journal, Feb. 19, 2015).   

Whether these #DerivativeStartups become successful depends on a number of factors.  Certainly, as a business model, derivative startups face higher risks of failure.  Either the “host” startup might fail or it might become a competitor.   Or the derivative startup might face other competition or an inability to meet market demand.  Yet this dual risk also creates an opportunity for a double success.  For this reason, derivative startups may attract investors who regret having missed an opportunity to invest in the “host” startup.

Lessons can be learned from studying key performance indicators for other ecosystem business models used by public companies and private equity.  Traditionally, public companies use carve-outs and spin-offs to exit a line of business that no longer fits the company’s core mission.   In a carve-out, the public company transfers shares in the “carved-out” stand-alone business to existing shareholders for no cash, or it sells them to a private equity group.  The public company facilitates the spinoff’s operations by providing a transitional services agreement for a year to enable the spinoff to keep operating smoothly.    Also, private equity uses consolidation (“roll-up”) strategies to combine core lines of business with some ancillary “feeder” business lines, for a bundle to be sold off.

Like any small company feeding its “mother ship”, a derivative startup can avoid conflict and competition by developing a product or service that the “mother ship” / “host” startup cannot easily provide.  By changing the “SWOT” landscape for the “host” startup, it must also discourage the “host” startup from entering the derivative startup’s own line of business.
  • Incentives for Collaboration; Disincentives for Competition.   The derivative startup must avoid being merely a supplier of “generic” products that could be copied or sourced from other suppliers.  It should strive to be a “unique” supplier.  The key is to offer incentives for collaboration, whether financial or otherwise, to the “host” startup, which in turn would discourage the “host” startup from competition. To achieve such a lasting alignment, the derivative startup’s management must identify commercial, financial, legal, intellectual property and regulatory frameworks that discourage the “host” startup from entering the derivative startup’s line of business. 
  • Intellectual Property.  Many startups are created by individuals who leave another startup due to disagreements over business strategy or opportunities.   A derivative startup could face claims of misappropriation of intellectual property or trade secrets in such situations.  A successful defense will involve proof that the “information” is actually not confidential and not proprietary.
  • Non-Competition Covenants.  Similarly, non-competition covenants could inhibit “look-alike” startups.   For the protection of both sides, it is therefore essential to define clearly the scope of the “host” startup’s business to avoid confusion and potential needless litigation.
  • Type of Relationship with “Host” Startup.  Before approaching the “host” startup, the derivative startup should decide whether it wants any funding, intellectual property, services or other value from the “host” startup, as well as what the derivative offers to the host.  The host might offer to invest in the derivative, creating a “cross-ownership.”   Such arrangements can create inherent tensions that can exacerbate existing competitive risks.
  • Exit Strategy.   The exit strategy for a derivative startup is limited since its raison d’etre is based on the host startup.  To avoid having a depressed price or being forced into an early exit, the derivative startup should remain focused on a business model of independent management and operations even as it seeks to ride the wave created by the host startup.  Additionally, it should seek other possible clients should the “host” startup fail.
High-risk, high reward derivative startups may be here to stay.  Derivative startups can improve their odds for success by taking some pages from mature multinationals and private equity tools of “carve-outs,” “spin-offs” and roll-up consolidation plays.