The Parsimonious Path To Profit

The entrepreneur had a problem. He needed several thousand colour advertising brochures in time for a crucial trade show. The best price quote so far had been around $1,500 but even this would challenge his already pressured bank account. What was he to do? The answer eventually came in the shape of a forklift truck. Our entrepreneur's uncle, who ran a small manufacturing operation in an industrial park, had a forklift which a printing company at the same site was in the habit of borrowing. A few telephone calls later and our entrepreneur had his brochures, without the daunting price tag.

 

This reflects three fundamental habits of successful entrepreneurs. First, a strict discipline of asset parsimony. Second, use of all the resources at the entrepreneur's disposal, in particular social capital. And finally, an approach to making investments of time and money that is analogous to the taking and exercising of financial options.

Asset parsimony

Most start-ups are chronically short of resources. So it is not surprising that entrepreneurs try to contain costs. Those of us who study entrepreneurship, however, observe that using the minimum possible amount of assets to deliver their outputs is not something entrepreneurs do only when cash is short.

Even wealthy entrepreneurs adhere to the same stingy ways with which they began their careers. It seems that holding down expenditure is not merely dictated by the situation; it is an overriding philosophy regarding the creative use of assets that permeates the successful start-up.

Consider the case of one of our recent graduates, who went into the import/export business, trading from New York to his native Brazil.

The first difficulty was that, being new to the business, he had to create credibility in the minds of potential customers. Using his small New York City apartment as a base, for example, was unlikely to instill a great sense of confidence in people who would have to entrust him with considerable advance business if he was to succeed. Clearly, a reputable office address was called for.

He could, of course, have simply taken a lease on such a space or rented shared space in a multiple-business complex. Doing so, however, violates one of the cardinal rules of asset parsimony: never incur fixed costs if they can be avoided.

How then to avoid incurring fixed costs on New York City real estate? The answer appeared in the form of an old school friend from Columbia days with an extremely fashionable Fifth Avenue address. The friend agreed to let our entrepreneur borrow an unused desk and receive mail at his address. Within a month, this was extended to include access to telephone and fax equipment, delivery vans and secretarial support - all paid for but on a strictly variable basis.

What is interesting about this arrangement is that both parties benefited. The entrepreneur acquired a valuable location and his host was paid for underused fixed assets.

Where the conventional corporate approach is often oriented toward maximising returns on a net present value basis, entrepreneurs willingly sacrifice some potential returns in order to minimise fixed investments and maximise flexibility. This has the effect of limiting their exposure if the venture does not succeed.

Successful entrepreneurs show genius at unlocking value tied up in underused assets. Renting computer time at night, laboratory equipment during the weekend and access to databases already owned are examples of how entrepreneurs, simply by being flexible enough to work when others are not, can obtain access to resources at a fraction of what it would otherwise cost.

Successful entrepreneurs are also expert scavengers. Every day, corporations literally throw away valuable assets. One of my favourite stories is told by a former colleague at the Wharton School of the University of Pennsylvania, Ed Moldt.

When the state-of-the-art in computers was switching from card-read data input and storage to tape-based technology, companies began to shut down their card-reading operations and throw away the equipment. So anxious were many to get the readers off the premises that not only were they not sold, good money was actually paid to have them removed.

Moldt recognised that the conversion from cards was unlikely to be complete and even the companies making the leap to tape technology were likely to need card-reading for several years to come. He then began quietly acquiring card-reading equipment.

As he hoped, the need for card-reading had not been eliminated but few suppliers remained with capacity to do the work, leaving him in possession of a near-monopoly. This is surely a case of asset parsimony taken to the extreme - not only did he not expend capital to acquire his assets, he was actually paid to take them on.

The same philosophy that applies to the use of physical assets is reflected in the entrepreneurial use of human talent. Sales people, for example, will often be generously paid but on a commission, not a salaried, basis.

Rather than use high-priced consultants to do market studies or develop proposals, entrepreneurs might call on friends or family or volunteer to sponsor a student project. In these cases, the basic idea is to bring cash flows in before allowing substantial expenditures.

The moral of the asset parsimony tale was coined by Ian Macmillan, director of Wharton's acclaimed Snider Entrepreneurial Center, some years ago:

Never buy new what can be bought secondhand;

Never buy what can be rented;

Never rent what can be borrowed;

Never borrow what can be begged;

Never beg what can be salvaged.

Social capital

As well as being choosy about how they invest their money, successful entrepreneurs are brilliant at leveraging social capital into valuable opportunities. They tend to be inveterate, energetic and continuous networkers.

Consider the approach to opportunity spotting used by Per Lovgren, a Swedish founder of many companies based on his knowledge of sophisticated Cad/Cam technology. The worst return on investment Lovgren has ever enjoyed is in excess of 500 per cent, to give the reader a sense of the power of his approach.

Lovgren travels extensively and on his travels frequently arranges social evenings with members of his network of management consultants. While he is quite happy to pick up the bill for an evening's entertainment, the consultant will be pressed to articulate a problem faced by his clients that requires a technical solution.

One problem that surfaced was the labour difficulties being experienced by foundry owners in Northern Europe. Foundries are dirty, hot, uncomfortable places to work and finding labour willing to endure these conditions was becoming increasingly difficult.

While a logical alternative would be to automate as far as possible, explained the management consultant, robots do not do well in the foundry environment either. The grit, dust and heat quickly bring their mechanical control systems to a halt.

Lovgren set out to find a "robust robot" that was technologically viable. He tapped into a second network, comprising professors of engineering. Over breakfast, the professor evaluated the problem, declared the technology to be a non-issue and offered to make a prototype for a budget of something like $300,000. At this juncture, Lovgren could easily have written a personal cheque to get the project under way. But wait - that would have violated the philosophy of asset parsimony.

Instead, he used his management consultant network to obtain access to their companies foundry consultants. Using these contacts, he was able to convince foundry managers to each contribute a small sum toward developing the prototype.

Not only did this allow him to proceed without investing his own money but it also ensured ready acceptance of the first prototypes and subsequent installation of the final product in a critical mass of foundries.

Memberships in networks, in other words, creates a form of "social" capital, which, much like economic capital, can be used to create productive assets.

The options approach

A final observation about entrepreneurial resource acquisition strategies is that they can be likened to the taking and exercising of options. In financial economics, options contracts represent small investments made against an underlying asset that yields the opportunity, but not the obligation, to purchase that asset at a later date.

Options thus provide access to opportunities at relatively low cost. In pursuing their business opportunities, successful entrepreneurs adopt a similar pattern of investment.

By building social capital, they begin to lay the foundation for gathering the information and ultimately the insight that generates new business opportunities. They can then mobilise their networks to acquire resources at minimum cost and subsequently validate their initial assumptions.

This has the effect in real terms of making incrementally more significant commitments to the business as better and better data are revealed. Should the indicators at any point suggest the business is not viable, the entrepreneur can simply stop pursuing it or look at other areas without having incurred huge losses in plant and assets.

The options logic allows us to pinpoint how asset parsimony and social capital help create wealth. If assets are acquired sequentially, with minimum possible investment, they limit the downside losses in the event of failure, just as financial options do.

Only someone with Lovgren's simultaneous access to those who could identify the source of the problem (the management consultant), could define the technical solution (the engineering professor) and could provide financing (the foundry managers) is likely to have started this particular business.

Only someone with Lovgren's skill at maintaining rock-bottom investment amounts would enjoy his level of substantial returns on equity. This has the effect of simultaneously allowing him to build a substantial business from an ordinary-looking labour problem while preventing competitors from simply copying what he was able to do.

In sum, we see in successful entrepreneurs not so much sudden flashes of inspiration and great good fortune as a consistent set of conscientiously applied disciplines that ensure the minimum possible investment for the maximum possible returns. n

The discussion presented here has benefited greatly from conversations with Ian C MacMillan of the Wharton School and Sue Birley of Imperial College.