024: Our Customers Can Be Your VCs

Hello and welcome again to the Scaling of Business podcast. We're talking today about the customer funded business or novel and really extraordinarily powerful ways to fund your business without going outside the company for help or not going to traditional sources like banks and VCs. So I know we talk to many companies who are like, how can I raise money to grow my business? And we're going to talk to you today about some places that many of us don't look or we don't take seriously. We're talking today with John Mullins. And this is a conversation that will make a profound difference in your business right away. So hi and welcome to the show. I'm Bill Gallagher, your scaling up business coach and host of the show. I have with us today John Mullins. John is just part of an extraordinary background and he's been named and noted by Fortune magazine. He was part of the team that built Gap. He started an entrepreneurship program at the London School. He splits his time between London and Denver. And he's very passionate about this subject of getting our partners and customers and suppliers and approaching the finance of our business and our growth in a whole different way. I, of course, have been familiar with his book forever and saw him first at one of our Gazelle summits. And I'm so happy to have you on the show. John, welcome to the show.

Thanks, Bill. It's great to be with you.

Thanks. And where are you today?

I'm in sunny Denver, Colorado.

Sunny Denver, Very good. Well, Denver in the summer is pretty nice and surprisingly warm.

Yeah. Quite toasty. But September is a great month here, and it's nice to be here.

I spent a month in Denver once in the summer. It was 100 degrees. I said, why don't we have air conditioning? They're like, oh, we don't have it. We don't need air conditioning. I'm like, it's 100 degrees. You need air conditioning. All right, so let's talk about how you came to write this book. Right. Tell us all about how this came to be, and then we'll get into the big five things that can make a difference for the business.

Yeah. So it's kind of an interesting story. I wrote a book in 2009 with Randy Commissar, who is a venture capital investor at Kleiner Perkins in California. And that book is called Getting to Plan B. And it's a book about business models and the five elements that comprise business models and how to put together those business models in sort of revolutionary ways. And one of the chapters in that book is about about fantastic working capital models like that of Costco, for example. So we studied Costco and written a part of a chapter about Costco. And Costco of course gets us to pay a membership fee before we join the store, before we can shop in the store. And Costco also turns its inventory really fast so they have our cash because we have to pay with cash or credit card. They have our cash before they pay their suppliers for what we bought. So we discovered that the day Costco opens a new store, they generate enough cash in that new store to open three more stores. It's just an amazing model because of the membership fees up front and then the fast turning inventory that gives them great supplier credit. So after writing that chapter and then working with companies on the ideas in that book, there was a lot of intrigue about that. As I worked with entrepreneurs around those ideas, I said, it's really cool what Costco's done, but I know lots of other companies don't go raise venture capital and they grow really fast. In fact, if you look at league tables like the Inc 5000 list and you look and see what portion of them have raised venture capital, it's a really small. So I said, gee, maybe I ought to study this phenomenon and figure out how this really gets done and see if we can get people talking about this. Because of course the VCs have stolen the limelight and everybody thinks the VC should be your first port of call when you need money. I said, maybe it was worth studying that and trying to figure out if there's another way. So I spent about a year and a half along with a research assistant, really digging into companies that had funded their business without venture capital. The result then is this new book called the Customer Funded Business.

Yeah, it's brilliant. That's the book that we're talking about today. In that book, there's five ways that you could fund a business that are not a bank or venture capitalist, angel, friends and family, seed money, etc. So talk to us about that. What are the five?

So it turns out there are five ways you can do this. So one way is you can be a matchmaker and you just bring buyers and sellers together, but you don't ever touch the goods or whatever. So that's ebay, for example. They don't ever touch the goods. It's Uber. They don't own any cars. It's Airbnb. They don't own any hotels or lodgings. It's just bringing buyers together.

A couple small companies just to Mention.

Yeah, exactly.

But it's good to remember they were all startups at one point.

Well, exactly. And they started without any vc. Some of them raised VC later, but they all got started without vc. So matchmaker models is one kind and then a second kind is what I call pay in advance models, which is what Costco did. You have to pay them some money before you could buy anything. And of course, if you're going to remodel your kitchen or something like that, or put an addition on your house, are you going to pay an upfront fee to the designer and the contractor? Of course you are. So that's widely understood. As are subscription models. That's the third kind.

You know, let me just interject on your second one there, because I had experience with this one in particular and I was the CEO of a jewelry company for some years and we struggled to fund and grow that business. And at one point we. So a typical thing in that business is 30 day terms, but that really means 41 to 90 days that you're getting paid with some collection. If you're really good, some of your customers are nicer. Like the good ones pay like 41 days on a 30 day. So anyway, that's typically what it looked like. And it's also really filled with what they call memo, which is just consignment goods. So they want you to send something on memo and then you can invoice it when they've sold it and they'll pay you for it there later. But of course there's no burden to really or motivation to really push things out or take care of them or. There's a whole lot of issues with consignment, not the least of which is the cash. So that was the industry that I was in and we managed to move virtually everyone to credit card payments. So even very large customers went from those kinds of 30 day plus terms to paying on shipment by credit card. And we kept very large and we grew rapidly millions and millions of dollars in credit card charges, which is, you know, we think of credit card charges like for your restaurant or whatever, but these are very large wholesale orders going up by credit card.

Cool. Yeah. Well, getting paid in advance is nirvana.

Yes.

So that's the second model. The third one is subscription model. So we all subscribe to stuff, whether it's the Wall Street Journal or Netflix or cable television or whatever. But again, you're paying some fee up front and then whoever's providing that subscription is providing that magazine or media product or whatever later. And again, they've got our cash up front.

So you mentioned those typical ones. But I think in our client base and our audience here, there are tons of companies that do services and they tack on services that they have as a subscription. So retainer types, support type maintenance agreements, ongoing training and certification programs done by subscription. There's a huge range of those kinds of things.

Exactly, exactly, exactly. And I'll tell some stories maybe if you like, Bill in depth about some of these models. But that's three of them. The fourth one is what I call a scarcity model, which is what Xara does. I think many of your readers probably have shopped at a Zara store. They have family members who have. And what Xara does ingeniously is the opposite of what we used to do when I worked at Gap. At Gap we wanted to sell as much as we could, as often as we could for as long as we could of every style in the store. Well, Zara flipped that upside down and says, well, we're only going to have a limited amount of each style and when it's gone, it's gone and there won't be any more. So they basically train their customer, you better buy it today because when you come back tomorrow it's going to be gone again. In a retail environment you're paying cash or a credit card and Xera then has that money before it pays its suppliers on 60 day terms. Again, not rocket science.

And I know a couple others that are like that. One of them is Nordstrom of course, who there's a certain number of regular standard goods that they have on replenishment that are always there standards. But there's a ton of things that they order thin in. So a signature advertised item, they might only have a couple in per store and they're really trying to train the customer to buy it now and not to expect it to be there when they return, which is different. And of course a large company like QVC will put things at their lowest price in the beginning and train people to act with urgency. So scarcity and I think also kind of goes with urgency. And we see this a lot with our clients where we create something that compels people to act now instead of later. And scarcity or urgency or something that disappears.

Yeah, exactly, exactly. And then the fifth model is what Bill Gates and Paul Allen did in starting Microsoft. They knew that, that every service business is inherently customer fundable because for most services you get paid at least something in advance. So they were in the service business and they were writing operating systems as everybody knows for the early PC players and they wrote one for Texas Instruments and one for Altair and one for Ricoh and on and on and on. But each one of those was a custom service job, you know, writing an operating system for yet another new PC. Well along the way they said, you know, these are all, you know, we've written a lot of these things, they all look kind of the same now. I wonder if we could just write one standard one. And of course they called that Ms. Dos and they put it in a shrink wrap box or downloaded it digitally with a new computer. So instead of having a having to rewrite or redeliver the service for every new customer, which is not particularly scalable, although it is customer fundable now, they had a product business that was inherently scalable. That's when the valuation of Microsoft took off, of course and what really drove that company to its astonishing heights. So five ways to do it. None of them new, none of them rocket science, but they just don't get talked about very often.

Yeah, it's really great and I think we see this with some of our development companies, software developers, web developers, a whole range of tech, software, app type development that then have an idea that they create into a product in itself and essentially they spin off a set of functionality. I did that years ago in the dot com phase as well. So tell us about some of the applications of them. Which ones do you find easier, harder to do your thoughts on, on just some of your war stories about it?

Well, it's not a panacea to do this and it's not easy to do it because for example, if you want to have a customer funded business that's paying advance, the customer's got to have a reason to pay you in advance. They're not just going to do it because you want them to do it. So you got to really be customer focused to do this. I think that's one of the real core benefits of building a business this way is it really forces you to think about your customer and do something that the customer really wants. I have a lot of my students at London Business School come into my office and say I've got this new idea and what do you think? And can I get an angel to fund me? And I tell them to stop and go see if a customer will buy what they want. And you know, if the customer doesn't want to buy it now, that might mean that the customer and pay you in advance. That might mean that the customer doesn't want to buy it later either. And that's certainly helpful information to have if you're an entrepreneur trying to do a startup and have earlier rather than, you know, spending weeks or months of development time on something that nobody's going to buy. So, you know, focusing on the customer is what it's all about. But I think most good business people know that the customer is really important. What they haven't really known, or many of them haven't known is that the customer in effect can be the VC as well.

Say that again.

The customer in effect can replace.

Yeah, yeah, yeah. They're funding and validating the whole thing. Well, we see it with, in the world. I mean, I'm not a huge fan, but I have seen some people do some pretty amazing things with Kickstarter and similar crowdfunding kinds of things, getting people to pay deposits and commit early on. We also see it in, I think the online business where in a variety of response based online businesses now where they're getting people first to say, can I get you to click on something now? Can I get you to tell me your email address now? Will you make a small token purchase? Then can I ratchet you up in the size of the purchase? Ease them into greater and greater.

One of the favorite stories I tell in the book is a story about an Indian entrepreneur named Krishnan Ganesh. Back in 2005, he built a business and sold it. And he was traveling in the U.S. and he saw a cartoon in a U.S. newspaper. And it was a cartoon of a father and a kid. And the father saying to the kid, no, you can't outsource your homework to India. And of course you can't do that. But that got him thinking. And then he saw a couple of newspaper headlines and of course for the last 10 years or more, there's been lots of consternation in North America about whether or not the, our educational system, particularly in math and science, is good enough. You know, Singapore is beating us and the Chinese are beating us and so on, right? And Ganesh kind of, you know, connected the dots and saw the cartoon and saw the headlines and he said to himself, you know, we have a lot of, a lot of people in India who are really good at doing math and they're really good at math because we have a lot of really good math teachers in India and they don't get paid very much. I Wonder back in 2005 if I could build a little web interface and connect these American kids who need help with their homework. Because of course mom and dad are both working and connect them with Indian teachers to help them with their homework when they get stuck. So he got three teachers and put them in a little room in Bangalore and built a little WebEx connection on which the teacher could call the American kid, or the kid would call the Indian teacher, and they'd work together on sort of a little whiteboard where the kid would write in one color and the teacher in another. But it turned out that it was a little awkward to monetize that because, you know, the American parent, the kid didn't pay. Of course the parent paid, and it wasn't clear how much help the kid would need. And, you know, do you charge 20 bucks an hour? And so on. So quickly he shifted to a subscription model and said, look, let's just make this simple. You pay me $100 a month. Your kid can have all the help he wants anytime, no limit. And we'll step in and help your kid when he's struggling with a formula for the area of a trapezoid or whatever the math challenge is. Well, very quickly, he discovered the renewal rate on the trial subscriptions was north of 50%. So once somebody signed up and the kid started getting some help, the kid loved it. The parent felt relieved, and they stayed on board. And so he had a subscription model going that was 100 bucks a month in advance. And of course, the Indian teachers, though he was paying him more than they would get otherwise, still, by American terms, were not getting paid very much. So his margins were phenomenal, and that business grew very fast. He did raise a little bit of capital once he proved the concept, but he sold it six years later for $200 million. All right, not rocket science, but proving that if you have something a customer wants and will subscribe for, you can grow really fast because you've got the cash. One of the things that that's kind of surprising in my research into all these models is while customer funding can let you start your business with no outside money and can also let you grow your business with no outside money if you decide you do want to grow faster than the natural pace of the business will permit. Investors love to invest in these kinds of businesses because they're so darn capital efficient. And investors really like capital efficiency. So he raised very little money to grow that thing really fast. Of course, Uber's done the same thing. Airbnb has done the same thing.

Well, I think one of the things that's interesting about this also is that at least four of your five are highly relevant to recurring revenue models. Obviously, recurring revenue is Tremendously valuable to the valuation of the company, the stability of the company and makes it more fundable and easier to grow and so on. But pay in advance, great. Lots of recurring revenue can be set up as a pay in advance, subscribe. Better still, creating scarcity, hey, we can only serve so many at this time or this month or whatever makes a big difference. And then all of these can spin off products. But we've got quite a bit there.

Yep. Yeah, so it's really cool stuff. So my goal here is to get people, whether they are entrepreneurs doing a startup or maybe mid market companies that are maybe growing at single digit rates and they'd like to grow at double digit rates, to use this set of ideas and think about financing in a completely new way. And again, not rocket science, but just to think about it in a different way.

So here's the challenge, I think that I hear again and again, and the sentence is roughly, you don't understand my industry or my company. Right. Oh, you don't know how we do things here.

Yeah, I hear that all the time.

Right. And that seems to me the biggest one is that your experience also?

Well, I hear that too because you get kind of tied into what people call industry norms. But I've got a former student at London Business School who started a business called pabl. It's an education business that, that seeks to attack the literacy problem that kids can't write anymore. And it's a social business but for profit. And John Smith, the entrepreneur, was making really good progress in growing it and wanted to do another generation on the website to improve some of the technology. And he came to him and he said, you know, I think I got a raise around the capital so I can spend the summer while, you know, while the kids aren't in school doing this next generation thing. And I said, well, tell me a little about how you get paid and when you get paid. So, you know, the schools sign up for a year and many of them, you know, there's no cash issue, they don't care when they pay. So they typically were paying in September or October when school got started for the next school year. And I said to John, well, do you think they'd pay you in May? This was May. We were having a conversation and he said, oh, I doubt it. But you know, I could ask him. Yeah, well, guess what, 60% of them did.

Yes.

And instead of having to raise a round of capital and be diluted, he funded it with those advance payments for the next school year. Well, you know, that's an extraordinarily efficient thing to do for your business.

Well, I've personally participated in a couple of significant business model shifts and each time it included, well, let's ask. So one time we went to a group of customers and said, listen, we're really bad at this thing over here, but if you'll do business this way, we promise you the following things. And we promised them a much higher quality of service and delivery and all that kind of thing in exchange for a different kind of upfront business model. And we thought we're going to lose most of these people and we were prepared for that and. But we ended up keeping over half of them. And then another time we had a hot product and a shifting economy and we went out to a new market segment and we said, if you'll order and do things up front like this, we'll do business. We also went to suppliers at the same time and did the flip side. The thing that I notice again and again though with clients today is that, and especially the ones that are, that are VC funded currently, and I'm in San Francisco area, so I encounter a fair number of well funded tech, mostly services companies and even one public company and they're like, oh yeah, yeah, we don't really need to do that or work on the business model. And that. And yet if you look at all of the priorities that they're chasing, all of the things that they're struggling with, the deep challenges, they're all about this limited cash Runway and they're like, okay, we have to hit these growth milestones and do all this. I'm like, yeah, but this office is ridiculous. You don't need this space and you could change the way you're doing. I'm talking there about expense burn too, but there's all sides of it where the money's coming in as well as where it's going out and so much is the norm. Oh well, we have to have this to attract the talent and so on. Yeah, I don't know about that.

That's right. That's right.

A big mission, a big purpose will attract talent too, not just a better snack bar.

Yeah, yeah.

So this is really great. How do you work with folks on this over time? What does it look like and what do you do with this beyond the book?

As I mentioned at the outset of our conversation, I really want to get people around the world thinking this way. So in addition to the book, there's a mooc, a massively open online course on Coursera called How to Finance and grow your startup without VC. So I've got, I guess the latest number is 12,000 people around the world using these ideas and putting them to work via that mooc. And I do workshops and I do keynotes and all kinds of things just to get people thinking differently. And once you can get them just past that, you don't understand sentence that you mentioned, Bill, to say, well, wait a second, if I can get my customers to think a little differently, and that means you thinking a little differently, then you got to give them something for that. There's got to be a reason why they're going to do that. But if you can find that reason, it does dramatic things for your business. But I think the most important thing it does for an entrepreneur is, especially in the growth stages of the business, is it gives you freedom. You know, you don't have bankers in their nasty covenants. You don't have VCs with, you know, a fund coming to the end of its life. And they maybe they want to sell and you don't want to sell, or they, you know, they're not going to follow their money. It just gets you out of all of that nasty stuff, which is, you know, which. That stuff causes entrepreneurs to lose a lot of sleep. And I'd rather have them. One guy who built a business this way told me, I'd rather be losing sleep over how to better serve my customers than losing sleep over how to deal with a vc.

Yeah, well, they'll push on all kinds of things and perhaps more focused on their exit and their return than the fundamental health, not just the growth of the business.

Yeah, exactly. You know, one of the interesting comparisons I came across is that between Michael Dell and Steve Jobs, they both built PC businesses in their infancy, right. And at about the same time. But they went out, went about it in two different ways. Steve Jobs, in the heart of Silicon Valley said, well, I'm going to fund this with round after round after round of venture capital. Obviously, he did so very well, and we'd all like to be Steve Jobs, but the percentage of the total value that Jobs created during his tenure at Apple compared to the percentage of the total value Michael Dell created for his shareholders, there's no comparison. Dell customer funded that business from the beginning. You had to pay for the PC before you got it. He really never had to raise capital. Even today, Dell, Dell controls that business. Well, as we know, Jobs got fired and later came back. But it's dramatic. I mean, you get to control your destiny, you get to own your business. And do with it as you please. And isn't that why many of us are in business in the first place?

Well, in today's Apple, of course, uses many of these things. So we've got subscription and we've got services to product and we've got, for sure, scarcity as people line up to get the latest iPhone and it runs out. You've got a whole lot of these kinds of things now in their world. But in terms of the lesson in funding and the business model, in the beginning, studying Dell would be better. I'm surrounded by Apple products in my office and I obviously care about the quality of the products and things like that. I love them. But that's a different lesson in a different part of the business than the business model and the funding model.

Yeah, yeah, exactly.

Well, this is fantastic. So we are. I think there's a lot of material here for people to work on. I noticed that it is a challenge that, well, you don't understand. And I think one of your comments was, well, you could just ask as one of the approaches. And the other one is to seize moments of change and shift. So a new product launch, a shift in the economy, some dynamic in the marketplace to shift things up on the supplier side, which we didn't talk a whole lot about. But just shopping your suppliers to get better terms can make a difference as well. And you can do that behind the scenes at all times, really. So all of those kinds of things go a long way. We'll put links to you and your course and that kind of thing in the show notes here, as always, so people have a place to turn to. And it's been a real pleasure talking to you today and I hope people take advantage of the message.

Thanks, Phil.

It.