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Why Small Companies Have the Innovation Advantage

Buy vs. BuildWhen I first started my company, I hit the business plan competition circuit for funding and feedback. At each event, I encountered the same question from a judge or a member of the audience: "This seems pretty simple, why doesn't [insert large competitor] just do this?" My response was always the same: "I don't know­--they just don't." The answer was always oddly sufficient, probably because the asker had no idea either.

That question ultimately became rhetorical, in the eventual sale of my company and in general observations on how big companies and startups act. Why do large companies more successfully acquire instead of innovate? They certainly have the talent, the money and the existing market share to launch startups with ease, yet they don't do it very well. What's clearly missing is something in their DNA, but also something in the numbers. As big companies look at growing internally or via a shopping spree, it's important to consider the underlying motivations and math.

People and culture: Startups require innovative entrepreneurs, and that typically isn't in a job description for a large company. Big companies hire people when the workload demands it, not when they can come up for air and think about innovation.

By the same token, people work for big companies when they want a stable paycheck, an eight-hour workday and projects lined up on their desk. Mechanically, the ability to break away from a billable workload to pursue something innovative requires significant buy-in and resources from managers. Those managers are likely evaluated by their higher-ups on the profitability of existing, not future, business.

Cost and organizational structure: Large companies simply can't compete with startups on a cost and execution basis. Organizational hierarchies slow decisions that could be made over lunch or beers in a startup, and established salaries and service providers create costs that would bury almost any early stage company. While startups beg, borrow and barter, large companies follow established processes, protocol and prices to accomplish the same things at a much slower speed and a heavy multiple of the cost.

Risk: Unfortunately, all of those extra dollars and time spent do little to mitigate the risks of the actual concepts and, unlike startups, big companies have a lot to lose. Failed internal ventures not only hurt the balance sheet, but the corporate brand companies invest significant resources in building and protecting. The only risk in acquiring established and derisked companies is overpaying. That premium debatably trumps the risk of having several internal failures to get something right. Like everything else in business, it boils down to math--mainly probability and statistics.

For instance, if a large company knows it could replicate a startup concept for $1 million, but only has a 33 percent chance of competing successfully long term, it could mathematically justify waiting around to pay $3 million for the derisked version. This allows it to leave the founding, flailing and failing to entrepreneurs, and acquire the company and competition in one fell swoop--no disruption to current projects, no need to retain internal innovators on payroll and no reason to change the corporate machine that put them in the acquiring position in the first place. No-brainer.

So why is this important? Knowing why big companies buy little ones is critical to positioning and pricing a company for an acquisition. Large companies are cash heavy and innovation poor, and when they seemingly sit on the sidelines, chances are they aren't being dumb, they are just doing the math. Making sure your company fits their price and formula requires thinking like they do.

It would be easy to just abandon a startup altogether because a bigger company could compete with it. Instead, knowing the innovation challenges of large companies transforms them from competitors into strategic acquirers. Building startups right in the wheelhouse of potential competitors isn't stupid--it's smart. And next time I'm asked why a competitor isn't replicating my concept, I'll confidently answer this way: "Because they are waiting to buy me." 

Image from Shutterstock.comOrla

Sam Hogg is a venture partner with Open Prairie Ventures, a Midwest-based venture-capital fund investing in agriculture, life-science and information technology.

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This article was originally published in the November 2011 print edition of Entrepreneur with the headline: Buy vs. Build.

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