Modern companies as specialized venture capital firms

By Philip Brewer on 15 April 2009 (Updated 26 April 2010) 5 comments
Photo: carol2chat

In the old days, companies actually produced stuff. They invented it, designed it, made it, marketed it, and sold it. Although there are still some companies like that, they're a lot less common now. Many companies have shifted to an "asset light" model where they no longer own their own factories and equipment. Instead, they hire other companies to do most of the work. Understand how this works and you can turn it in your favor.

I first came to understand this model with regard to publishing companies, so I'll use them as an example.

Publishing companies as specialized venture capital firms

What does a book publisher do? Very briefly, it finds things to publish, buys the rights, edits the manuscript, designs a book, markets it to bookstores (and other sales channels), has copies printed and bound, and sells them.

In the old days, one company would do all those things. Nowadays, very few do. In fact, some companies outsource every single one of those activities: Acquisition, editing, and book design are done by freelancers; marketing is outsourced to a marketing firm, printing and binding to a printer, and sales to a distributor.

Of course, a publishing firm may choose do one or more of those things, if it thinks it can do it better in-house--many firms still do their own acquisitions, a few old-line companies may do their own printing and binding, many do their own marketing. But they can all be outsourced if the company doesn't have the expertise in-house.

There is one exception: buying the rights. That--putting up the money--is now the core activity of a publishing firm.

This is why I call publishers specialized venture capital firms. Putting up the money--paying the writer's advance (and also fronting the money to pay the freelancers and the printer) in exchange for a big chunk of the profits from sales is a straight-up venture capital model. (Rights are usually acquired on a profit-sharing basis: The publisher pays an advance against royalties. If the book does especially well, the author will get further payments, if it does poorly he gets nothing more.)

Other companies as venture capital firms

As one aspect of globalization, more and more companies have shifted to this model over the last twenty or thirty years. Specialized tasks were outsourced early--everything from janitorial staff to lawyers got contracted out. Anything with high labor costs--manufacturing especially--was moved overseas in search of cheap labor. The idea was to identify a "core competence" and retain only that activity, outsourcing everything else.

To the extent that you can get things done better or cheaper, outsourcing is fine. At its current absurd limit, though, we've gotten to the point where companies no longer seem to have any "core competence" except hiring outsourcing firms. At this point their only competitive advantage would seem to be superior skill at managing deals with overseas contractors.

Actually, there's one other: cheaper access to money. In fact, for a specialized venture capital firm, access to cheap risk capital is the core competence. And US firms have had a huge competitive advantage, because in the years between the dotcom collapse and the recent financial panic, the Federal Reserve made money as cheap as it had ever been.

The financial crisis put an end to that. (The money is still cheap, but you can't get any of it.)

However, there's a more fundamental limitation to the whole system: When your competitors are all shopping from the same universe of outsourcing firms to hire things done, it gets a lot harder to find a competitive advantage.

Even if you have a real core competence, you're still suffering in this recession, but you're just suffering in the usual way--sales are down because your customers don't have any money. But if your so-called core competence was either your skill in managing outsourcing firms or your access to cheap money, you're in a world of hurt now. The people actually swimming in that quagmire don't need me to tell them that. But others are affected as well. Stockholders should take a close look at the companies they own. Vendors, clients, and suppliers should look at the companies they do business with. If the company still does something real, it may well have a bright future. If it hires everything out, though, there's no reason to think it will ever again do well (even if it might manage to hang on as a third-tier firm for a long time).

Why it matters

Having said all that, there are really two points I'd like to make.

First, ordinary people can also take advantage of the outsourcing phenomenon. If there's anything that you can do better than other people--if you have a core competence--there has never been a better chance to turn that into a business. The outsourcing firms that will do everything else for you will be begging for the work. Of course, since you're turning yourself into a specialized venture capital firm, you'd better have not only a core competence but also some capital--it's going to be tough to get much from the financial markets.

Second, though, understand that once your company gets to the point where it doesn't actually do anything except put some money at risk and manage contracts with other companies to do the work, it isn't really much fun to work for.

There are, I suppose, some people who like nothing better than managing contractors and managing risk, but the rest of us would prefer to actually do something--design something, build something, repair something, improve something, maintain something.

This matters for both managers and employees. Hire people whose skills complement your business's core competence. Work for companies where you'll be doing real work that you're interested in. Avoid owning or working for companies where there's no longer any real work going on. (Work instead for the outsourcing firms that are doing the work.)

In any case, understand what it means to own or work for a specialized venture capital firm: Success is mainly a matter of managing your contractors and coming up with risk capital that costs less than the profits of your firm. Finding some real work that you can do better than anyone else is both more promising for success and more fun.

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Xin Lu's picture
Xin Lu

Interesting article, but I think outsourcing is pretty different from venture capital.  Venture capitalists generally put up "seed money" to bootstrap and start up a company and get shares in the company. Their role is of an investor, and having worked in venture funded startups I think they do have a purpose because they often provide the original capital for a business or money to expand the business.  Without the original funding a lot of people I know would not have jobs. 

Outsourcing is where a company hires contractors or people outside of the US  for its own operations.  So the company is still producing something, but they are trying to cut their costs by not having employees.  I think that's  completely different  from venture capital so I'm not sure if the two things are very comparable. 

Philip Brewer's picture

Of course none of what I'm talking about applies to the companies that receive venture capital--such as the start-ups you're talking about.  I'm suggesting that huge swaths of the American corporate landscape have started acting like companies that provide venture capital.

Of course, hiring an outside firm to do some task is not the same as making an equity investment.  But I think a firm that doesn't do anything except put up money--hiring out all the work to other firms--is best viewed as a financial company, and best analyzed as a venture capital firm with all its capital invested in the one venture that it's hiring other companies to do the work of.

Xin Lu's picture
Xin Lu

Well, when you're hiring out work you still need to tell people what you want them to do.  So in that aspect the company is doing more than just providing money.  They're providing plans or direction.  For example, Nike outsources a lot of work to manufacturers in China, but they provide designs and specifications for their shoes. 

I actually can't think of an example of a non-financial company that actually sells a product that acts like a venture capitalist where the only thing they do is provide money.  Even book and game publishers provide services like marketing and distribution.  Sometimes game publishers provide a lot of technical infrastructure, too.   Even the chip companies here that outsource all manufacturing do the design and marketing in addition to providing capital equipment and such. 

Philip Brewer's picture

...but I think some of the brand-only companies are coming pretty close.  (I'm thinking of companies like Levenger, Tommy Hilfiger, and the old Banana Republic and J. Peterman company.)

Smart companies retain at least the design work, because that's where the biggest part of the value-add is.  Many companies also retain the marketing (although that's as much because they're run by marketers as because marketing is a huge source of value-add).

In fact, almost no book publishers do any distribution any more, because the major booksellers all have a preferred distributor and refuse to do business with any other.  They do often still do their marketing.  Video games are very different because producing a video game is a huge joint venture (more like making a movie than writing a book).

But the film industry is a good example of what I'm talking about.  There is a production company, but almost all the work is contracted out:  the actors are hired under a contract, as is the director, the sound and film editors, costume design, set design, etc.  Separate firms are hired to do everything from special effects to catering.  The production company doesn't do much except buy the rights to the screenplay and then hire out the actual work of making the movie.

I'd expect video games to move toward the film model over time.  The only reason they haven't already is that the game companies own the underlying game engine which can be upgraded and used for the next game more cheaply than writing a new game engine each time.  New game companies generally appear when some small group of individuals puts in the heroic work of creating a new game engine from scratch.  There's another model, though:  One of those small groups writes an incredibly flexible and powerful game engine, and then makes it available under a license.  That will enable a shift to the film company model.  It'll happen.

Guest's picture

Great post-- the little guy can more successfully copy this model more today than in the past because of the internet . . . it spells opportunity to me.