Where Do Startups Start?

Frictions in markets and within companies create opportunities for entrepreneurs to unlock value — but not without costs.

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James Steinberg

Sometimes a simple tweak can have a profound impact on a business. That’s what three former colleagues found in 2003 when they left the recruitment site Hot Jobs to found their own company, The Ladders. Focusing on emerging mobile technology and reversing Hot

Jobs payment model to charge job seekers instead of recruiters, they were able to attract $7.6 million in funding and 5 million registered users in less than a decade, outflanking their former employer.

“It’s a pretty cool opportunity for a potential entrepreneur when they realize how tied up in knots firms get, often with only the best of intentions,” Evan Rawley says. Company politics and bureaucratic inertia, however, are just one way in which markets can fail to provide value-creating goods and services. “Often,” Rawley says, “firms see that there’s a need for a product or a service in the market, but it’s not trivial to deliver it.”

In these cases, Rawley continues, “something’s broken in the market. Firms would like somebody else to fix it, so that they can offer the service, but if nobody is going to do it, they have to. The firm has to integrate and provide a number of other services or products in order to solve that one market need.” Examples abound, from the nineteenth century need to develop refrigerated train cars in order to bring meat from the West and produce from the South to the lucrative markets of the Northeast, to Uber’s more recent development of complex queuing, tracking, and pricing software to offer a more efficient modern car service.

Rawley calls this process “internalizing externalites,” reducing frictions in the target market by tackling tangentially related, and often complex, problems. When undertaken successfully, as in the case of The Ladders or Uber, the process can unlock tremendous value, allowing some entrepreneurs, Rawley says, “to thrive even in areas where there are huge firms with tons of resources and brilliant people.”

“There’re bureaucracy costs, politics, distractions, misallocations of capital, lack of transparency. Suddenly, there are all these coordination problems internally and the firm can no longer address new opportunities efficiently.”

But as Rawley is quick to point out, the process isn’t without peril. From Google’s recent reorganization as Alphabet, to Uber’s push into food delivery, slim, narrowly focused entrepreneurial businesses have a tendency to grow in size and scope as they seek out potential synergies. As these businesses move to internalize additional externalities, they quickly become significantly more complex as new teams enter to address additional challenges. “There’re bureaucracy costs, politics, distractions, misallocations of capital, lack of transparency,” Rawley explains. “Suddenly, there are all these coordination problems internally, and the firm can no longer address new opportunities efficiently.” When that happens, opportunities begin to emerge for new entrepreneurs both outside and within the firm, kicking off a fresh cycle.

“It’s a dangerous game trying to put together different activities and create synergies,” Rawley cautions. “But it’s the only way to internalize many of these externalities. You have to be careful about evaluating how important an externality is. There are a lot of externalities you could solve, but they might be too expensive for it to be efficient.”

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