Why government procurement hurts start-ups

30th October 2018

By Shaun Abrahamson, Managing Partner at Urban Us and Investment Committee at URBAN-X

Lots of government officials want to work with start-ups. Lots of start-up founders want to work with local governments. But there is a problem. Very few venture capitalists (VCs) want to fund start-ups to work with local government. The main reason? Procurement.

If procurement were changed tomorrow, we’d expect almost an immediate increase in interest from venture capital investors. So what is it about procurement that worries investors? Procurement makes it look as though local governments don’t really want new products and services, at least when compared to most other customers.

When a company has been in business for only a year or two, how can you tell if it is destined to become great? There is no historical performance to analyse. Perhaps you could just look at the team. Have they built great companies before? Or perhaps you could look at the product. But what if the company is making a product for local government? How can investors figure out if this is useful? Most investors know very little about what local governments need.

The best evidence for investors is traction. Traction, as used here, is the evidence that a company is making something that a customer wants. For Google, it was an increase in search traffic. For Airbnb, it was an increasing number of bookings. For companies selling to businesses or local government, traction is viewed in terms of sales: how many customers do they have? How much are customers buying? And how quickly is this changing over time?

So here is what happens when a founder goes to talk to a VC about his or her company, that sells to local government. Usually one of three things.

We’re waiting to hear the results of an RFP: the start-up has chosen to participate in the RFP process. They generally know what’s coming. Investors will ask why they have so few customers. Then the investors tell them to come back when they have more traction.

Then the start-up team has a new problem: where to get the money to pay their people for the next 12 to 18 months? This is exactly the reason venture capital exists in the first place.

We found a loophole. But it doesn’t work: the start-up has chosen to avoid procurement by setting a price using discretionary spend thresholds. This seems like a great idea at first, until investors say: this looks promising, but why don’t you charge more?

Investors have seen similar companies selling to businesses (B2B) which were able to charge more. Ultimately, if you aren’t charging enough, the business economics aren’t going to work very well, usually because your cost of sales will keep exceeding what you can charge your customers. This is the trap of discretionary spend.

We have a pilot: is really just a preamble to one of the above two discussions. Investors will shortly ask what needs to be done to move from the pilot phase into a real contract. And the answer is going to be one of the prior two responses.

We’ve seen a few companies triumph in each of the above scenarios. But most fail. Even if they continue, they aren’t able to secure the resources they need to build their teams or to build out their products or sales.

But that’s not even the worst of it. A founder who has a great idea that would help local government will give up before they begin after hearing the above cautionary tales. Who knows how many great start-up ideas, with teams deeply committed to local government, were abandoned because of fear of procurement?

But what about companies like Dropbox? They sell to government and they went from start-up to IPO in about ten years. Importantly, when Dropbox was just a few years old, they didn’t have to worry about discretionary spend or RFPs because their traction came from consumers and businesses. Here’s the irony: the companies that choose to focus on serving government first–those that focus on the specific problems that local government wants to address–get penalised by procurement!

More than any other single idea, we think changes to procurement would ensure start-ups can access the private capital they need to build and quickly scale their impact. Consequently, this will also increase the number of start-ups focused on local government problems.

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