The Government is the Worst Customer – and the Worst Investor

The Invisible Hand versus the Regulator’s Pen.

We will always invest where Adam Smith’s “Invisible Hand” is pushing things forward, and avoid businesses where the regulator’s pen can wipe it out.

We avoid regulatory risk, and so should early stage companies.

Governments, by accident or design, distort the market in many ways. For example, the tax code has been designed to give advantage in some situations and disadvantage in others. Administrative bodies advance their mission by encouraging investment or making investment directly in every part of the economy.

Many entrepreneurs see these governmental actions as opportunities that they can exploit.

This is by design. Governments put policies and programs in place to follow (typically) the legislature’s desires, and they intend for entrepreneurs and large companies alike to change their objectives accordingly.

Especially for entrepreneurs, who can be nimble and quickly respond to changes in the market, these “opportunities” can be very enticing.

We do not think they are, and we avoid investing where the government-induced anomalies in the market are the driving factor in a business.

Governmental institutions do not work in a predictable, logical manner. A new regime can wipe out billion dollar industries with a stroke of a pen, and we will avoid this risk as much as possible.

We invest where the underlying economics always work, regardless of governmental or regulatory action.

As investors, we need the underlying economics of a product to always work. What I mean is that there always needs to be an economic advantage of the product, regardless if there is a government-created anomaly that may assist the business.

For example, I spoke with a company who makes a product used in large scale fire fighting. As someone who lives in the mountains of Colorado and has been evacuated several times for wild fires, I am not unfamiliar with this.

As I probed the company, I asked if their product was lower cost than whatever is currently being used. There answer was no, it is not cheaper. Their product was better for “performance” reasons, more specifically, for the environmental impact and more comprehensive fire suppression.

We would be very excited if their formulation was lower cost first, with performance benefits as a secondary factor. Of course, the performance benefits would be touted in the marketing and sales aspect, but the economic advantage is actually more important for us. Even if they cannot make the sale on their alleged performance benefits, they can certainly make the sale on price. (Obviously, we would love the product to be sold with a premium for the performance benefits, with the economic bonus of it being more profitable than the competitors.)

If the economics of the product worked, the fire suppression product might be very successful.

The economics of the business are a much stronger indicator of potential success than anything else. You can argue that the economics are the only indicator of potential success.

It is hard to stop drinking from the government trough.

The government has many programs, such as Small Business Innovation Research (SBIR) program and other grant programs from countless agencies, that are designed to get startup companies moving forward. The SBIR program puts billions of dollars into the hands of researchers.

A typical SBIR grant will include a proof of concept grant up to $285,000, and then a phase 2 grant of up to $1.8M. Conceptually, these grants are fantastic for an early stage entrepreneur. Their ownership in the company is not diluted down by investors, but more importantly, they do not have to go through the slog of raising money from investors.

In short, an entrepreneur who can write a couple grant requests every year can make a comfortable living doing their favorite things: research and innovation.

Most entrepreneurs fail not because of lack of a good idea, but for poor business execution.

The “idea people” are terrified (rightly so) of the drudgery of building a business. It takes an incredibly thick skin, relentless determination, and the ability to be rejected over and over to raise money from investors. It is much like being the prophet in the wilderness – thankless, unrewarding, and grueling.

It is so much easier to write yet another grant request, deal with a single customer (the SBIR) and just get good a writing reports for the government. Entrepreneurs are supposed to “commercialize” the results from the SBIR grants, but many find it so much easier to just write another grant request and start over.

I see this pattern emerge with startup and seed-stage companies: entrepreneur gets started with government grant money, and their next fund raising activity is to write yet another grant request rather than raise angel or venture money. This pattern is addictive and is only broken when they start losing their grant requests over and over, and they are forced to start a new venture.

The government will not buy your product.

The government is a terrible customer, especially for early stage companies.

It may seem enticing to think that the Department of Defense to buy your nifty product that our troops carry into battle, but that is not an easy sell.

For better or worse, the government is the world’s worst customer. Their purchasing procedures often require competitive bidding, conformity to countless regulations, and other requirements that can be difficult (and very expensive) with which to comply.

In many cases, there may be discretionary budget and purchasing authority to buy small amounts of product without all the regulatory hassle, but this is not the giant purchase orders that entrepreneurs envision. Just because one person in the Special Forces bought and used your special water bottle does not mean that the entire Department of Defense will issue that water bottle to all the millions of troops.

If the government is the only possible customer for your product, I would suggest trying a different product. The length of time it takes to sell to the government, the bureaucratic nonsense and red tape required to get your product qualified, tested, and available for purchase, then getting the actual purchase order may be eternal.

On the other hand, selling your product direct to consumer or business to business is something that can be started immediately. Products in these categories can get to you to the Promised Land much faster, the Promised Land of Profitability.