By my count, around 100 startups focused on local were launched between Q2 and Q3 of 2011. there are mobile apps, deals/offers companies, social relationship management dashboards, ad networks, merchant acquiring/ processing solutions and more. (Although the slow down in the last 30-60 days has been seriously alarming). By 2013, I doubt no more than 10 of them will still be in business (and potentially none, if the Euro collapses – but in that case we are all in trouble anyway). Most would have gone out of business because they failed to solve the “Local Innovator’s Dilemma” – how the heck do you profitably acquire hundreds of thousands of SMBs when hundreds of companies large and small failed to do so in the past 20 years.

Many local startups founded in the last year or so since “So-Lo-Mo” got hot, have hit inevitable the wall. The valley is starting to wake up to how hard this problem is to solve.  Peter Thiel understands this problem.   He said, “High paid sales people can get big companies, mass marketing can get consumers, but it’s difficult to get small businesses.”

Dave McClure echos the same sentiment, saying.“We’re pretty bullish on Groupon and LivingSocial as being future platforms for local. Everyone thinks of them as buying platforms. We think of them more as small business platforms. If you think about it, in the U.S., there are millions of small businesses. These people have historically not been that easy to get to, so it’s been hard to have a business focused around small businesses.”

There are limited options to reach the SMB market, and all of them require significant acrobatics to work profitably:

  • “I’ll build it and they will come!” a.k.a self service – Self service for local rarely works – but entrepreneurs and companies, like Ponce de Leon – keeps on trying. Online merchants are able to focus on customer acquisition and marketing while the operations of their businesses are automated by the website. Offline merchants, on the other hand, have exactly the opposite problem –they must spend 9am-7pm everyday serving their customers or manning the register – as a result, marketing or infrastructure investments become their after hours activity. In such a context, the online solutions they are buying must be so simple and so obvious that “checking out online” is a no brainer (such as domain registration, email list management).  Even Google Adwords (targeting mostly online businesses, after more than 10 years of education) has less than 20 percent of their revenue from their self service operations – local compounds that problem by a magnitude. Even Groupon tried its hands in self service, before retrenching again. The reality is that local startups should be conservative and thus expect online self-service conversion rates to be less than one percent based on the industry average. And they must be creative in how they acquire that traffic (i.e., SEM is usually not the answer).
  • “Forget selling to an advertiser, I’ll outsource that problem to an (local) ad network” – This strategy is only viable for consumer application startups – if the startup is selling a service or applications to SMBs, they obviously need a sales force.  Here is some crazy math – it’s somewhat facetious but it does explain the scope of the problem.   Assuming an average of $2 CPM to generate $100M in annual revenue, an application would have to roughly generate 4B impressions a month or roughly 200M to 400M monthly unique visitors.  The only local mobile application close to achieving that scale would be Google Maps – for most local apps – it’s pure dreaming. Ad Networks are great to bootstrap your business and to augment your revenue stream – but it could never be the final answer in local.
  • “I’ve got $10M from a tier one VC, I’ll build my own sales force” – Oh boy, where do I start.  First of all, it’s a huge operational task. Second of all, even if you know how to build a sales team, can you make the sales rep commissions and ROI math work in the long run?  Again, some rough math: a sales person needs to make about $100K a year to feed a family and send his or her kid to college. Assuming sales commissions of 20 percent (generous), that means the sales person needs to sell $500,000 worth of products a year to make his number. Sales cycles in local are not necessarily shorter than selling to Fortune 500 enterprises.  A $10K outlay a year for a $1M business is just as big of a decision as a $1M expenditure for a $100M business. So assuming your sales person can close one sale a week (can they?), he or she would have to sell around $10K a year worth of “stuff” to an SMB for about $800 a month.  There are a couple of problems with this math. First, only about the top one percent of the SMBs can afford to spend $800 a month. Second, does your offering really provide at least $800 of value a month to the SMB?  The math gets even more complicated when you factor in churn rate – which will create significant leverage on both the negative and positive side.
  • “I’m good friends with the CEO, I’ll strike a reseller partnership with X company” (insert a newspaper, radio, or Yellowpages company with a local sales force) – Due to consolidation and attrition, only a few of these companies are left; as a result, there a lot less chairs than startups in this game of musical chairs. Furthermore, these so called “dead tree” companies are getting smart and smarter – the forward thinking ones have their own web/mobile development capabilities and management teams capable of dreaming up these ideas too.  The longer-term problem is that these sales forces are declining rapidly at a rate of 20 percent or more a year (because high margin “dead tree” products are dying), creating a huge vacuum in the overall marketplace for a uniform channel to reach the SMBs. There will be survivors and even winners, but I believe five years from now this channel will be less than 80 percent of the size of what it is today, and the start-up is either back to square one or has completely lost its leverage. In short, it’s a lottery ticket with an expiration date.

Building compelling local product is only half of the equation. Selling locally is even harder and is really how winners and losers will be determined. The best product will not win in local – it’s a critical part of the equation, but not the only part. If it was easy, it would not have taken almost 15 years since the dot-com era for Groupon and Living Social to “crack the nut” – and even now, their long term sustainability is still in doubt. At least in the short term, Groupon and Living Social have discovered a product that generates enough revenue on a per sale basis, with short enough sales cycle, to support a direct sales strategy at scale.

It’s easy to think that there is a pot of gold at the end of that rainbow given, let’s say, Groupon’s rapid growth – the reality is that the merchant acquisition conundrum is harder to solve than most entrepreneurs wants to believe. I’ve spend most of the post bitching about local as a homage to Clayton Christensen.  I still believe in “local” as an investment thesis and the opportunity for a startup to disrupt existing infrastructure and make a ton of money in the process.  It is not impossible to crack the nut (and I’ve came across a few companies in the last month or so that are almost there). My next post (maybe I’ll get around to it next week), naturally pre-titled The Local Innovator’s Solution (original book here) will focus on how to navigate the treacherous waters of how to go to market in local.  (and just like the original, you’ll be forewarned that the sequel will be a lot less satisfying).

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