How government procurement hurts startups

This post was first published on Citymart in March 2018 by Shaun Abrahamson, Managing Partner for Urban Us.

Lots of government officials want to work with startups. Lots of startup founders want to work with local governments. But very few venture capitalists want to fund startups 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.

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 analyze. 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’s the number of bookings. For companies selling to businesses or local government, traction is viewed in terms of sales: how many customers are there, and how much are they 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.

Slow death by request for proposal: The startup has chosen to participate in the RFP process. They generally know what’s coming. Investors will ask why they have so few customers. Then they’ll tell them to come back when they have more traction. Then the startup 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!

Illusion of progress by discretionary spend: The startup 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? They’ve seen similar companies selling to businesses (B2B) which were able to charge more. At some point, if you aren’t charging enough, the business economics aren’t going to work very well, at least compared to B2B opportunities.

We’ve seen a few companies triumph in both scenarios. Many fail. But that’s not 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 startup 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 startup 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 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 penalized by procurement!

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

Shaun is a member of the Urban Us investment committee, and he leads investment selection and communications with portfolio companies, members of the Network, and limited partners in Fund II. Before founding Fund I, Shaun was an active angel investor, investing in more than 20 firms between 2007 and 2013 in his personal capacity. Shaun has an MSc from MIT; an MBA from the Berlin School of Creative Leadership; and a BSc from the University of Cape Town. Disclosure: Urban Us is an investor in Citymart.

This post is part of Citymart’s guest blog series. Citymart has invited partners to share perspectives on problem-solving, innovation, and procurement in cities. This post does not represent an endorsement by either party.