Will the Real Entrepreneur
Please Stand Up?

Until recently, Web companies could raise large sums from initial public offerings by substituting vision for lack of profits. This widely accepted practice, while sensible in some cases, inadvertedly eliminated an important winnowing process. After reaching a peak of 2415 in March, the Bloomberg IPO Index, which measures the performance of stocks during their first publicly traded year, lost 75% of its value -- or about $600 billion -- in the last five months. Naturally, this index is heavy with Internet issues and "visionary" CEOs.

While many Internet outfits remain solid investments and stocks rise and fall for many reasons, too often exuberant investors fundamentally misunderstand what an entrepreneur is and what he does. Most entrepreneurs aren't revolutionaries -- at least not intentionally. They are savvy dealmakers who see opportunities and rush to fill them. Most don't start out with a revolutionary blueprint; they simply seize small and often fleeting opportunities. After they have accumulated some cash, won credibility, and gained new insights into their niche, a few of the determined and lucky ones expand and build sizeable businesses. These entrepreneurs, whose strategies and capabilities have been formed in actual markets and have actual profits, represent a far better bet for investors than visionaries with "high concept" business plans.

Still, many cling to the romantic belief that entrepreneurs are visionaries or revolutionaries -- talk partly encouraged by the public-relations shops of Silicon Valley and London investment houses. Research shows that the entrepreneurial reality is more mundane. Most successful businesses start out as "me-too ideas" or incremental innovations; their founders rarely have exceptional foresight.

When Microsoft founders Paul Allen and Bill Gates were developing the Basic programming language for the first personal computer, the Altair in 1975, so were a score of competitors. Mr. Allen and Mr. Gates had only one "innovation" -- they were the first to persuade MITS, the maker of the Altair, to sign a licensing agreement. They went on to develop programs for Apple in 1977. When IBM was looking for software for its PC launch in 1980, Microsoft was a small -- about $5 million in revenues -- but credible vendor. And the rest is history.

Most successful entrepreneurs fit the Gates model -- conventional wisdom aside. Richard Branson's first step towards building the Virgin Empire was the 1967 launch of the magazine, Student. This was followed by a mail order record business, a record shop and, in 1973, a music-publishing business, Virgin Records. In 1981, Narayana Murthy and six colleagues launched Infosys Technologies, now India's leading software firm. In the early years, Infosys earned its revenues through contract programming for U.S clients -- precisely the same activity most of the founders had been engaged in as employees of another firm.

Indeed, most entrepreneurs seem to have more in common with Mr. Branson and Mr. Murthy than they do with the dot-com wonder kids. Two research assistants and I interviewed the founders of 100 companies from Inc. magazine's list of the 500 fastest-growing private companies in America. These companies typify successful startups: The an average of 100 employees and sales growth of 1,800% over five years, financed thorough cash flow, not external investment.

A majority started out imitating an idea from a previous job. Any innovation was incremental or easily replicated -- too obvious to qualify for a patent and too visible to be a trade secret. Only 6% even claimed to have started with a "unique product or service." Almost 60% said that identical or very close substitutes were available and the rest indicated slight to moderate differences between their offerings and their competitors.

Unlike the dot-coms that raised tens of millions by promising to change their industries, startups based on undistinguished concepts often cannot raise much outside funding: Dell Computer and Microsoft were started without any capital, Hewlett-Packard with $500, and Infosys with $1,000. One-quarter of the Inc. companies I studied started with less than $5,000. Some 79% started with less than $50,000.

Many get started like Compu-Link did. Steve Shevlin and Robert Wilken launched Compu-Link in the early 1980s. They had a simple idea: They bought large rolls of the cable that connects printers to PCs, cut them and sold them to computer stores. The idea wasn't even original. Mr. Shevlin knew his previous employer was enjoying a gross margin of 90%. Compu-Link founders knew that they could buy cable for $3 and sell it for $16. This was much less than the competition was charging, but still a thick profit. Over the next five years, Compu-Link morphed into a manufacturer and installer of computer cables and networks with 95 employees and $3.6 million in revenues.

Importantly, most successful entrepreneurs start in unstable markets. Only one entrepreneur in my sample of 100 started a business (in brake remanufacturing) connected with the automotive-service sector. Even in a new or changing market, it takes sustained effort to turn an improvised startup into a solid business. Hasso Plattner and four other engineers started Germany's SAP in 1972, but the company did not become a major player until it developed a client-server system and attacked the U.S. market in the early 1990s.

Most of those visionaries you've read about start in mature markets, where the weaker technologies and firms have already been shaken out and obvious innovations have been implemented. To prosper there is much harder--it requires breakthrough innovations and staying power to educate customers and wrest business from entrenched rivals. This is why e-tailers -- CDNow, Toysmart and Peapod -- have been closed or sold.

Josef Schumpeter, the patron saint of the new economy, conjured up an entrepreneur whose radical new ideas unleash "gales of creative destruction." Sometimes. But the better bet for the investor is on canny entrepreneurs who focus on profitable growth rather than path-breaking innovations.

-- From The Wall Street Journal Europe