The hot-swap startup
[Credit where due: this is James Cham’s spark. I’m just the typist.]
There’s a new and important kind of startup that’s become wildly successful the last few years. These startups f̶o̶r̶ ̶w̶h̶i̶c̶h̶ ̶w̶e̶ ̶s̶t̶i̶l̶l̶ ̶l̶a̶c̶k̶ ̶a̶ ̶g̶o̶o̶d̶ ̶n̶a̶m̶e̶ look to their customers like a direct replacement to some large, familiar incumbent, but use technology to provide a strictly superior offering.
We call them hot-swap startups, as in “replacing part of a system while it’s still running.”
Examples of hot-swap startups: Compass (a real estate broker), Flexport (a freight forwarder), Doma (a real estate title company), Newfront (an insurance brokerage), Campuswire (a soon-to-come community college), AtoB (trucking payments), Clover Health (a Medicare provider), Periscope and Modern Empathy (home builders), Deep Sentinel (home security), etc.
What makes these startups different? Like the more general “full-stack” startup, hot-swap startups don’t sell software — they sell some product or service that their customers are used to buying. That said, many full-stack startups force their customers to adapt to some new way of doing things (think Warby Parker before they had stores or even Tesla).
A hot-swap startup:
> Competes directly with a valuable incumbent in an industry
> Offers a “strictly superior” product to the incumbent’s (i.e., it is at least as good on every important dimension to the customer and better at least at one very important dimension) — the main reason for customers not to buy from them is fear that a startup might not deliver
> Avoids asking its customers to change their behaviors much, if at all (e.g., doesn’t ask customers to switch to buying in a new way or taking a new risk in exchange for some other advantage)
> Enjoys advantages that would be impossible without technology, but where technology alone is insufficient to deliver the advantage — these startups have to refactor the entire way an incumbent in that industry would operate.
Isn’t this just another “full-stack” startup? Yes, hot-swap startups are all “full-stack” in that they own more of the stack of delivering their service than just software. That said, most full-stack startups still require their customers to “trade” some advantage for other disadvantages (again, with Warby Parker — before they had stores — you had to wait to try on the frames at home, but you got a better price and a modern experience). The same is true with Uber (can’t just hail one on the street), Netflix’s original DVD service (wait for the envelope to arrive), Airbnb (no room service), etc. So a hot-swap startup is a special kind of full-stack startup.
Why not just sell software? If you can, great! Companies like Microsoft, Google, Salesforce, and Facebook have done just fine! There are many industries, though, where selling software seems to be insufficient — usually because customers have to adopt so many changes to use this software, that it’s difficult to make much headway. (Note that Google and Facebook’s customers are, in the main, advertisers, whose businesses have had to adapt to technological change much more frequently than many other industries.)
How is building a hot-swap startup different from any other kind of startup?
It’s better in a few ways:
> There’s zero product-market fit risk! You know that your service is wanted by the market.
> There’s no market size discovery risk! The demand is already present and enormous.
> Hot-swap startups often enjoy better unit economics than their competitors — so get valued more richly, though no “tech magic” is required to value them.
> They can often scale to much greater sizes than their competitors — because managing businesses with paper, manual processes (even automated versions of those old processes) often has a natural limit to scale.
> You can grow hot-swap startups in many more ways than a traditional tech startup — namely, it’s easier to grow with M&A, because you can acquire incumbents and roll them up.
It’s also harder, because:
> Managing the many kinds of talent you need is hard. It’s easier if you mostly have software-building people and salespeople.
> Execution has a higher bar to get to parity with incumbents on many aspects of your service on which customers depend. It’s harder to focus on the few aspects of your service that matter.
> Many early VC’s will try to convince you to go a more traditional tech route (we’ve heard of companies trying to become hot-swap startups by competing with incumbents, only to have their VCs insist they sell software to those same incumbents… and then fail). That said, growth-stage investors often love them a hot-swap startup.
And then it’s just… different:
> The founders who start hot-swap businesses are often cut from a different cloth. They avoid tech Twitter, have never launched anything on Product Hunt, are less likely to apply to YC, and wouldn’t get the jokes on Silicon Valley. This hot-swap startup is often their second or third company.
> These founders often need to shape the company’s story carefully, to “get a tech multiple,” so it helps to be good at communications.
> These businesses often attract a different kind of software engineer, too. People who are more focused on the real-world effect of the technology build than solving the most technically-advanced problems. Craftspeople as opposed to scientists.
Of course in fundamental ways hot-swap startups are the same as any other startup:
> These startups only build or own what they must build or own… they might even rely on their later-competitors to deliver their service.
> These startups use software wherever possible. They often turn even emailing a human being at a partner into a software-driven, API-callable event.
Why are hot-swap startups emerging now? As software continues to get easier to build, founders introduce it into more places — and industries that have resisted technological change become more susceptible to the tools tech founders use to shape them. (There are also industries where a software-first approach has already worked — e.g., Zillow — and so this kind of startup is the best opportunity left — e.g., Compass.) More founders are building the confidence to “schlep” through these kinds of businesses.
What are some industries where one could create a hot-swap startup now? Literally every enormous industry in the world has multiple opportunities: Real estate (including development, construction, management, and plenty of other categories). Healthcare. Education. Logistics. Financial services.
How do you build this kind of startup? Sometimes you just start offering the service — Flexport did that — and introduce technology until you have a tech-on-the-inside system; other times you start by building the technology and later wrap the rest of the stack around it to offer a more comprehensive service — Cobalt Robotics is doing that.
We’d like to invest in more hot-swap startups. If you know one, using technology to bring to life an entirely new way of serving customers — without asking those customers to take a chance on an entirely new way of working — please send them our way!
Note: Bloomberg Beta is already an investor in many but not all of the startups we mention in this post.
Thank you to Anshu Sharma for naming this kind of startup; to our partner Karin Klein, my friend Jason Morton, founders we’ve backed — Elizabeth Slavitt, Tade Oyerinde, Amjad Masad, Gordon Wintrob, Zack Kanter, Will Beecher, Travis Deyle, and Jim Greer — and Lan Xuezhao for thoughts on this post. (And in some cases, for building this kind of startup!)
