Startups should be a good deal
Startups are a good deal. Just under certain circumstances. And for certain investors. And at certain periods of times.
These conditions are most often missed by smaller, non-institutional investors. The low amount of research, and working with estimated and incomplete data (often provided by the startup itself), leads to unsuccessful investments.
Institutional investors aren’t exempt from startup investment mistakes. A (deliberate or honest) misunderstanding of the business model of a startup, and its worth can go on far longer than expected. Along with it, more funds getting poured into the startup.
Why some parties frequently end up with a bad outcome when investing into a startup? Is it possible to eliminate riskier startups out of a list of possible investments in an easier way?
Startups have been controversial since…
…their very beginning. It’s possible to trace the beginnings of startups (businesses whose main goal is growth and disruption, funded mainly through venture capital) to late 1970s. The model hasn’t changed since: quick growth and astronomic returns are (should) be delivered for funding given without as many questions as banks ask.
The “should” is important. Many factors, mainly wrong goals, bad and toxic company culture, and founders which haven’t worked in the industry on the analyst/developer level, lead many startups to doom. Along with it, the funding put in by investors. The missed opportunities from the unsuccessful investment shouldn’t be forgotten. Thus, creating many unsuccessful investors.
A startup requires a founder which delegates less tasks to her/his subordinates than in a traditional business. When almost every decision is critical, it is only natural that the captain of the ship should steer it.
However, the praise of this strategy shows a very obvious survivorship bias. Startups with good products tend to have more hands-on founders, but almost all failed startups have had bad management as a problem.
After all, many blame a bad product to market fit for the failure of many startups. But does the bad fit more often come from ignored comments made by non-management workers, or from the vision of the founders?
It’s not that the inexperience, vague or overtly specific goals, or company culture is the problem. This is the reality of many businesses. The promotion of quick growth above every other goal is the real problem.
When many investors view an investment into a startup as a way to quick wealth, more pressure is put on the startup to grow quickly. Also, then startup investing attracts more people which prioritize potential over the real value. It exacerbates every other negative outcome associated with startups.
Quick growth requires quick thinking, quick decisions, and above all, quick funding. For individuals, better hindsight often leads to a better evaluation of the smaller, less important decisions. Eating one type of breakfast can be small decision, but with hindsight, a direct tie to certain health outcomes.
For startups, quick thinking and quick decisions facilitate the fast tempo of growth that startups have to chase. Yet, with quick thinking, the people working on the startup become more likely to rely on heuristics, stereotypes, and bad interpretations rather than analysis and rational evaluation.
Quick funding is the worry and goal of many founders. When cash flow is weak, a successful round can save the company from ruin.
With quick funding, conditions that may not at all be beneficial for the startup also may come. Changes to the model or the management can turn the startup into a company that is very much unlike its core.
Diving into startups as a beginner
When the potential bad outcomes of quick growth become obvious, many tend to forego investing into startups. Instead, to some, slower growth but less risky investments are the best choice.
For those who still choose to invest into startups, it is important to remember the mistakes many beginners tend to make. Here are 5 of them:
1.The successful founder(s) fallacy. This fallacy often clouds the judgement even of experienced startup investors, and is all the more common with beginners.
A successful founder or founders, previously having worked in a different or a bit similar industry, now launch a startup in a new industry. The phrase “past performance doesn’t imply future returns” is the key here. The past performance of the founder has some, but still limited impact on the success of their new startup.
2. Good design, unneeded product. This one is harder to detect. And to separate the emotions the invoked by the design of the product, and the actual product.
When good web design started meaning a very particular type of website and app (thin lines, minimalistic design, easy flows), the websites with simpler design started being viewed as unprofessional, or promoting a worse product.
If two startups are put up for a comparison, what percentage of beginner investors will separate the design of the product or the website, from its demand in the real world?
3. Low competition is there for a reason. Many startups highlight low competition as an advantage to investors.
It sounds good on the surface. After all, lower competition should equal a higher probability to succeed, and to deliver profits to investors.
Yet, how often does it happen that a profitable niche goes unexploited for long, and a new startup (out of all others) manages to strike gold? Not often, and often there’s a reason why not many companies are competing in a particular niche.
Many also don’t see that perceived low competition doesn’t equal actual low competition. Just because there aren’t many competitors in a particular niche, it doesn’t mean that other industry players also aren’t competitors.
4. The presence of venture capital doesn’t always lead to good long-term returns. In venture funding, the earlier investors are the winners. It often doesn’t matter that a company fails to take off – just that its value increases.
Beginner investors should be wary of putting weight on the presence of venture capital, when choosing startups for investing.
5. Market growth doesn’t equal company growth. This has been the case mostly with startups in emerging regions, and startups in completely new industries. Market growth can benefit startups, but it rarely will be the direct cause of their success.
The role of funding
Startups exist from one round of funding to another. It wouldn’t be false to say that there are startups which chase funding far more seriously than they chase revenue or new consumers.
Hence, it can be useful to put away the pitch deck and instead to try out the product or service.
Startups are also chasing the funding of famous investors or institutions. The investment made by a famous VC “X” or “Y” is beginning to be viewed as some badge of honour. This helps to attract, other, subsequent investors.
Investments made by famous investors are good for the startups. For other investors, not always.
Instead of examining each investor and their decisions to invest, many smaller investors think emotionally and go with the crowd. It’s important to remember that even the big players will make mistakes from time to time.
The other key thing to remember when investing into startups is that, according to US law, and in some other countries, stockholders are the last be paid in the case of a company’s bankruptcy. Even employees and suppliers are prioritized more than the stockholders. This is an added disadvantage of investing into a startup.
The good news is that secured creditors (those who lend based on collaterals), are the first in line to be paid of a case of a bankruptcy in the US. For non-institutional investors with large enough sums to invest, some startups could agree to take on a secured creditor.
For risk-averse investors that are looking to invest into startups, choosing to invest through loans instead of equity could be a smart choice. Even in the worst case scenario, they should be the first in line for any left-over assets. That is, if any assets are left at all.
Employees vs. investors
Employees in startups are often in a better position compared to employees in other companies, because of the ability to acquire equity through work. Stock compensation is becoming more common, but still is a fairly rare way of compensation for work.
Every benefit comes from some disadvantage. Stock compensation sounds great, until the work according to high demands of investors has to be delivered.
The growth required to be achieved by the investors for not pulling out or investing more, often is beyond the abilities of employees. This may be due to skills to compensation ratio, or a small team tasked with delivering output better suited to a large one.
Many workers with lower amounts of capital free to invest, look into startups as a way to invest through work. This can be a good choice in startups with reasonable founders, and a product already in high demand.
In other startups, this could mean working beyond your own or your team’s capabilities, and receiving nothing in the end. It only takes large investors to pull out or vital round of funding to be unsuccessful.
Investors looking to make not only profitable, but also ethical investments, should investigate each startup thoroughly. Employees in startups are often treated less than ethically, and are often given fake promises, and too much work for too little compensation.
Reading employee reviews, or talking with non-management employees which have left, can be good. It can help to clarify doubts whether a startup is operating according to the investor’s ethical standards.
If the startup is engaging in unethical behaviour, choosing to not invest, can lead to a prevention of losses which unethical behaviour often brings.
Because of the get-rich-quick atmosphere surrounding startups, they have started to attract individuals who may not be fit to lead businesses, or a fast growth businesses in particular. These individuals may be able to impress investors, and successfully “sell” the startup to them.
Yet, many of these managers and founders are good sales people, but bad leaders. And bad leaders create bad work environments, pushing out top performers, and often leading businesses to ruin.
Researching the management of a startup and their leadership should be as important as making sense of the model of the business.
Startups do matter
It is easy to become pessimistic about startups and investing into them. As with any investment, there are a lot of potential roadblocks that can destroy the startup. Or, those that will be overlooked by the investors.
In a highly competitive environment, some will take all, and others will be left with nothing.
Investing into startups is an indirect engagement in this competition. How successful it will be, rests almost entirely on the quality of research and rationality of the decision making of the investor.
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Disclaimer: the article should not be taken as investment advice. Statements made in the article are only the personal opinion of the author. Only the investor is responsible for the losses or profits they incur.