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START-UP ... REALITY

Raising Capital is NOT a Measure of Success

Before the Tech Era, there was a set of rules … 

Before the tech era, nobody cared if you raised funds. Public companies generally don’t run around releasing PR statements about how they just got a bank loan. It wasn’t in any way considered a measure of success, it was (and probably still is) just a run of the mill task that most businesses go through. In the case of more than one owner / shareholder, generally it was a debt, or at the expense of existing shareholders though dilution. Neither of these things have a celebration-worthy effect unless you are teetering on the brink of failure.  Fundamentally, this hasn’t changed.

What has changed since the early stage tech boom began is that raising funds is now used as a proxy for business valuation given the inability to use normal fundamentals for this purpose. Shareholders rejoice at being diluted because the theoretical value of their holding has increased. The shares aren’t liquid, so it’s theoretical. In reality, their % of the shares on issue has decreased. The shares are theoretically more valuable AND it’s true they own less of the shares on issue, but only one of these is objectively measurable in the absence of liquidity. It’s seems to have the hallmarks of cognitive dissonance. Investors may well be thinking “I’m getting richer” while simultaneously thinking, “I’m being robbed”.

Valuations are About Convincing the Next Investors of More Blue Sky

While private ‘normal’ companies are valued usually by a multiple of their profit, startups leverage the public markets valuation method. The difference is that in general public market company values are underpinned by EBITDA translated to a PE ratio. The market is unforgiving and values plummet if a company doesn’t perform. Startups often don’t have EBITDA as the cash-burn frequently is higher than the revenue … so the EBITDA is negative which doesn’t make for much of a PE value!

The startup news stream is largely about who raised what amount of money, and more rarely who sold what to who. These are used as ‘good news stories’ to perpetuate the system of valuing based on capital raising. Simple fundamental measures like profitability, EBITDA and PE seem fractionally important compared to raising funds. Except in the rare case of startups on public markets, the terms of exit deals are generally kept secret and therefore real PE ratios, ROI and other measures are often not known.

It’s a Secret!

As a simple example, recently there was a story about a successful exit where a small manufacturing company ‘sold the assets and kept the IP’. The assets of this company would appear to have been written down manufacturing equipment and some inventory. The IP appears to have have been considered worthless by the purchaser but they obviously considered it easier to buy the manufacturing equipment and inventory than start from scratch. This means that all the funds spent ‘building up the IP of the company’ (basically all the R&D) was worth nothing. There is no detail of the sale anywhere in the media. The acquisition is not mentioned anywhere by any other company.

As far as exits go, assuming the price was the inventory plus written down value of assets, this ‘exit’ would have most likely returned the shareholders absolutely nothing. We’ll never know, as the terms of the sale are not public however if there was any great story here it’d be shouted from the rooftops. The founders go onto their next venture heroes; the investors are left with nothing. The myth of success without profitability continues. This is not an unusual story. The terms of these deals are rarely fully disclosed.

Failures and Walking Dead 

Shareholders don’t like talking about their ‘fails’ / losses, so these stories go largely untold. In the end, these companies are founded with the intent of making the founders and shareholders rich, so the risks to some degree are known on both sides, however there’s probably naivety on both sides about the likelihood of success … see Numbers Game post.

There are also a large number of companies, based on conversations with members of prominent angel groups, that end up what is considered a ‘lifestyle business’. That is, makes a good living for the founder/s and maybe a few close friends /family, but will never give the angels any kind of return. This is one of the risks that angel investors need to consider. VCs kill these off eventually, but angel terms rarely seem to allow any radical intervention where a business goes into cruise mode early.

Risk Transfer

Many of these companies, even the big names social media companies, are sold on blue sky valuations so these traditional business measures don’t suit the purpose. There’s a huge amount of risk that gets transferred to public markets and retail investors. The market is dumb and greedy enough to take the risk on, and so the cycle goes on. For investors, as always, if you make money, good for you, but don’t be surprised if you don’t.

Comes with the Territory

There isn’t really another way to measure and value these companies which are pre-revenue or with PE values that are outside the general trade-sale or public market valuations. It’s a fact that if you want to scale into high barrier to entry (due to capital requirements) markets, you need a lot of money upfront. The difference with these companies is when they fail, a lot of the time they leave very little of value. If you build a new piece of software, the code will end up deleted from existence often already superseded by the the latest technical advancements.

It’s Just Capitalism

This post is obviously not an ethics assessment. It’s just the financial facts. The value of the contribution of these companies, the opportunity cost of this human and financial capital use, the moral issues around passing financial risk onto a less capable / educated / aware party, and the societal benefit of these companies are a separate issue.

For entrepreneurs, it’s more complex. Often there are other drivers than money. It’s absolutely necessary to celebrate ‘inputs’ rather than outputs or you end up with mental health issues as so many factors are outside control. This is an issue for another day …

It’s just the way it is … like it, play the game.

Don’t like it, do something else.

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