I love startups and I strongly believe that they are here to change the world. The best technology companies in the world were startups at some time. The founders strongly believe that they are making the world a better place, and investors and consumers valued it.
With the cost of starting a company declining, more and more aspiring entrepreneurs are starting their own companies. While this has fostered innovation in different areas, many people are creating startups for the sake of creating startups. Though passionate, they lack the grit and determination to keep the company running. Fling is a recent example.
This post, however, dives into the economics of the congested startup scene. The matriculation rate for startups from Seed to Series A has always been low, given that early stage investing is extremely risky. This number, however, has drastically fallen over the years as evidenced by the graph below.
Regulation: Protecting Investors
With many companies failing at Seed stage, retail investors are unable to extract the same/similar value as experienced venture capitalists. I’m a huge proponent of Title III of the JOBS Acts, but I know that there is a definite need to improve the private fundraising process from the public.
Experienced VCs are quick to reject impassionate founders, but many inexperienced and public investors are often duped to investing millions of their dollars with no return. And as Equity Crowdfunding (EC) becomes popular, this problem has become heightened with fraudulent startups.
One way to go about this process is through a rigorous background check by EC platforms on which companies they share on their website. Though the investor should act with caution, EC platforms have a duty to build upon the existing regulatory requirements and reduce the risk to its investor base. There are due-diligence consultancies that are focused on transparency and compliance in the online fundraising space. CrowdCheck, for example, performs a rigorous valuation on the company to evaluate whether it is legitimate. These services should be more heavily used by crowdfunding platforms as well as active investors.
Another solution to go about this is to provide support to portfolio companies that fundraise on their platform. This is one of the biggest selling points for top-tier VC firms as they provide deep industry experience and partnership to their fellow founders, giving them a better chance at succeeding. Building their portfolio support model will not only reduce the risk of failure, but it is also an attractive feature for founders and investors alike. EC companies can benefit from increased deal flow.
Economies of scale vs Innovation at Scale
With so many startups competing in the same market, it has become extremely difficult for any one company to stand out and dominate the market. Apart from reduced startup costs, increased VC competition has fueled the many startups in exciting fields. As VC funding increases rapidly, many more companies have the potential to break into the industry.
While increased competition between companies leads to increased innovation, no particular companies will hold a significant market share. This limits the cost advantage that companies can achieve through economies of scale.
Prices will obviously decline as technology becomes cheaper, but it is difficult to see it happen because of increased economies of scale. Therefore, the price will fall at a slower rate. Companies will be incentivized by increased competition, but only be successful in providing cheaper products if the technology of producing them itself reduces. It would be difficult to see another IBM in the near future. Cost advantages would slowly disappear and product differentiation would be the key driver for a company’s growth. There would be smaller companies targeting specific demographics.
Delay to Market
Founders who usually try to build a company have demonstrated valuable skills for any company. The spend years trying to “beat the odds” and deliver a successful company. This time can be spent working at a well-established and innovative company that is willing to incorporate new ideas. These companies have capital and capability to deliver the same results that the startup intended upon, and with a higher success rate.
I do believe, that is one of the reasons why the M&A space has become more active than the IPO market. Founders are unable to build a successful business and end up selling their company to a Fortune 500. The founders would then end up managing the same group of people but under a well-known brand and capital. Therefore, a great idea that should have taken 2 years to come to the market has now taken 5 years. This reduces the benefit that consumers can realize.
Furthermore, the company’s product may not be revolutionary anymore. Timing is crucial for startups and products.
“At Netscape, we went public when we were fifteen months old. Had we started six months later, we would have been late to a market with thirty-seven other browser companies” – Ben Horowitz, The Hard Things about Hard Things
With many small players in the industry, no particular company has enough R&D capital to foster innovation at scale within the company.This stumps product development and the market relies on new ideas to come from outside the industry.
For example, the lending marketplace is burgeoning with exciting FinTech startups. Companies like Earnest, Prosper, Upstart, etc. are revolutionizing the way consumers take out loans. No particular company, however, has a fully-developed and extremely viable product. Earnest has built a revolutionary precision-pricing technology for its consumers, whereas Prosper has enabled P2P lending for cheaper loans. If these two products are combined, they would deliver an immense value to the consumers., but neither company has the capital to invest in R&D to capture this need. Growth is slower than what startups should be experiencing (think Facebook or Google)
Therefore, the reliance on VCs and PE firms increases as companies with demonstrated market value and profitability need funding to feed their R&D goals. This reduces the self-sufficiency of these companies and investments take longer to realize.
Financial Loss for Employers and Employees
Employees at startups trade salary for equity with the hope of increased returns when the company goes public or is sold. These employees are extremely smart and talented. They have taken a considerable risk by joining a startup that offers little to no money. And when the startups fail, they are left with pretty much nothing. They end up taking the crappy jobs to pay rent.
Finding another job is difficult because people attribute capability to success.
“You get more credit than you deserve for being part of a successful company, and less credit than you deserve for being part of an unsuccessful company.” – Andy Rachleff, Executive Chairman at Wealthfront
Founders believe that they are extremely talented and starting their own company is the best way to maximize financial returns. This, however, is not entirely true as employees at Facebook/Google make far money than Silicon Valley entrepreneurs. In the end, incredibly smart people are the ones who are at the bottom of the pyramid.
Realization of investment value for investors
Another significant challenge to too many startups is that often no one company is able to capture enough market share to be profitable. “Me Too!” attitude of founders before they jump to build their company has resulted in more startups than what the market can handle.
VC competition fuels startup competition as multiple startups with similar business models get funded. No company is able to grow to a stage where it becomes profitable because of high competition. Valuation suffers and investors are unable to realize their investments. And LPs lower their interest in VC funds, depressing growth opportunities for really amazing companies.
As I mentioned at the start of this post, startups are a wonderful thing but too much of anything is harmful. Founders need to honestly evaluate their options before starting a company. They need to understand the pragmatic trajectory of their company and not be drawn by the startup mirage as the reality is often quite different.
This is a controversial topic and everyone has their opinion on it. I’d love to hear yours!