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Start-ups are infamous for extremely low success rates. Most new businesses are nonexistent after 5 years of their creation. This begs the question, who are the private investors and companies that support these businesses, and why would anybody take such risks?
"Venture capital has done much more, I think, to improve efficiency than anything." - Kenneth Arrow
The reason why risky start-ups are getting funded is simple: the higher the risk, the bigger the reward. Although a start-up goes through several stages to become a business, the risk and reward ratio varies from stage to stage.
Every start-up begins with an idea. At the very beginning stage, investment capital may come from the start-up founders, family, and friends. This is known as FF&F. At this stage, the decision-making is influenced by biased opinions about the business model. The fact that FF&Fs are not professional investors and are not used to evaluating chances of success, makes the future of the start-up very uncertain.
By stage 2, the start-up should already have a product, or some kind of working model and should be able to claim the first revenue. Entrepreneurs usually make two kinds of mistakes when it comes to product offerings.
It’s obvious why selling an unfinished product is a mistake. Customers are not going to line up to buy a bicycle that has no wheels. The product needs to be ready to an extent that meets the customer’s expectations.
The second mistake is spending too much time and energy on R&D. Many entrepreneurs burn through cash and become bankrupt before the product even sees the light of day. Funds are like oxygen to businesses. Especially newborn baby businesses require a revenue stream. It's ok to start selling a product even when it’s not fully finished. For instance, Tesla sells Beta versions of its fully self-driving autopilot and uses revenue for R&D.
At this stage, the company has already acquired vital experience. The business plan is solid and the business strategy is focused on gaining momentum. The company is receiving revenues from sales, but the company has not reached the profitability level yet.
At stage 3 venture capitalists, or VCs for short, join the game. Venture capital funds seek start-ups or small companies with exponential growth potential. These companies are characterized by very high risk and very high reward potential.
Venture capital funds turn small businesses into larger ones and profit from selling them. The best case scenario for a venture capitalist is to take a business to the “initial public offering” (IPO) stage. Historically, IPOs offer the highest possible returns. Moreover, venture capitalists can profit from mergers and private acquisitions.
Venture capital is often mistaken for private equity funds. Both are very similar in terms of how they make money, but there are key differences in how they operate.
Both firms help businesses grow and profit from selling them, but they choose different types of businesses and invest different amounts of percentages of their portfolio in each.
"The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined." - Peter Thiel
Venture capitalists choose high-risk companies and spread risks by providing funds to many start-ups/small businesses. Private equity firms choose already established companies and focus their energy and resources on growing them. As mentioned before, risks and rewards are two sides of the same coin. Already established companies come with lower risks of completely going bankrupt, whereas most start-ups tend to lose everything within a few years.
It’s very difficult to get into a start-up at a very early stage unless you're a founder, family member, or a friend of someone that is set on becoming an entrepreneur.
As mentioned above, the earliest stage is the riskiest. The business model might be attractive, but the execution is the key. Successful entrepreneurs don’t make the right decisions, they make their decisions right. No matter how good the idea is, without the proper execution, it’s just an idea.
There have been instances throughout history where visionary entrepreneurs have turned bad ideas into great businesses. The first crazy entrepreneur that comes to mind is Elon Musk. How does starting a private rocket company with a goal to help colonize Mars sound? Crazy, right? Would you fund your friend to colonize Jupiter’s moon? Yet, whenever Musk comes up with another la-la land idea, everyone seems to be throwing money at him. The man behind the project is the key to success.
The second stage remains very risky for investors as the product is in the early development stages. Most investors do not even consider investing in a company that has not made any sales yet.
However, this is the cheapest point at which to become a part of the company and make the biggest impact on its development.
When deciding whether to invest in a start-up or not, there are numerous factors to take into consideration.
You can trust your funds to VC managers, and they’ll invest the money for you. Venture capital funds get interested in start-ups with solid business plans and when the first revenues appear. The fund managers are very careful about selecting the right investment opportunities. As a result, many small businesses and start-ups remain unfunded.
You might be wondering if the start-up has revenues, why would it seek external funding? Well, there are two potential scenarios.
Furthermore, small businesses and start-ups are seeking to diversify their risks. By selling the ownership of the company, they get partners and supporters.
On the downside, new owners can negatively affect the company’s decision-making process. The most famous case where the board decisions damaged the company is when the format CEO of Apple, Steve Jobs, was fired.
As mentioned before, funding new businesses carry a high likelihood of losing money. Investors use different strategies to reduce the risks. The things that we have already discussed can help you make better decisions when thinking about investing in start-ups.
It’s worth mentioning that some modern venture capital companies have a bad influence on consumer products. Their main motivation is to increase profits and care very little about research and development.
From the very beginning, many venture capitalists focus their resources on growth and marketing. This large customer base translates into an inflated company price.
But what happens when the company goes public and artificial following does not generate dividends? The stock price drops and investors lose money.
There’s a conflict of interest between start-up founders and venture capital investors. The initial founders (assuming they want to keep a stake in the company) are hoping that the company will be successful in the long run. The venture capitalists are willing to make the firm look more successful than it actually is to sell it advantageously.
Too much focus on expansion can cause the company to lose its reputation and in turn, this will help competitors take its place by providing better quality products.
Another great risk comes from selecting the team behind the start-up. At the initial stage, creative minds and liberal types tend to do better at generating ideas and coming up with strategies. Conservative thinkers are better at managing businesses. Creating a business requires very active, out-of-the-box thinkers. Moreover, staff might experience burnout as there’s a ton of work to be done during the beginning stages.
In general, 9 out of 10 new companies go bankrupt in 5 years. This means that for every 10 investments made by venture capitalists, one should generate more than 10 times the rewards. The difficult part is choosing a business model that can create exponential growth annually.
Historically disruptive technologies offer great investment opportunities for exponential growth. Disruptive products completely replace or limit widely consumed products. For instance, smartphones have replaced maps, digital cameras, and many more devices in today’s world. Smartphone manufacturers have increased their values exponentially. Disruptive products are characterized by the S curve on the adoption charts. Usually, high adoption is linked to high profitability, therefore, investors are trying to find disruptive businesses at an early stage.
Some more examples of disruptive products are:
"No growth hack, brilliant marketing idea, or sales team can save you long-term if you don't have a sufficiently good product."
– Sam Altman
You may have solid reasons for investing in a certain start-up, but keep in mind that there are other available options as well.
It’s very risky. 9 out of 10 start-ups go out of business within 5 years. On the other hand, the potential for high rewards is great. To decrease risk exposure, investors lay eggs in many different baskets.
Entrusting your money to a start-up is not an easy decision. You should take into account the business model, founders’ abilities, the potential for exponential growth, competitors, product, and many other factors.
You can fund a start-up using your own judgment, or you can entrust your money to a venture capital fund and the managers will make the decisions for you. Either way, there are high risks associated with start-ups as well as high rewards, and you should make decisions with your eyes open. Remember, the early bird catches the worm.