What are startups all about?
- 6 min read
(disclaimer: when I say “startup” in this article, I mean the Silicon Valley definition or, more precisely, Y Combinator definition of “a small, early stage company designed to grow fast (...) 50-100x growth in a year” I recognize this definition applies to a very narrow, specific kind of new businesses, and especially in Europe it’s not necessarily how things are done, but this is the phenomena I’m describing here. Also note that the “growth” in the above definition is ambiguous, but that’s sort of the point.)
Many people in tech look up to Silicon Valley startups, treating their practices and habits as some sort of recipe for success. It stems from fundamental lack of knowledge of how SV startups are run and for what purpose.
SV startups are not businesses. They’re financial instruments.
To be considered a unicorn, your company has to fulfil only one condition. Can you guess what it is? I’ll give you some time to think about it.
…
Is it a huge market share? Nope. Is it a large number of users/customers? Nope. Is it a sweet gigantic pile of revenue? Nope. Profit? Hell no.
The only condition that a company needs to fulfill to be considered a unicorn is that the next round of investors think the company is worth 100x more (give or take) than the previous round of investors. It has nothing to do with the business reality, it’s all down to how the investors feel.
You may think that investors are rational and they carefully look at all the financial numbers, analyze the market, and after many hours of thoughtful consideration they arrive at the valuation. That would seem like what rich money-people do. If you’re a techie without any business background, I would forgive you for believing that. But you cannot predict a future financial success of a company, not with high certainty. The younger the company, the lower the certainty. This leaves investors with heuristics, or as some of the famous ones admit freely - with gut-feel and hand-waving. Yes, the founder still needs to show some number go up. It has to be based on something at least somewhat related to our reality. That’s the “growth” that everyone talks about but no one can tell you precisely what aspect of the business is supposed to be growing. As long as the narrative is plausible and sounds exciting, investors will buy it. The investor’s job is not to ensure success, it is to make enough reasonable gambles so that one of them brings a big payout.
The biggest payout is not when the company is making healthy profit - that takes way too long to accrue. It is when the investors that come after you are willing to pay a lot more per share than you did. It may correlate with revenue, but doesn’t always correlate with profit. (Just for the sake of making it clear: profit = revenue minus cost, it’s what stays in the bank at the end of the day)
So the game you’re playing as a VC-fueled Silicon Valley startup founder is not to be profitable, or speaking more broadly, successful. It is convincing enough investors that you will be successful. It isn’t to actually make money, that’s a problem of tomorrow’s tomorrow. Right here, right now, the problem boils down to optics of being successful rather than actual success. In fact, moving towards sustainable profitability may tank your valuation, as the next batch of investors may perceive it as “playing it safe”. Safe is not how you win big.
There used to be an excellent article explaining this on a blog that’s now defunct (here’s a hopefully still active Reddit link instead), so let me summarize the main point. In nature, male peacock’s tail is detrimental to survival, yet it evolved as a signal to a potential mate: I am strong because I can survive despite sustaining this useless, costly tail! Startups work the same way - not by being the best businesses or having the best product, but by convincing the investors that they can succeed despite burning ridiculous amounts of cash. If you want to build a unicorn, you must be like a peacock. Which means a good SV startup founder cannot worry about profitability. Instead, they should be spending money on things that make them seem like the best, the biggest, the strongest player in the market. That’s very different than actually being the best, biggest, or strongest. And while it may seem like it’s easier, it isn’t. It’s just a different kind of difficult.
That’s why we hear a lot about those startups. They’re in the news, spending a lot of money on publicity. They do costly stunts. And since the main game is to convince others of their success, they managed to convince the whole tech industry that they’re doing things “the right way”. How else would they be so successful?
If the success of a business is defined by “how many people talk about you” or “if investors think you have a lot of potential”, then these companies are indeed very successful. But this has nothing to do with building a great product or being profitable, although a great product or profit may happen as a side effect. Usually it’s one or the other.
So why should we look at these companies as some sort of role model of how things should be done?
Now, I don’t think there’s anything wrong with playing the SV startup game. For founders it’s similar to playing in a casino - lots of fun, you lose time and money more often than you gain, but if you manage to win, you win big time. And like casinos, you have very little impact on the outcome at all. Though for investors, it’s a great way to put free money to some use (although in the current market, there’s way less free money to play with). It’s great when it works. But for every success story, there are a hundred failures. That’s part of the deal.
So let’s not fool ourselves that this is a good way to build a business or even to make great software products. Next time you want to emulate something a Silicon Valley unicorn did, remember - they do it for display, to convince the investors that they can succeed despite their lavish expenses. If that’s not your company’s goal, you’re setting yourself up for disappointment.