Start-Ups Need to Stop Prioritizing Investments Over Sales & Silicon Valley Needs to Stop Making Up Valuations

If you take a trip across the digital landscape, you will see self-proclaimed entrepreneurs cropping up left and right. Sprinkled across the infinite plots are solopreneurs, proudly self-declared unemployable. These iconoclasts are redefining what success means across entire markets—and not necessarily for the better.

As the story goes, confronted by a friction point, these enterprising men and women set out to fix—rather than complain about—their woes, sometimes disrupting entire markets in the process.

Technology is the Wild West of entrepreneurialism. Brave souls tell anyone who will listen about their bootstrapping and business prowess. Words like “innovate,” “disrupt,” and “digital transformation” are flung willy-nilly. The underlying belief animating this hubris is that technology is a panacea, and everyone—investors and customers—want in.

Well, that’s simply not the case.

Customers transform your product into a business. For all the opportunity seeking and bootstrapping, I see an equal lack of awareness. Creating a solution aimed at profitability and nothing else entirely misses the point of technology.

In my view, before even thinking about technology or solutions, customer discovery must be done in earnest. All tech solutions must solve an urgent and existent problem. The solution must address a real need.

The reason start-ups get around real solutions to legitimate problems is encapsulated by a single word: unicorn.

Unicorn start-ups valued at over $1bn without making any profit are sold to tech-hungry giants for a substantial profit, incentivizing a culture of tech gimmickry. For example, the Snapchat IPO valued the Firm at $24 Billion, despite losses of $515 Million last year. In fact, Snap itself said that it may never be profitable. That’s just strange!

Our love of technology clouded our business sense.

Mark Cuban, billionaire entrepreneur and Shark Tank investor, once said: “Sales cures all.” That’s because Sales are inherently customer-oriented and mission-driven. True, at one point sales were all about the bottom line. But that’s in the past. (Marketing, branding, and the Internet took care of that rub.) Yet, there are still start-ups that aspire to be acquired by tech behemoths without making any profit or innovating in the truest sense.

Nobody gets this more than Leon Emirali, a media entrepreneur, investor, and co-founder of marketing agency Crest.

In a recent article, he questioned those that apparently abandoned the core principles of business in preference of funding, increasingly clocking up losses with an unproven revenue model.

The marketing and media agency I co-founded likely made at least $1bn more profit than Uber last year. We also made $515m more than Snapchat and $450m more than Twitter. - Leon Emirali

It is dangerous to worship an unsustainable and unhealthy image of greatness. Tech start-ups that continuously prioritize investment over sales cause problems for themselves and the market culture.

Back in 2000 it was all about the stock market with hundreds of companies going IPO except for one major difference from today's investment frenzy. Back then all the hullabaloo was focused around public companies, so even if they turned out to be terrible, investors could still liquidate them, given they were public stocks. The blister today is made up of private investors (Angels, VCs, Equity Crowd Funding groups etc) that are pumping in insane amounts of cash into apps and small tech startups with zero revenues. One must not underestimate the importance of this key difference. 

According to the Angel Capital Association, the best available estimates are that about 300,000 people have made an angel investment in the last two years. That's a lot of gamble capital given that 52% of this investment will likely be entirely lost. Many more people could become angels based on a net worth of $1 million or more. The potential number of angel investors is 4 million. In fact, if we throw in the equity crowd funding groups that allow people to invest with just $5k, the potential universal set of US investors willing to play the tech startup roulette is massive. 

All these investments have zero liquidity if things go south. Zero. 

Everybody is chasing that proverbial Unicorn promising that exit or cash payout from Ops. The opportunity for startups with sub $25MM raises to go public and create any semblance of liquidity for their investors is non existent. 2000 was a market with collapsing valuations. Today the startups are a market of no liquidity. 

What is the stock of these companies really worth when there is actually no place to sell them? 

So why is Silicon Valley fabricating valuations out of thin air for companies like Snapchat and others that shouldn't be worth any more than say a globally recognized brand like Clorox? Here is what Bloomberg wrote some time back:

"Here's the secret to how Silicon Valley calculates the value of its hottest companies: The numbers are sort of made-up. For the most mature startups, investors agree to grant higher valuations, which help the companies with recruitment and building credibility, in exchange for guarantees that they'll get their money back first if the company goes public or sells. They can also negotiate to receive additional free shares if a subsequent round's valuation is less favorable"

I have personally invested in several startups over the years and maintain close ties with the investment community. Frankly, these high valuations do not matter either. Scratch any VC deeper and they'll tell you. Bloomberg did and got a response from Randy Komisar, a partner at one of the nation's top venture firms Kleiner Perkins Caufield & Byers.

"These big numbers almost don't matter. Those numbers are just a middling shot at a valuation, and then it's adjusted later" 

In other words valuations are really not an indication of what these companies are really worth as they can be adjusted later based on economic realities. Simply put the investors just made these big numbers up boasting big market shares of the markets they made up. In fact Bloomberg cites "other factors" making up a much higher proportion of the overall valuation number: factors such as "market share, growth projections, and a founder's ego" than the good old cash flow of the startup. 

In my experience of having been involved in scores of early stage investments, the industry not only ignores cash flow, it also tends to not worry too much about operating costs. So they come up with a valuation that ignores actual cash flow and operating costs. 

I am not finished yet. Let's not forget the founder itself who will add his or her own sense of what they think the startup is worth, taking into account its last valuation, the valuations of competitors, and, of course borrowing a leaf out of the real estate playbook, the valuation of the company's neighbor down the street.

VCs have hedged themselves from getting hurt by instituting downside protection in the event things don't exactly go per plan. Bloomberg:

"Buried in their corporate filings, startups tuck away all sorts of provisions that reward investors for accepting these mega-valuations. The practice is more regular and egregious in financing rounds for mature companies. Their capital requirements tend to be much larger, so they must turn to more sophisticated investment firms that demand these kinds of terms. Startups that are generous with these guarantees can garner much higher valuations. Each provision covers different ways to make sure new investors get paid back, even if disaster strikes, if an initial public offering gives the company a market cap far less than its private number, or, more commonly, if the startup has to raise money again at a lower valuation. One stipulation, called senior liquidation preference, ensures that a certain group gets its money back before anyone else, including employees. Another class, called downside protection or ratchets, automatically grants additional shares in the event of a declining valuation, removing a great deal of risk that the stake will ever lose value."

In the end the ones that get shafted are the employees because unlike the VCs, their stocks ("common stock") are based on a realistic evaluation of the company usually conducted by a professional third part auditor. 

For these reasons, many predict that we are overdue for another dot com bubble. Style-over-substance solutions are one of many warning signs of imminent burst. When it happens, I will try my hardest not to be the guy saying I told you so.

What are your thoughts on the current trend of glamorizing investment over sales and made up valuations?

This post was published on the now-closed HuffPost Contributor platform. Contributors control their own work and posted freely to our site. If you need to flag this entry as abusive, send us an email.
CONVERSATIONS