Start Up Economy.... Paradise under Threat

We live in exciting times as far as the startup economy is concerned. Incubators are popping up everywhere, venture capital funds are seemingly more active than ever, seed capital and business angels are everywhere these days. In a way, this came to be in the aftermath of the financial crisis, with renewed entrepreneurial incentives all around the world. Even if we look outside of the U.S., which has been "the" place to be if you're an entrepreneur, for a long, long time, things are changing dramatically. European countries are buzzing with entrepreneurial projects. Main cities around the continent have invested significant resources in boosting facilities and the so-called "soft infrastructure" (promotion events, workshops, pitch academies, networking with national business community, etc.) to support local startups. The European Union even went as far as recognizing just last week as "European Entrepreneurial Regions" for 2015 the cities of Lisbon, Valencia and the territory of the Northern Ireland. Particularly in Lisbon, the capital of my home country, the startup scene has indeed exploded in the last 3 years. Incubators are everywhere, non-profit support organizations have been working tirelessly, organizing events of all types, workshops, bringing investors and entrepreneurs together. Organizations like Beta-i, Startup Pirates rank among the most innovative and dynamic that I know, anywhere in the world, and they are good examples to follow. Even the government pitched in, with some tax-incentives for startups, in the middle of a financial assistance program, which wasn't entirely expected. Elsewhere, there are some "hotspots" of entrepreneurial activity in Latin America that are worth mentioning, like the very successful Startup Chile program and others that are popping up in Colombia, Brazil, among others. There's still a long way to go, though.

So, all is well in the "startup world", right? Well, not really.

Two major developments are concerning a lot of people around the world, myself included: the fact that startup valuations are seemingly going through the roof, with significant implications in the economy and the way that the startup culture is evolving. Let's take a closer look at these issues.

Startup valuations

Let's start with an example. You probably heard and read extensively about the recent acquisition of Whatsapp by Facebook, for a jaw-dropping deal of US$19 Bn in cash and stock options. As an experienced financial analyst, I have to say I was as surprised as you probably were. Simply put, there's no fundamental basis for that much of a valuation... or is there?

Whatsapp boasted 500 million users by April 2014. Ignoring the meager subscription fee of US$1 per year, the company really didn't have any other large sources of revenue that would value the company anywhere near the value Mr. Zuckerberg agreed for its acquisition. Still, the basis of any good valuation is the value of future cash-flows, plus other considerations, like synergies, strategic value, brand value, etc. So, what exactly does Whatsapp have going for it in this regard?

1. Its large user base hints at Facebook's intent to monetize it as soon as an elegant solution to achieve it arises. Mr. Zuckerberg announced that Whatsapp is on track to become the first 1 billion-user messaging app in the world. So, monetizing a large and growing user base is definitely going to become a reality. We don't know the exact strategy that Facebook is developing for the app and its users, but it's more than obvious that a large part of the valuation already takes that into account.
2. Strategically, Facebook acquired the largest and most relevant messaging app in the market, a company that could conceivably be acquired by its rivals or grow into a competitor by itself. By acquiring Whatsapp, the company assured its dominance of the instant messaging market, quite possibly for years to come, while mitigating any short or medium-term threat.
3. Whatsapp can possibly be seen as complementary and even evolutionary to Facebook's own core business, like Instagram was when it was acquired. There's real value here to be unlocked by integrating services, user bases and even the wealth of business intelligence data to be mined out of it.

There are more aspects to consider in this particular deal, but my point is this: even if people doubt the US$19 Bn price tag, there is real and very significant value in Whatsapp for Facebook. Whether it justifies such a big valuation, it remains to be seen, but at the very least, there are several billion dollars there of "tangible" value.

I brought this example up to show that these valuations are far from being an exact science. While there's value in tech companies like Whatsapp, Instagram and others, there are startups where I admit I have trouble finding a business case for investment (Yo! comes to mind), particularly in the tech scene.

There is significant amounts of money flowing through venture capital funds, without a doubt. Low interest rates, sluggish economy in the U.S. and Europe, perceived investment risks in emerging markets, among other factors are probably diverting funds to the "startup economy". Some economists and analysts have pointed out that a second dot-com bubble might be inflating, but it's really hard to be sure at this point. If I were to offer an advice to investors, it would be to focus on startups with real solutions to everyday problems, even the ones we don't know we have yet. The keywords here are product and solutions.

Startup culture

A possibly more pervasive issue is the recent evolution of the startup culture itself. The success stories are in the spotlight, there's more publicity and awareness than ever. Entrepreneurship is cool and entrepreneurs are rock stars.

In my experience, this is having a detrimental effect on the approach that would-be (and many established) entrepreneurs are taking in their projects and companies.

An example. I've had the opportunity to work with a relatively well-known startup a couple of years ago (which I won't name here for obvious reasons). This company developed a really cool SaaS solution for B2B and B2C clients of a specific industry. Their timing was perfect, they started being talked about a lot, getting a lot of attention from the specialized media and the industry insiders. At the time, my company was brought in to assist in their financing and expansion plans. After a successful first financing round, the company had investors and money to burn in expanding the business. The company was not profitable and was not having any relevant revenues. The product was cool, however, and generated a lot of excitement among those who came in contact with it. Two years passed, and this company hasn't significantly updated its product, it's still not profitable and it does not have any relevant revenues. The CEO and the co-founders have been "on tour" for this period of time, winning awards and accolades in several startup competitions, in several countries. They are heralded as one of the great and promising startups of the European startup scene.
Can they be truly successful in the near future? Most definitely. But the main focus of the company is publicity, being in the media as much as possible, possibly trying their best to be acquired by a large player in the industry. But while this is their focus, the product remains the same as two years ago (an eternity in the tech scene) and the company completely lacks a business model that works or that generates excitement in the people that actually can purchase the service.

Reading an article on entrepreneurship, a few days ago, I remembered this example quite clearly. In his remarks, a well-known serial entrepreneur of the tech scene in Portugal, remarked that he was now understanding what older businessmen kept telling him, that companies are created to be profitable and not to be on the news. He concluded that that is a lesson you learn as an entrepreneur, sooner or later, and I couldn't agree more with him.

One of the most worrisome trends, in my opinion, is the fact that this type of approach by entrepreneurs is being reinforced by some investors, who actively push companies and their founders to focus more on growing their user bases and not on selling, much less being profitable. While this is an approach that has a reason to be, not all companies can be Whatsapp or Instagram. Ignoring the fact that companies are meant to generate profits for its shareholders, as a general rule, will surely cause more failures than successes in the future. Sadly, market conditions are indeed reinforcing these approaches.

To conclude, it's not my point to discourage anyone from pursuing their entrepreneurial dreams, much to the contrary. I am, however, trying to make would-be entrepreneurs more aware of the difficulties, the many highs and lows and the winding roads that they'll have to navigate should they "jump in the water". Entrepreneurship is not for everyone.

All in all, I remain highly optimistic about the startup scene and I'm very encouraged to see Europe as a whole becoming much more active in it. There's a long way to go, particularly in terms of venture capital funding, but the course is set.