What’s wrong with the Startup Ecosystem? The Middle Path is the future

I must confess - a lot of the inspiration that I got to write this essay was because of Rand Fishkin (Founder of Moz & SparkToro ) & HubSpot . This video of theirs got me thinking.?

Is our ecosystem designed in a way that startups are bound to fail? (I said Startups, not founders).?

Back in 2015, fresh out of law school, I had written an article on “Million Dollar Questions Startups need to answer” - looking back at the crux of my essay - In 2024, it still holds good - In this essay, I question the fundamental nature of a “startup”.?

The goal of a business is always to be profitable and make money. With access to capital becoming easier than before - there is a shift in the way people think now. Instead of taking out loans from banks entrepreneurs prefer getting venture capital to invest funds into the company for a multitude of reasons. From the outside, raising capital from VCs has become sexy. The pros outweigh the cons if you’re VC-backed.?

A company with no revenue - is of no value. But when you are funded by a Venture Capitalist - early on in your startup journey - your company has a valuation tag attached to it. This becomes the benchmark for further fundraises or anything that may happen thereafter (of course, things can go south as well and valuations can fall).?

Going to the fundamentals of why someone starts a company. It would revolve around the following:?

• To make profits or
• To get acquired or
• To go IPO?

Sure, it can be all three. A natural progression you might think. But when startups go the VC route - the expectations that are set are completely different from how you’d run a bootstrapped business. Startups need to be synonymous with ‘High-Growth’. High Growth means it needs to be worth a billion dollars or at least a few hundred million dollars. But why? For this - One needs to look at Venture Capital as an asset class. Just like direct equity, mutual funds and PMSs (Portfolio Management System) - Venture capital is an asset class. The return VCs need to deliver to their investors needs to be significant enough that it beats traditional forms of investments by a substantial margin. Therefore for a VC to invest in a company that grows 10-20% YoY does not fit the bill.

As a VC-backed startup, you are expected to “Grow at any costs” - You operate from a fashion that puts you in a position that gives you maximum growth in a limited period of time. The goal is growth, not profitability. The expectation within the a period of time is that You will get to (or close to) Product Market Fit. At this stage - “growth”, “momentum” and? “revenue” are more important than the bottom line. These metrics help you raise further rounds.?

A question that may have occurred to you -? why can’t a VC-backed startup run profitably? That’s an oxymoron. VC money is like NoS in a car - It makes you run super fast only for a limited period. After that, the car either goes back to normal speed or the car breaks down or you need another injection of Nos. (Having said that there are definitely exceptions to this)

Why are these loss-making companies still thriving? The answer is fairly simple. An Investor mainly cares about making returns on their investments. That’s the holy grail - and fairly so. The success or failure of the startup does not matter.?

What? How does that even make sense??

Let me explain.?

So when a company raises their seed round or pre-seed round, the company is extremely early in its journey. They are just in the process of building their product. The funding helps in building and scaling faster.?

So, the investor cares about the quality of the founder here (Founder-Market-Fit as they call it). The main question that is asked at this stage is “Does the founder have the ability to raise another round of funding?” ‘Does the founder have it in him to figure out a way to take the startup to the next stage” (While some may argue that that early stage investors also care about whether or not the founder has it in him/her to make it a billion dollar company - I think the other two questions I’ve mentioned above also help in their decision-making process).

Why does raising another round of funding matter to the early-stage investor? Assuming $3M is raised at a valuation of $10M. When the startup raises their series A, the valuation is more then 2.5x of the valuation of the first round (the valuation at the series A stage becomes way more $25M). The $3.5M invested has become $7.5M.?

But you have to keep in mind that this is unrealized. The only scenarios where the seed investor makes money is when:

• the startup ends up getting acquired
• On IPO or?
• Secondary exists (on raising multiple rounds, the new investor buys shares from an investor at an earlier stage)

So the founder’s ability to raise funds is valued more than the founder's ability to run a successful self-sustaining profitable business.?

The thought process at this stage is - one can cut costs when the time is right which will help get the business to profitability. In a crowded market, many perceive - Market-share to be more important than unit economics.?

Where does this lead us to? Companies are raising more and more funds predominantly to gain market share. It essentially becomes a game of ‘who is cheaper’. Consumers are more attached to discounts rather than the brand (B2C). The discounting game is a never-ending cycle - it becomes a function of who can raise more money. When the funding cycle stops - There will be blood in the market. It won’t be pretty. Valuations will be cut down. Companies will get desperate and do anything in their capacity to raise further funds. Eg: Byjus was valued at $24B and with all the cash burn, they are trying to raise $200M at $225M valuation. Oyo is raising funds at at $2.3B valuation as opposed to the $10B valuation in 2019.

Everytime, I think or talk about startups and the state we’re in -? I am often reminded of Vaitheeswaran K who is the founder of Indiaplaza - The First E-Commerce company in India (no it was not Flipkart) - while sharing his story of winding up the company he states “ A company that is not profitable has no business to exist. And I am not saying Day 1, but a reasonable period of time; the goal must be profits. No other goal, including sales, growth, number of consumers, valuation or fund-raising can replace profits. Because profits allow you to control the destiny of the company. Without profits, you may pretend it is in your hands but it is not. Your destiny is controlled by your ability to constantly raise money. Because somebody has to fund the losses, right? Losses don’t get funded by miracles.”

On average, the majority of the unicorns have existed for over 10+ years. In the eyes of the VC - How many rounds of investing does it require before a startup breaks even? Or Start generating profits??

Real efficiencies and real business will only emerge when we emerge out of the discounting era.?

Until then, it becomes a battle of the wallet.?

On the contrary - I’d also like to mention that raising funds is as hard as running a business, if not harder. I just feel startups need to start focusing on achieving profitability and making profits within a certain period of time as opposed to raising indefinitely. As Rand Fishkin pointed out - Not all companies need to be billion dollar startups - Running a profitable company a good amount of revenue is equally challenging.?

The external stimuli has helped the startup ecosystem thrive but this has also caused a mindshift in new-age entrepreneurs. A lot of entrepreneurs have begun optimizing for valuations over sustainable growth. I believe that VCs are directly related to the health of the startup ecosystem.?

There is no middle path to take, or is there??

I reckon the middle path will be the one the longest to survive. Sustainable profit-generating companies that grow faster than traditional companies will be as hot as startups are today. The Startup mindset will change when the funding dries up.?

The Middlepath might be boring but the middlepath will be the future.?