Why Investors pay billions to loss-making startups?

Background

One of the never concluding debate in the business/intellectual/intelligent world is whether startups deserve people's money even when they make "huge loss"?

Ideally, in any social debate, those who have failed to make these billions may appear foxes complaining about the grapes they can not have. However, this is maybe a very genuine question. At a time when so many businesses are closing down, leaving its people unemployed, how justified it is for a 10 member company to walk away with $1B? What is there contribution.

When I tried to search the answers by the experts, I did not get any clarity. So I thought, there must be many like me who still do not have the answer. The ones who have made it have failed to clearly portray why they deserve beyond "hard work", "taking risk" etc.

Therefore, in this post, I would try to answer this question in a simple way, take some examples(called case studies) and try to justify the argument. A point to be noted is that the arguments provided in the article will be heavily biased by history and philosophy.

But before we start, let me provide you my authority so that the article looks authentic.

Author's Authority

"I am an Investment expert. I have worked with Steve Jobs and Narayan Murthy. I have 25 years of experience in building companies and have 20 successful exits. I have a net of 100M USD."

Were you looking for such a bio at the bottom of this article in "About the Author Section"? I am sorry to say you that you won't find any such "About Author" in this post. I value your time, so I do not want you to read the article if such an author's bio was your starting point.

Before you read the rest of the article, here is a disclaimer that you must read very carefully.

I am neither a VC nor an Angel. I have never written a million-dollar cheque(Read, I have never seen a million rupees reflected in my account). I am no authority in funding. If you were looking for an Expert Analysis of Startup Failure by a Market Leader then you will be disappointed.

I am a struggling entrepreneur, writing this post, hoping to impress few investors in linkedin to trick them to get interested in my venture. I am also looking for some startup founders who after reading this post will find me to be a domain expert and offer me a 5% equity of their startup and an advisory board position.

If you are neither an investor nor a startup founder, then I will still try to trick you to believe that I am some kind of expert so that you can share this among your investor and founder friends so that I can fulfill my actual desire of tricking them as mentioned earlier.

Ready to be tricked? Let's start.

The Basic Difference Between a Startup and a Business

Yes, I know you are already a subject expert in business and may well be running some businesses or a startup. I do not question your wisdom or authority. However, can I politely still request you to read the following article first? The following article will give you startup and business terminologies that we will be using in this post thoroughly.

Basic difference between a startup and a business

Done?

Let's recollect and summarize the difference between a startup and a business here.

A business is a permanant entity that meets wants of a known set of people called customers in a known market with an end aim of making profit.

For example, a restaurant is a business. When people want to eat out, they go to restaurants. We already know that people eat out and already there are many restaurants. So, a new restaurant is another business out of many other businesses meeting the wants of the hungry people. The same thing is with the cloth shops. A new cloth shop is another addition of already existing several cloth shops. Because there is already much business like this and there will be many other businesses like this, the business can make money only when the market is growing at a rate higher than the business growth. If there are more hungry people every day than new restaurants then the new restaurant can make money(or at least are expected to make money). And this is highly competitive in nature.

A Startup is a temporary entity that tries to solve a huge need for a huge number of people, called problem and attempts to prove a set of assumptions about the need and the solution in a scientific way with an end aim of converting the need to want and the temporary entity to a permanent, profitable and scalable business.

Further simplifying the definition

A startup is a temporary entity in search of a profitable and scalable business model.

So, the major goal of a startup is to solve a critical problem with the hope that when such a critical problem is solved, people will actually pay for such a solution. A startup is simply hope and a scientific search. That's all it is.

Historical Context

Example 1: Aeroplane Startup

Take for instance the period of 1880 onwards. The population was growing and the world was dying for a good transportation solution for people to transit from one place to another. Traveling for 60 days in a ship to go from Australia to America even though was possible, but was not the smartest thing to do. Some crazy people like Right brothers thought, what if we could fly from one place to another place just like birds?

But they were not the firsts. In 1450 Leonardo Da Vinci created the first design of a flying machine.

So, it is safe to say that people wanted to fly from the year 1400. There was a huge need for flying. With the industrial revolution in the 19th century, transportation became a huge problem. The "need to fly" just became a huge need. But when Right brothers had the first glider attempted to fly in the year 1896, they had no idea as to how the end product would look like, whether the manufacturing of the end product would be feasible in a huge scale, once the product or the flying machine is made, if there would be anyone ready to pay for it or not. How much money would it take for one flight to complete? Who will operate that flight? Who will use that flight? The only thing they knew was that there are a growing need and a problem of fast aerial transportation.

So, Right brothers and thereafter some more established a life mission to solve this problem. This is what the startup is. Imagine if they had not taken up the problem, would you be in a position to see the world that you are seeing today?

Now, for a flight to be created and taken to the commercial stage, huge money was needed. Would you give someone money if they said that you may get a return after 120 years? So, not only they had to design the flying machine but also to create some small paid simple flight for which people were ready to pay. A demonstration that even with this crappy solution people are paying, so if we put a lot of money to expedite the speed of development, a lot of people will start giving a lot of money and then we will make a lot of money.

Example 2: The automobile revolution by Henry Ford

Motor vehicles, just like flights became an increasingly expanding need and the problem of the population witnessing one of the craziest growth of human population and industry. Horses were good but there were too many odds against continue to drive around with horse cart. More horse cart needed more horse population, maintenance, medicine. Humans have no responsibility for survival and thriving of another species. Does it?

Many people were trying to create a motor car. Replace the horses by motors. Henry Ford too tried a few times to do this but failed. He and all the automobile fanatics of his time knew only one thing. "We are not going to let another species grow and we need to replace the dependency of another species from our transportation need."

Again, it would need money. Investors had to pay money. But why should investors pay for something that doesn't exist at all? Who knows if it will be successful if it does, how it will be mass-produced, who will use, who will pay?

Of course, the great Ford had to tell a story, a roadmap that gave fair hope which had a chance to become big if the problem was solved.

Be it Flight, Automobile, AC Current, DC distributions, Motors, all of these started with an invention where the goal was to solve a big problem. Because the problems are so big, it needed a good time to solve and for that time and effort, people needed money which someone had to spend.

The psychology of opposing and complaining

You are sad and pained that startups are valued billions even when they do not seem to solve any problem, bringing any profit. But you are not unique and alone. Historically also people have done the same thing.

"Who wants to fly when we have so many hungry people?"

"Who wants to have a car when the health of horses is a major concern for us?"

Those who hate startups getting money are like modern socialists, who will book an Uber, reach to a Starbucks, then write about the evils of Capitalism in their iPad.

The psychology is nothing new. It has always existed from the beginning of humanity. And the opposers, the traditional and the neo socialists play an important role in the innovation. If nobody is complaining about a change, then the change is too small. People must be very worried about their current status quo, must be threatened by a change they see coming for that change to be substantial.

When Britishers left India, the average life of an Indian was only 37 years(you read it right). That India, that dying, crying, begging India that we left, same India is reaching to the Moon? The same country that we looted, whose people we butchered is about to walk past our economy? No No, it is not a desirable state. We must do something about it. People at the top of the status quo loves the status quo. There is nothing new with it.

I want the apple but I will hate the garden, the gardener and even the tree. Why? Because I see nothing but the fruit and I have to pay for the useless gardener for getting my apple.

How investors are convinced to pay for a startup?

Let us recall again.

A business is a profitable way of meeting people's wants. Whereas a startup is a scientific way of trying to solve a huge need with a hope that the solution may lead to profit.

Value

People pay for only two things:- Things that help them survive(Want) and thrive(Need).

Take for example our children. Why do we pay for their education? Why their upbringing is important to us? They are not bringing any money in any near future to us? They don't help us survive. Children help us thrive. When we leave the world, the only way we can still live is through our gene and our legacy. Therefore our gene must be given every possible support to build itself to a position where it can compete and survive and thrive. Children are important for many parents because they foresee in children hope for their old age. At a time when we will no more be able to thrive, when survival will become a problem, our children then will look after us(I consider this as a false reason).

We invest our life's earning and good time of our life for nurturing something that has no current value(yes children give us happiness, but that has no monitory return value). We spend on children due to their perceived future value. We need to.

We have to arrange resources for our food and cloth because we have to. These are basic requirement for surviving.

How you convince yourself to spend almost a bulk of your earning on your child when they bring no immediate value? You see immense future potential in them. You make yourself believe that if they are given good education, nutrition, and support when they grow up, they will take care of our economic need and support us in our old age. This is a story you tell yourself. A story to convince yourself that it is important to spend and take care of the children. Do all the child grow up to become financially successful? Definitely no. Do all the financially successful grown-up children take care of their parents? No. Do you for sure know that your child will be both successful and will take care of you? No. But you hope. This hope gives you happiness. This happiness helps you to put more effort into your work. This hope often becomes a dream and you live to realize the dream.

Hope and Dreams are one of the reasons that we live and fulfilling those dreams are important part of our life. It makes us happy, gives us a strong reason to live and prosper.

Startups are to business and the financial world what your child is to you. A small child, when grown-up will generate a lot of money. A child that needs to be given every possible opportunity to survive so that it can thrive later.

A startup is not an Investor's child. Why does he pay then?

An investor has a lot of money. But he wants to make still a lot of money. But at the same time, he also wants to be remembered. He wants people to love him, respect him(we all do). He wants to leave behind a good world for his children so that the excessive money he has earned will be enjoyed by his children. He knows I am not taking this money with me when I die. But if I make the world a better place, my friends, my family, society will respect me. I will die a satisfied man. This is such a big subconscious motivation in life that not many of us even realize it.

So an investor opens his pocket for a startup that he sees a future value in.

Don't confuse the terminology. There is a two-fold inspiration for an investor to open his pocket:- Contributing for a future that he wants to leave behind for his children and to leave behind a lot of money for his children so that they can enjoy life in the new improved world that he has contributed in creating.

A business is valued based on its current revenue, market, and profit, but startup value is the value of a dream, a story that makes the dream appears doable

Gosh, do I have to even tell you that dreams are invaluable? My dream is to leave behind a disease-free and an idiot-free world for my child. It is a powerful dream. So I have turned this dream to a goal, and the goal to a vision and the vision to a mission. Is it worth? Yes of course, to me. Seeing a disease and idiot free society when I die is a powerful reason for me to invest my life into. It is the purpose of my life.

Same way, an Investor also has a powerful purpose. A reason is so strong that he is ready to take risks. Money is never a powerful reason to invest the life. It is always a hope, a dream. But then is every hope, every dream equally invaluable? Certainly not.

If my dream is to build a steam engine car, that may be a crazy dream, but not a valuable dream. Why? Because chances of anyone else dreaming this is too low.

Now we know that a Startup is a story that makes a seemingly impossible but important dream to a hopeful reality.

A dream is a desired reality, a huge need. The path from dreaming to reality is the problem.

Startup Value= Value of a dream. --Eqn(1)

Where,

the value of a dream=

(Value of the Problem) x (Number of people having this problem) x (Possibility that this problem can be solved) x (Possibility that people with the problem will pay when the problem is solved) / (Total entities that can solve the problem)

--Eqn(2)

The value of a problem= The powerful desire to go to a stage that we would rather be from a stage that we are currently in.

A startup is simply a convincing story that makes a huge problem appear solvable and the solution appears to generate money.

Therefore a powerful story in itself is worth millions of dollars(not the idea, remember). But when the story takes a journey towards reality, the more milestones it crosses, the more the dream seems possible. Because this dream is so strong that when you see it on its way to reality, you put more money. There is another powerful part of the equation. The denominator. It is interesting because, if 0 companies are perceived to be solving this problem, it will have infinite values, which means it is just a dream. If there are thousands of entities who are perceived to solve the problem, then the value comes down. The equation is optimal only when just one entity is perceived to be solving the problem.

Suppose you see a child who is extremely poor in Maths but great in Music. Say, he is ten years old. Would you pay a ten million US dollar if someone comes and tells you that he will win a Nobel prize in Physics 20 years from now and will return your money? Hell no. (You sometimes even can do, human craziness has no limit).

But you may actually sponsor for his music training if you like his music and feel that he may actually sell millions of records if nurtured well. Suppose he has started doing some concerts and people are loving him, would you want to pay more money so that he can quickly reach to a stage where he can sell plenty of records? Yes, you will do. You will put more and more money as you see your dream is fulfilling day by day.

This is exactly how a startup works. The startup starts with a million-dollar story, then one assumption after another is completed by the team. Investors see a real chance of their dreams fulfilling. They put more money, the more shreds of evidence they see this startup making money, the more they put money.

An example:-

Idea:

I will create a pill which will take care of people's hunger for one week. If they consume this pill, they will not be hungry for another week.

Big idea? YES. It will solve a big problem? Hell yes. Will people be ready to pay for it? Of course, who wouldn't want to be not hungry for a week just by the consumption of a pill? Getting rid of society's hunger is a big dram? Yes.

So what is the value of the idea? ZERO. Why? The possibility that this problem will be solved is zero(see eqn(2))

Now say, I prove to a certain degree that yes, a substance can be created. For this proves, I have to make some assumptions, research and create a document. See, a story is getting created? Once we cross the stage of Impossible, the story will have some value as it appears possible. If I create a pill that can keep one hunger-free for even 5 hours, then that takes the story to little more value because now the story looks plausible. Now if I can manage to extend the capability of this pill to help a person survive a whole day, then it becomes probable.

A Probable Solution of Huge Problem has more value than an Actual Solution to a Small Problem.

Why?

Because doing is way more realistic than dreaming and trying to fulfill that dream. We value diamonds more than we value our kitchen still knife. Why? Diamonds are rare and difficult to get. A hypothetical pill that can solve society's hunger problem even at its idea stage is way more valuable than a restaurant. Why? Because restaurants are a solution to current hunger. Proven solution. So many will open restaurants. But only probably one or two crazy people will start investing their life in making that pill. If that pill is made 5 Billion people on earth will be benefitted. If a new restaurant is opened, it may hardly serve a few hundred to a few thousand people in an area, not a billion people.

Therefore even a million-dollar profit-making business will have less perceived value than a 100 billion dollar impossible but important problem which is on a positive journey from Impossible to probable.

Why investors lose money?

One of the most successful VC of this century is Peter Theil. You must and should read his pathbreaking book "Zero to One" to even understand this problem. Investors do not lose money because they are betting on a dream, but mostly because many of them get too fascinated by quickly solving a problem rather than solving a big enough problem in totality. A huge problem needs at least ten years to get matured. The problem must be at the right time and the right place of the history where the tools and technologies available will be sufficient to try a solution. The problem also must be so tough that others will be intimidated to even think about the problem.

They lose money because:-

1) They select the wrong/right problem to back at the right/wrong time/place instance.

2) They select the wrong reason to support a problem(money is not good enough reason to back a dream)

3) They select the wrong team to solve the problem.

4) They lose interest/faith in the journey.

or

5) They get carried away by quickly solving part of the problem than to actually solve the problem.

The reason for us to not have too many Peter Theils is that too many investors even with their smartness and expertise make the mistake that a startup is the miniature version of a large business.

Conclusion

You may very well feel that your current job and career is more important than your child because your current job is taking care of your basic necessity. No offense, no complain, no anger against parents who leave their kids to nannies and go to job.

There will also be very few parents who will realize that for the society to prosper, we need high-value individuals for the future society and creating such high-value individuals, the true masters of the future world would require parents to invest more time, energy, resources into their child. It would require sacrifices and a powerful dream.

The way parents, who are living to see their child becoming an icon of the future are not complaining about the parents who are happy and satisfied with their current earning and status quo, the same way these parents should also not complain about the parents who are creating kids for future.

If you are running some thousand US dollar profit business now, you definitely are doing great for society. Many like you are doing. But those who are trying to build a future society are equally important, not only for their kids but also for your kids too.

Next time you want to condemn and mock a startup valuation, know this for a fact that you can never justify human dreams and the power of such dreams for a more beautiful future. Those dreams and dreamers will have much significant value to a set of individuals whose current value is way too high for you to even perceive their position. Such a dream may fail, but chasing such seemingly impossible dreams will not stop.

Business value is the value of the solution, a startup value is the value of a huge problem that can cross the path from impossible to probable in relatively short period.

In another article, I will take up use cases and show how startup valuation is actually done based on Eqn(2). By then just accept the below fact and see if you find similarity in your own life or not?

Investors pay billions for a startup because for us humans the hope of a great future is often more valuable than an acceptable reality.

Please share your thoughts in the comments. If you like the article, please share in your network. Thank you for your valuable time and attention in reading the article. I appreciate your willingness and effort to consume the information presented here.