When you invest in a startup, you invest at a very steep valuation multiple.
It isn’t possible to justify the valuation at which you’re investing using traditional multiples like revenue, gross margin, EBITDA, or net income. The latter two are almost always negative, and depending on the stage at which you’re investing, the first two range from small to non-existent. Your reason for investing is that you believe that the startup will grow to produce revenue, gross margin, EBITDA, and net income in the future. It is this growth that you pay for.
However, even if the startup is successful in growing to produce these figures, the relevant multiple at which it is valued in the future is very often lower than that which you invested at. The reason is that even healthy businesses are eventually valued at traditional multiples that reflect a lower growth trajectory.
As a result, for an investor to make money in a startup investment, the increase in the company’s valuation which is produced by the company’s growth needs to offset the decline in the company’s valuation which will take place as a result of the lower future valuation multiple assigned to it.
This is why growth is so important for startups. If it stops or declines, even if the company is able to manage its costs so as to achieve break-even, the decline in valuation multiples makes it very difficult to achieve a return on your investment.
Leo Tolstoy begins Anna Karenina with the quote: “All happy families are alike; every unhappy family is unhappy in its own way.”
The more startups I see, the more I feel that the same is true for startup success. All successful startups are alike while every unsuccessful startups is unsuccessful in its own way.
The similarities of successful startups aren’t at the layer of what they do but rather why they do it and the resulting how. What you do is often the same across many competing startups and can easily be copied at the surface. But why you do it and the resulting how you do it, which are the determinants of success, are different. And there’s a very limited range of why’s and resulting how’s that produce success.
Having the same why’s and resulting how’s doesn’t guarantee success. However, it’s the only way to have a shot at it.
Among other factors, the motivations of the founders, their ability to attract others to their mission and the attributes of the people they attract, and the resulting identification of a product which the market is ready and willing to pay for are very similar across all successful startups.
The corollary to this is that a few misguided motivations, recruiting mistakes at the outset of the company, or target markets where creating and capturing value are an uphill climb rather than a downhill run are all it takes to fail.
If you know that you don’t know something, you don’t act on it. As a result there’s no danger to you or the people who would be impacted by your actions if you were to take them.
If you know that you know something, you act on it. And since you know, in expectancy you produce a positive outcome for yourself and those around you.
The danger is when you know just enough to think you know something, without actually knowing enough. Because you think you know something, you act on it. But because you actually don’t know enough, in expectancy you produce a negative outcome for yourself and those around you.
Since they hold the potential for very large upside but also carry a lot of uncertainty at the surface, startups attract a lot of people who think they know something without actually knowing it. This is true for entrepreneurs, investors, LP’s, and many other groups of constituents.
This problem is exacerbated by the fact that you don’t need to actually know something to convince someone. You simply need to know more than the person you’re trying to convince. So startups also attract a lot of people who know that they don’t know something but act like they do because they know that those around them know less.
When working with startups, you need to pay attention to act on what you know and not act on what you don’t. You also need to watch out for people who think they know but actually don’t and people who don’t know but act like they do.
In this video, John shares how the roles of different team members in a startup are analogous to the roles which our ancestors played as part of tribes. There’s the leader (chief), the creative thinker (shaman), the seller (hunter), and the operator (skinner).
This isn’t the only way to think about the different roles performed by different people at a startup, and people often fill multiple roles, but I like the essence of the analogy. Great startups have people with different strengths who complement each other, rather than people with similar strengths that overlap and thereby leave open big weaknesses.