A couple of years ago, I wrote a post about start-up companies. In that post, I expressed some reservations I have about the world of start-ups, even though I generally welcome the creation of new, innovative companies. Since the publication of that post, I have had the opportunity to invest a small amount of money in some start-ups—directly and through specific investment funds—and this has allowed me gaining an insight into this world. I can therefore talk about what I have learned so far.
Technically speaking, investing in a start-up is a piece of cake today, even in Italy. If you have grasped a little bit of sarcasm here, don’t be surprised. Regular readers of this blog know well that my country is not a business-friendly place at all. In several posts, I described how suffocating bureaucracy, an extremely high taxation rate, hard-to-find skilled technical profiles are factors, among other things, that make it terribly difficult to create and run a business in Italy. Despite all this, there are very few business-related operations that are surprisingly easy to do in my country. Equity crowdfunding is one of these. Thanks to some young, tech-enthusiast members of the Parliament, Italy was one of the first countries in the world to regulate equity crowdfunding a few years ago. This law has given retail investors the opportunity to buy shares of many different companies very easily. From the start-up point of view, this is a phenomenal way to carry out significant fund raising. As known, there ain’t no such thing as a free lunch, however. The fact that equity crowdfunding is so accessible has some drawbacks, too. I’ll talk about the flaws of this process I have encountered in the last years.
In my opinion, the first and most relevant issue is the lack of a robust “Darwinian selection” prior to the foundation of such companies. The effects of this are clear during the early stages of the new born start-ups. The majority of the founders don’t have the entrepreneurial skills required to run a business nowadays. The effects usually show up in the form of common, repetitive errors that often lead to the a premature end of the company. A recurrent example is to neglect the importance of marketing and finance. It is often seen that the start-up founders have a strong, solid technical background, which, combined with a fervid creativity, allows them to have a brilliant intuition for a new game-changing product. They are so technology-oriented, however, that they think this is enough to develop a successful company. Even though you’ll never read a business plan in which there are no expenditures for marketing, in practice, a lot of start-ups burn all the funds to develop their product from a technical perspective. At the end of the day, they go bankrupt with a wonderful product on their hands without a market willing to buy it. Or, even worse, they couldn’t complete the development of the product before depleting all the capital because they didn’t take care of financial balancing.
Another tricky aspect is management transparency. It is inevitable that equity crowdfunding enlarges the amount of shareholders dramatically. Most of them own an infinitesimal fraction of the company but—legitimately—they would like to know everything about it. For instance, they would love to be updated constantly about common parameters and indicators that affect daily business decisions such as cash flow, number of active customers, and supplying conditions. On the one hand, this is positive because it proves they are not just mere financial investors. They feel they are part of the company and they would like to contribute to its success in a more engaging way. Some of them also have skills the company could benefit from, if these shareholders were more involved in its life. On the other hand, much of this information is sensitive, and the company’s board is reluctant to reveal it for obvious reasons. It is not easy to find a compromise between these needs that push in opposite directions. The Italian regulators manage to find a reasonable solution to address this issue, however. According to Italian law, in fact, it is possible to differentiate the stakeholders into several categories in function of the value of their share. Simply put, the more money you invest, the more rights you have in regard to the company’s evolution. This classification prevents a myriad of small investors from interfering with the administration of the company. Nevertheless, the board has all the means (mailing lists, Telegram channels, webinars, etc.) to easily keep them updated regularly about how the company is generally performing. The problem is that it is common that the board of directors—which in many cases is composed only of the founders—does not take this opportunity and “forgets” to inform the stakeholders on a regular basis. Of course, this may be perceived as a suspicious lack of transparency by the investors because they don’t have any idea about how their money is actually being used. In this regard, I think the Italian legislation should be improved and that stricter obligations should be enforced in order to make this process way more transparent, yet respecting confidentiality.
The last point I would like to discuss is the valuation of these companies. There is such hype around the start-upping phenomena that, in many cases, their pumped-up value is so high that it is totally disconnected from reality. For instance, I have witnessed the selling, for many millions of Euros, of not yet established start-ups, which were performing well, but not exceptionally well. Not to mention the pre-money valuations. Frequently, they are so elevated that one could think these start-ups would become larger than Amazon in less than 10 years, even if they performed half of what their founders expected! In this regard, we are in the middle of a crazy moment that reminds me of the dot-com bubble. It seems that the start-up market has reached the maximum of its irrationality. Several founders have surfed this wave cleverly and have not missed out on once-in-a-lifetime opportunities. Thus, they have exited in an extremely remunerative and timely fashion by maximizing results in the short term. I don’t blame them but I hope that operators in the start-up business will come back down to earth quickly to restore more credible and reliable market conditions.
Editing assistance by Dr. Emily Braswell.