This will be a short article, followed by a part 2. There are a handful of warning signs that appear again and again in start-up investing. They appear again and again because they work - at least, they work for those looking to raise funds. They are fundamentally all about generating hype. But they don’t work for investors, since investors are looking for value, especially discounted value. If you invest based on hype, you lose money repeatedly.
What ties all of these warning signs together is the dynamic of hype, rather than of demonstrated value. The key logical fallacy then, is that hype (if it is to be trusted), can only ever be a derivative of value. All the hype in the world can’t produce true value. Let’s get straight into them:
‘You should invest because big names have invested’. So what? Maybe it helps the big names to generate more hype and boost the value of their existing investment. After all, if I bought magic beans, I would go around telling everyone how great they are, just so that I could sell them off. Here’s the key point: the very fact that ‘big name’ investors (including trendy VC funds) form part of a start-up’s pitch is actually a reason to stay away, since it shows a lack of confidence, or clarity (or both) about the actual value that start-up is generating. The root question never changes: are you making something great, that people will continually pay for?
‘You should invest because we’ve won awards’. So what? This is another version of the first warning sign. It is leading with hype, rather than demonstrated value. Again, no amount of derivative can produce the real thing. Start-ups need to decide early on whether they are going to aim a) to win awards or b) to build a successful organisation that creates value over the long-term. We assume the two are correlated, but they aren’t. There’s a way of aiming for awards that doesn’t, in the end, make money. A parallel is restaurants. Restaurant owners need to decide if they want to please critics, or run a successful business serving people food that they’ll love, pay for, and keep paying for. It’s a warning sign that a start-up, in the early days, is out to win awards.
‘You should invest because we’ve already raised this amazing amount’. So what? This is like the other two warning signs. It’s basically saying, look at this amazing hype; how can you question that we’re winners? It’s motivating investors by the fear of missing out, rather than actual, demonstrated value. This fallacy, by the way, becomes worse and worse - as a parallel of all the historic bubbles that burst. The longer it goes on, the more implausible it becomes that ‘this’ could ever fail to grow.
In part 2, we’ll focus on one more warning sign, and then switch to highlighting a handful of heuristics for seeing through the hype and quickly assessing demonstrated value in start-up investing.