Startups Don't Need to Make Financial Sense

I’m sure some investors will be rolling their eyes just about now. And with good cause. Yes, companies are supposed to make financial sense, and there is an apparent reason for that.

Entrepreneurs start companies with the goal of generating value for society. The larger the value, the more their customers are ready to pay for it. The more painful the problem the company solves, the more money they’ll be able to charge. The more universal is the issue, the bigger their market is.

That’s the theory at least.

Money isn’t only a ‘reward’ for bringing about value. That payoff allows the company to sustain their operations. In other words, it makes the value generation sustainable.

If we look at System Theory, it’s what we call a reinforcing feedback loop. The more value a company generates, the more money it gets to do more. If the company stops reinvesting, the money it makes will eventually decline. 

However, on some occasions, the entrepreneurs can’t deliver value without initial capital. This initial capital or seed is what in System Theory we call Stocks. Investors are usually the ones providing the starting stock (money) of the system.

Their goal is to provide the kindle to start the system going. Once it’s grown, investors can take a big cut on the enlarged money stock earned by the company if everything went well. And that’s a big If. And that’s why it’s called Venture Capital investment and not safe-and-easy-as-bonds.

The thing about feedback loops is that they’re rarely immediate. It takes time for a company to create value. This is what System Theory dubs feedback loop Delay. In the case of companies, this delay can range from near-immediate to decades.

There is an increasing movement in the industry called Deep Technology. One of the main characteristics of Deep Technology is their long delays of this feedback loop.

The longer the delay, the more money the company will require to survive before depleting their capital, also known as going bankrupt or system collapse. 

Most investors want this delay to be as small as possible. The quicker the company can show they can generate value, the higher their worth is. VCs measure this “valuation” both as the amount of current profit the company perceives from the market, and the potential profit of the next iteration (future potential).

To maximize this valuation, they pour their money to accelerate the iteration. On the one hand, investors want to increase the speed at which the company can deliver value (reducing the delay of the loop). On the other, they want to sustain the company as long as possible until the market starts reacting.

Here is the catch though. While companies can increase their value and the speed they deliver it, the delay of the returning loop is beyond their control. The market will react at their own time.

What’s obvious is that if the market takes a long time to react, the company will run out of capital and die, plunging their investors with them.

The question though is if that’s bad for the system or just for some of the actors. From a financial perspective, primarily, from the company’s investors, it’s terrible. They’ll lose their money.

But is it bad for the system at large?

One of the aspects that make System Thinking so compelling is the fact that all systems are connected. So while, on one side the system at large exposes a particular behavior, on another subsystem you might bear testimony to something completely different (i.e., Chaos theory).

Let’s forget financial sustainability for a second (a subsystem). If we focus on the impact of certain startups on the broader system, then a new picture emerges.

Startups, spurred by their investors, push the boundaries of innovation and try to provide ever-increasing value to the market. The effects of such innovations affect the end consumers and their latent behaviors.

For most failed startups, this effect is trivial and negligible. But a few do capture the market’s imagination. And while the market’s reaction, from an economic perspective, might be timid, they do react in other ways. One of these ways is by reinforcing an emerging behavior. A behavior that will stay in place independently of the startup that reinforced it. 

An excellent example of this is WeWork. Many keep focusing on the risky and fragile financial position of the organization. And while they’re right to be wary of it, they’re missing the broader trend.

WeWork is tapping into a new emerging behavior. One, few are seeing, much less exploiting. And while it’s probable that WeWork crashes and burns, the subsequent crater will change the market landscape forever.

WeWork’s value is strengthening this new behavior. The demand for Co-Living, Co-Working, Co-Everything, will remain in place, independently of WeWork. And this is the real power of Disruption; it doesn’t go away.

Worst than that, all incumbents laughing at the predictable fall of WeWork, are not picking up the new trend. Most will fail to see it, even after WeWork’s potential disappearance and will implode as a result.

Another beautiful example is the recent drama with Vice Media. It’s easy to highlight the gross negligence of their lack of business model. Nonetheless, their continuous innovations in media formats are shaping and shifting the market. It’s irrelevant they aren’t the ones benefiting from them. Someone will and when that happens, they’ll disrupt the market. 

Sometimes we mistake financial soundness for innovation. Both concepts are connected, but as I’ve shown, they work at different speeds. Delays in the feedback loops that govern the system will make them play, sometimes in tandem, sometimes independently.

Particular caution should be observed when the technology employed by such companies is disruptive. The mere nature of disruption prompts the system to run at different speeds and this will have an impact on the competition landscape subsystem too. Some incumbents will collapse, some entrants will thrive.