Investing in Startups–reward is fraught with pervasive technology, hype, and chasm risks

Reward of investing in Startups is tempting indeed. According to NBC, if you had invested $1,000 in Nvidia 25 years ago, the day Nvidia went public, your investment would have grown close to $2 million as of Feb. 20, 2024. More interestingly, a ten percent stake in Apple, which its 3^rd co-founder sold in 1976 for $800, is now valued at more than $280 billion. Unfortunately, most startups do not appreciate investment—let alone at this scale.

Most startups with great new product ideas do not make it. Upon getting funded, more than 90 percent of startups fold up within three years, leaving nothing for investors. As startup ideas are around emerging technology cores for pursuing Disruptive Innovation, they are fraught with pervasive uncertainties.  Hence, investing in startups could be highly rewarding, provided we pay attention to underlying technology possibilities, hype, and crossing the chasm of challenges. Otherwise, startup investment runs the risk of losing the entire amount.

Startups are after leveraging technology possibilities to fuel a creative wave of destruction for unleashing disruptive innovation effects on high-performing incumbent products and firms. However, irrespective of greatness, invariably, all technologies are born in a primitive form. Hence, despite the possibilities of reinventing matured products and unleashing disruptive innovations, startups begin the journey by rolling out loss-making inferior alternatives. Besides, early successes cause inflated expectations and do not scale up linearly. More surprisingly, they get caught in a chasm. Hence, disruptive innovation possibilities pursued by startups are fraught with pervasive uncertainties. For this reason, many commonly cited advice for startup investment fail to reduce risk and maximize reward. Hence, this article sheds light on the technology life cycle and uncertainties of inflated expectations, causing hype and chasm in adoption. Consequentially, it will empower startup investors to reduce risk and increase rewards in startup investing. 

Importance of Investing in Startups

• Slow growth or eroding trend of valuation of matured firms—despite proven profit-making records, incumbent large firms suffer from the slow growth of matured products. As a result, their stock prices very slowly appreciate. Unfortunately, often, they suffer from erosion. Besides, dividend earning is not far more than risk-free bank interest.  For example, since 2000, GE’s share price has been on a downward path.

• Incumbent profitable firms run the risk of disruption—as startups pursue Reinvention of matured products, incumbent high-performing firms run the risk of suffering from disruptive effects due to the rise of startup innovations as Creative waves of destruction. For example, highly profitable Polaroid and Kodak suffered destruction due to the rise of digital cameras.

• Interest income risks to be less than the inflation rate—often, the interest rate is less than the inflation. Hence, risk-free interest income does not provide much breathing space. If you solely rely on it, you will be getting poorer. 

• Startup investment may appreciate at a very high rate—There have been many examples of high growth of funds invested in startups. For instance, in 1976, Apple’s 3^rd co-founder sold a 10% stake in the startup to the other two for a mere $800. Today, a 10 percent stake in Apple would be worth more than $280 billion.

• Investing in startups could be a better alternative to interest and dividend income—as explained, both the theory and data suggest that startup investing may grow your fund far faster than other options. However, as most startups will end up burning your entire investment, how can you figure out less risky startups to invest your funds in?

• Satisfaction in investing in a new wave of growth—in addition to making money, investing in startups gives the satisfaction of fueling innovation and the next wave of growth of the economy. Investing in startups gives a money-making opportunity while helping young people pursuing technology possibilities to recreate the world.  

Reward and Risk of Investing in Startups

• Possibility of a high return on investment—in some cases, capital gain from one out of 10 startup investments could be highly rewarding. However, that does not mean that randomly selected ten startup investments could be worthy. 

• High failure fate of startups—upon screening 3000 applicants, on average, VCs find 20 of them worth funding—0.7%. Despite such a low success rate of getting funded, in the best-case scenario, three out of 10 funded startups will likely take off, giving 1x or similar returns.

• Risking of losing entire invested funds—on average, 1 out of 10000 startups in the USA gets VC funding. Five of the ten funded startups will close, and VCs will be losing the entire amount.

• Challenges in selecting promising startups—in 2023, 5.5m new businesses or startups applied for licenses in the USA alone. In selecting investment candidates, investors face the reality—“You never know which firm is going to be the next growth firm.” Hence, investors are left with the impression—”more shots on goal you have, the better.” However, every shot costs money. Therefore, with the given statistics, the random selection of startup funding will likely make the investor poorer.

Investing in Startups Success Examples

Google was founded in 1977 with $1 million FF&F seed capital. In 1999, two VCs acquiring 10% stack each pumped $25 million to scale up Google’s search engine idea. The raise of $1.2 billion from IPO in 2004 generated around 1700% return for the VCs. Such a return on startup investing is lucrative indeed.

Mega corporations like Google’s Alphabet, Meta, Nvidia, Microsoft, HP, GE, Sony, and Apple started the journey as startups. Each of them succeeded in unleashing reinvention waves of Creative Destruction. To get an idea of how much to gain from investing in these companies, even in their public stocks, let’s look into the following conservative example:

If you had invested $1000 in Google stock on August 19, 2004, you would have $60,107 on April 1, 2024. However, if you had invested the same amount in an index fund replicating the Nasdaq and S&P 500, you would have got $9,000 and $4,815, respectively. However, due to the given failure statistics, figuring out which startups will succeed in growing investment has been a great challenge. 

Startup Success Challenges—turning reinvention into a creative wave of destruction

As explained, startups are primarily after reinvention ideas. They reinvent existing products by changing the matured technology cores with emerging ones. Their challenge has been to fuel the creative destruction wave through a Flow of Ideas to unleash the disruptive innovation effect.  For example, Apple reinvented the personal computer with a graphical user interface. Similarly, Sony reinvented the matured film camera by changing film with an electronic image sensor. Similarly, Microsoft succeeded in winning the race for the reinvention of typewriters. On the other hand, Tesla has been on the journey of reinventing automobiles.  However, irrespective of the greatness of ideas, invariably, all startups face the following key challenges:

1. The emergence of inferior alternatives—from Edison’s light bulb, Sony’s digital camera, and Apple’s Apple 1 to Tesla’s electric vehicles, grand ideas of highly successful startups were rolled out as inferior alternatives. 
2. The mainstream market rejects initial offerings—due to its inferior nature, the mainstream market rejects’ startups’ initial offers. For example, individuals having film cameras rejected digital cameras in the early 1990s. Similarly, autonomous vehicles are yet to be accepted by the civilian market.
3. Finding a non-consumption market for primitive offerings—due to uniqueness, startups’ reinvented products may find customers desperately looking for alternatives to incumbent matured products. For example, professionals on the road were looking for other options to land phones. They formed the nonconsumption market in the 1980s for the mobile phones. Similarly, satellite image platforms and industrial inspection applications found primitive digital cameras better alternatives to higher-resolution film cameras.
4. Loss-making beginning– due to the high cost of R&D and low willingness to pay for inferior alternatives, so startups’ products start the journey at a loss. Hence, the challenge has been to overcome it through quality improvement and cost reduction.
5. Growing loss due to scale—increasing production for expanding the market neither lowers the cost nor decreases the loss. Hence, initial subsidies for creating the market increase the loss.
6. Conventional means fail to reach profit—tactics like discounts, cost cutting, scale benefit from production expansion, supply chain, partnership, advertisement, and many others taught in business schools fail to turn a loss into profit.
7. Winning the reinvention race—as startup success depends on creating the flow of ideas for improving the quality and reducing the cost simultaneously, startups face the challenge of winning the reinvention race. 

To overcome all of those challenges, the emerging technology core, chosen for reinventing matured, existing means of getting Jobs to be done, plays a vital role.

Leveraging Technologies for Creating Investing in Startups Rewards

Due to the inferior emergence of startups’ products, the core challenge for creating startup investment rewards has been to keep increasing the quality and reducing cost—through a flow of ideas. More importantly, such a journey should be sustained until the newly formed reinvention wave crosses the attractiveness of incumbent matured products. Hence, startups need to have a systematic flow of ideas to empower a great idea. Therefore, creating success out of startup investment has been leveraging technology core for creating a sustained flow of ideas, for improving the quality and reducing the cost simultaneously. 

Unfortunately, instead of creating a flow of ideas through advancing and leveraging technology core, subsidies, and predatory pricing strategies have surfaced to create a market for reinvented primitive products. Such a strategy of acquiring customers through subsidies has created enormous demand for startup investment from venture capital funds. However, leveraging technology possibilities to deal with startup challenges has been fraught with pervasive uncertainties.  

Technology Uncertainty Risking Investment in Startups

Technology is key to creating success in investing in startups. However, technology possibilities are fraught with pervasive uncertainties.

1. Primitive emergence with latent potential—irrespective of the greatness, invariably, all technologies emerge in primitive form. Potential remains latent. Besides, each of them is not equally scalable. For example, electronic image sensors, lithium-ion batteries, and OLED displays emerged in primitive form. Hence, creating startup investment success from technology possibilities is highly uncertain.

• Loss-making beginning—despite the latent potential, unfortunately, startups’ reinvention alternatives start the journey at a loss. Invariably, willingness to pay at the initial stage does not cover the marginal cost or cost of replication. Hence, scaling up the primitive emergence increases the loss.

• Competing multiple technologies—often, startups pursue multiple technologies to reinvent the same matured products. For example, plasma and LCD competed to reinvent CRT displays. Similarly, battery and fuel cells have been competing to reinvent automobiles. Hence, startup investments face uncertainty from competing technologies.

• Misleading early progress—due to misleading early progress, startup investment based on extrapolation suffers risk. For example, extrapolation of early progress of autonomous vehicles triggered startup investment. Unfortunately, due to Premature Saturation, such investments are now stuck.   

• Costly experimentation, demanding scientific discoveries—with the given nature of emerging technologies, there has been an increasing need for time, investment, and scientific discoveries for turning startups’ initial products into successful reinvention waves, unleashing disruptive innovation effects. For example, Tesla’s EV reinvention has been progressing due to the continued progress of battery technologies over the past few decades. Similarly, Nichia’s LED light bulb idea needed Nobel Prize-winning scientific discovery to cross the tipping point.

• Unclear spillover effect—often, startup investment success depends on the spillover effects that unfold along the way of the progression of their technologies and reinvented products. However, they are uncertain.   

• Unfolding ecosystem and partnership need—for successful reinvention, no startup can rely solely on its in-house advancement ability. Invariably, success depends on the development of the global ecosystem of innovation. Each ecosystem partner, responsible for component-level innovation, plays a vital role in determining the success of startups’ products. For example, the success of the iPhone depends on the collective innovation ability of more than 200 component suppliers. 

Hype Cycle in Investing in Startups

Technologies do not show up in matured form and do not grow linearly. Hence, startup innovations also experience similar life cycles. Besides, until chosen technologies cross a threshold level, mainstream customers will not adopt them.  

• Misleading early progress—initially, technology’s progress rate is very high. However, it does not sustain, resulting in an S-curve-like life cycle. Hence, the extrapolation of such progress runs the risk of being misled. Besides, technology and startups’ innovations may experience premature saturation before crossing the threshold.    

• Non-consumption differs from the mainstream—although mainstream customers reject startup products at the early stage, the non-consumption market finds them suitable due to their uniqueness. However, it does not mean that with a certain time lag, an impression created by Rogers’ risk-based model, mainstream customers will adopt the same products. 

• Expectation manipulation for inflating valuation—sometimes, entrepreneurs and early-stage investors manipulate early data to fuel hype so that they can disproportionately increase the valuation of loss-making startups for raising disproportionate money from later stage investors.  

• Initial success inflates the expectation of diffusion—the adoption of primitive versions of reinvented products by the nonconsumption market segment and rapid early progress of technology runs the risk of inflated expectations. This is the genesis of creating hype about the business prospects of startups’ products.

Crossing the Chasm Challenges

Crossing the chasm has been a big issue for creating startup investment success. This is due to a pause in startups’ innovation adoption after the initial response from the non-consumption market segment. 

• Progressive innovation diffusion—the initial rollout of reinvented products out of emerging technology core is unsuitable for the mainstream customers. The underlying cause has been the varying nature of Getting jobs done and the economics of deploying startups’ products. Hence, innovation diffusion progress is coupled with the technology life cycle, as opposed to the adopters’ varying risk perception and management capabilities.  

• The non-consumption market creates initial demand—due to inferior alternatives, mainstream customers will likely refuse to adopt startups’ products at the early stage of their life cycle. However, customers who find existing mature products inappropriate to get their jobs done may find the uniqueness or novelty of startups’ reinvented versions more suitable. Hence, startups should fund and target this non-consumption market segment early in the life cycle.

• The mainstream market demands higher maturity—to be a better substitute for mature products in helping mainstream customers get their jobs done better, startups’ products must evolve beyond the take-off stage. This is a critical challenge for startups when creating a market for their reinventions. Hence, technology progression is a must to meet this challenge.

• Chasm demands further technological progress—as there is a performance and cost gap between the non-consumption and mainstream markets, startups’ innovation adoption gets caught in the chasm. To overcome it, we must progress further. For example, line array CCD image sensors having 512 pixels were suitable for real-time industrial inspection (non-consumption market for digital cameras), which film cameras could not support. However, to make digital cameras attractive for adoption by photographers, the pixel count of area sensors had to cross 2 million.     

Investmenting in Startup Stages  

Startup investment takes place at different stages of their idea life cycle, as explained below:

• Pre-seed fund—investing in startups begins with the money of founders, friends, and family (FF&F). Due to critical importance, founders must review technology, hype, and chasm risks facing their ideas. 

• Seed fund—often, seed fund shows up from Angel investors. Through seed funds, startups reach the rollout stage of their innovations. Due to its multifaceted and unfolding nature, it is tricky for angel investors to assess technology, hype, and chasm risks in determining the risks and rewards associated with candidate startups.   

• Venture Capital— venture capital (VC) is a type of private equity financing professionals manage. Usually, VC funds are used to scale up the production of startup products. VC financing is structured as Series A, B, C, and D.

As explained, the reward of investing in startups is fraught with pervasive technology, hype, and chasm risks. As the startup’s success depends on developing and exploiting latent technology possibilities, it poses formidable challenges to investors’ challenge of filtering prospects. Due to high risks, experts suggest minimal investment in startups. They also indicate that they are in favor of spreading the capital to over 15-20 startups. Such an approach reduces the risk but does not help improve target selection to maximize gain. Notably, increasing the probability of success by spreading over 15-20 is not much as the startup population has become very large. For example, almost 5.5 million startups in the USA alone applied for licenses in 2023.  Hence, as explained in this article, it’s time to pay attention to technology, hype, and chasm risks for increasing filtering capability and increasing rewards from investing in startups.