Ok, but… What is a Startup?

Credit: a personal illustration

In my academic research I have analyzed in detail the characteristics of successful startups. Speaking with people I have noticed that a frequent question I am asked is: “Ok, but… What is a startup? Why can’t any new company be called a startup?”

To give a definition to the concept of startup is a rather complex task. The term often reminds of the idea of a small team of people who, with a highly innovative idea, succeed in founding a big successful company.

But what did all these companies have in common at the beginning of their journey? What defines a new company as a startup? Over the years many authors have tried to formulate an expression that could capture the essence of this specific type of ventures.

Well, in this article I will try to shed some light on what a startup really is. I collect some of the most well-known definitions of startup and highlight the peculiarities of these companies compared to other ones.

I hope you enjoy reading about it.

1. Some Popular Definitions

According to Marc Andreessen, co-founder and general partner at the venture capital firm Andreessen Horowitz:

for a startup “the only thing that matters is getting to product/market fit. Product/market fit means being in a good market with a product that can satisfy that market.” (Andreessen, 2007)

Eric Ries, the pioneer of the lean start-up movement, says that

“A startup is a human institution designed to deliver a new product or service under conditions of extreme uncertainty.” (Ries, 2011)

Another key definition is given by Paul Graham, co-founder of many successful organizations including the renowned startup accelerator Y Combinator. In one of his famous articles on his blog he reports the following consideration.

“A startup is a company designed to grow fast. Being newly founded does not in itself make a company a startup. Nor is it necessary for a startup to work on technology, or take venture funding, or have some sort of “exit”. The only essential thing is growth. Everything else we associate with startups follows from growth.” (Graham, 2012)

Steve Blank, author of the “Customer Development” model, the heart of the Lean Startup movement, distinguished between existing companies and startups. He says:

“A startup is a temporary organization designed to search for a repeatable and scalable business model. The corollary for an enterprise is: a company is a permanent organization designed to execute a repeatable and scalable business model.” (Blank, 2014)

Finally, Peter Thiel, co-founder of PayPal, Palantir Technologies, and Founders Fund, as well as the first outside investor in Facebook, in his book “Zero to One” says:

“All happy companies are different: each one earns a monopoly by solving a unique problem. All failed companies are the same: they failed to escape competition.” (Thiel & Masters, 2014)

Bringing them all together

Considering these extracts, it can be seen that each author placed the emphasis on different elements, looking for an effective definition of the concept of startup. By carefully reading each definition, some keywords can be extracted: product/market fit, uncertainty, growth, business model and competition. Although it is challenging to give an exhaustive definition of startup, it is nevertheless possible to come up with a naive formulation that expresses some of the key characteristics of this type of companies.

A startup is a temporary human institution that, once identified a unique business opportunity, works to develop and deliver a product / service that can fit with the target market. To get out of the business competition, the company proposes an innovative solution that makes it operate in conditions of extreme uncertainty. All the operations of a startup are oriented to search for a repeatable and scalable business model that allows it to achieve its ultimate goal: to grow fast.

2. Startups VS Small Businesses VS Scaleups

To make the concept of startup clearer, it may be useful to highlight the differences between this kind of company and two others types: small business and scaleups. The figure positions these three types of ventures in a matrix whose dimensions refer to the existence of a validated business model and the company’s ability to grow (in accordance with the definitions given by Blank and Graham). So, you can see that:

• A startup has a high grow ambition but not a market validated business model. So, first of all it must find the business model that will allow it to achieve its growth goal.
• A small business is a more traditional type of company, which uses an already consolidated (and therefore safer) business model that will not, however, allow to achieve high growth-rate.
• A scaleup is the evolution of a startup company since the effectiveness of the business model is validated by the market. The focus is on execution: apply a scalable business model to achieve an “exponential” growth.

Difference between startups, small businesses and scaleups. Credit: modified from source

Now that the differences between these three types of companies are getting clearer, it can be interesting to go into detail by analyzing how they behave with respect to certain aspects of their business.

2.1. Startups VS Small Businesses

Let’s start by seeing what are the elements that distinguish a startup from a small business.

• Growth. Startups are designed to grow, and I mean, grow fast! If this may seem like a common element of all business, well it is not! Most companies do not need such a big growth to operate effectively. Small businesses simply need a reasonably large (and well segmented) local market and they need to be able to serve it best. On the other hand, in order to grow quickly, startups aim to enter a really big market. To get into it and beat out existing competitors, startups develop innovative solutions that are able to have a concrete impact on their users/customers’ specific problem. The statement “just one more product the same as all the others” does not exist. Startups aim to disrupt a specific market, and this is precisely to change the behavior of potential customers, increase the market share and then grow fast. In many cases growth is very much linked to technology: for example, once an online platform has been developed, any person from anywhere in the world can access it. This is why so many startups are typically founded in the tech-industry. But remember, technology is only a driver, not the target. You can also find a startup in a non-technological sector, but technology will give you the necessary boost to grow fast, let’s say almost exponentially!
• Ultimate goal. Small businesses are generally founded with a long-term perspective. It is very likely that in this case the entrepreneur intends to continue the business for a long time. The goal is in fact to generate revenues (and profits), which will allow him/her to maintain his/her lifestyle, even possibly becoming very rich. The ultimate goal is therefore “simply” to stay in business. When the entrepreneur gets tired, he can simply pass the business on to someone or sell it to an interested buyer. On the other hand, the goal of a startup’s founders is not to run the business for the rest of their lives, but rather to bring the company to such a high value that they will be able to make an exit after a few years. An exit can generally take place in two ways: through the acquisition of the startup by another larger corporate, or through an Initial Public Offering (IPO). Through the exit, founders can sell their equity stake, and since the value of the company is assumed to have increased greatly over time, they can thus generate a return on the initial investment (made at the time the startup was founded). For example, if initially each one of the 5 founders had 20% of the company, whose valuation was $100,000 (so each founder put in $20,000), at the time the company is acquired, each founder could have 2% of a company worth $500 million. In this case, each founder would have $10 million. So, having put in $20,000 as input (along with an exterminated effort), gave each founder $10 million in output. This is therefore the way of thinking of a startup founder: looking at his/her company as an investment instrument. The capital gained from the sale of his/her equity stake can then be used for example to found another startup (and thus become a serial entrepreneur) or to invest in other promising startups (and thus become an angel investor). Of course, founders can also decide not to sell their equity stake, even if the company has become very successful: in this case, the dynamics of a large company will be triggered.
• Funding. In order to grow fast, startups need a large amount of capital. Since the founder’s initial capital is generally not enough to cover development costs, the team look for money from other external sources. However, due to the high level of risk their project and having no financial history behind them, access to debt capital is not an option. Here then equity investors come into play (initially in the form of angel investors and then as venture capital firms). Equity investors inject capital into the company in exchange for equity, or ownership. They goal is to make a high return on investment (ROI) when the company will make an exit. In order to cover their management costs (and specially to cover the capital loss resulting from companies in portfolio that will fail) equity investors look for companies able to grow fast i.e. the invest in startups. If everything goes well, during its life cycle the startup will welcome many investors in its equity, making several funding rounds (seed, early stage, series A, B, C, etc.). Therefore, founders must be comfortable in giving up shares of their company. At each round, the founders’ equity stake will decrease (and therefore also their ability to control the company). Investors will join the board and will play a key role in the management of the venture. However, on the other hand, investors will also bring their experience, actively supporting the startup in it growth. The value of the company will also increase and the founders will have a smaller slice of a bigger cake. This logic does not apply to small businesses. Not having a high growth, they do not succeed in attracting equity investments and instead turn to different sources of financing (loans, lines of credit, asset-based financing, etc.) to fund their activities. Also, small businesses’ owners are not very much in line with the concept of giving up their equity. They prefer to have a small company, but can control it completely independently, without having to respond to investors’ needs. The issue of equity dilution is a very important aspect that every entrepreneur should consider carefully before deciding the type of business he/she wants to start. The fundamental tension yields “rich” versus “king” trade-offs (this theme is extensively discussed by N. Wasserman in “The Founder’s Dilemmas”).
• Level of risk: When it comes to starting a new business, there is always a high rate of risk. Products may not be able to reach the customer, the brand may not be clear to communicate its positioning, partners may not have the skills to operate effectively and efficiently. All elements that in the long run, make the business unsustainable. However, when we speak of startups, the risks are multiplied out of all proportion. In fact, small companies have the benefit of starting in an already established market, in which the effectiveness of their business model has already been demonstrated for a very long time. On the other hand, startups aim precisely to disrupt the existing market, testing new ways of generating revenues with an innovative product or service. In this case, the risks already begin in the research and development phase of the product (from the proof of concept, to the minimum viable product, to the prototype). The technology used can then be very advanced (risks related to the Technology Readiness Level) and therefore one must proceed by a long trial and error process. It is then necessary to fully understand the user’s problems and the way in which a new product can solve his/her needs. Not to mention the fundraising process: convincing an investor to put real money on what at first is almost just an business idea, well it’s not easy. And not surprisingly, the success rate of startups is very low. According to Shikhar Ghosh, of Harvard Business School, for an investor, “If failure is defined as failing to see the projected return on investment — say, a specific revenue growth rate or date to break even on cash flow — then more than 95% of start-ups fail” (Gage, 2012). Despite these uninspiring statics, it is important to remain proactive. The point is: every startup must be seen by founders as an experiment, through which they can improve in their entrepreneurial journey. Even if one goes wrong, a new lesson has always been learned, to be applied in the next venture.

2.2. Startups VS Scaleups

While startups and small businesses are two different ways of doing business, what was previously a startup becomes a scaleup when the scaling process is triggered, that is when the growth mechanism is working. So, let’s see some elements that make a scaleup different from a startup.

• Market validation. Although a startup has very clear (at least theoretically) which market it wants to disrupt, its ability to succeed is still to be demonstrated. A startup proceeds experimentally, making hypothesis on different customer segmentations, exploring several product features, and gaining information on the real customer acquisition cost. We therefore proceed by trial and error, and sometimes, when the founders realize that something really doesn’t work, the company even decide to do a pivot, radically changing its business (while using the assets already developed, e.g. by applying the same proprietary technology but in another area). On the other hand, scaleups have really proved that their product/service is sustainable in the market. In this case, it is said that a scaleup has reached the so-called product-market fit i.e. the company’s value proposition satisfies the underserved needs of the target customers.
• Stage of Funding. As for funding, one milestone that can make it clear that a startup has become a scaleup is access to a series B round. In their process of launching and defining their business, startups try to collect a first round (seed) from one or more angel investors and some of them manage to access a series A round from one or more venture capital firms. Being able to raise a second round of venture capital means that the company has managed to demonstrate the validity of its business project. The team has gained credibility in the field and can propose a realistic plan to scale. The capital raised in the series B round is used to accelerate no longer product development and market testing, but the actual production and marketing.
• Level of risk taking. The larger a company becomes, the greater its aversion to risk. If for a startup the keyword is “test it”, for a scaleup the mantra is “multiply it”. The validity of both the product/service and the strategy have been proven and now it’s time to execute fast. Investors, clients and team members expect to multiply the results. As the company works effectively as it is, there is not much room left to test new ideas. A scaleup is still a high-risk company, but its risk propensity decreases over time. Risk management is therefore oriented towards maintaining what has been built up to this point (competitive advantage, market share, brand identity, intellectual property, etc.). The product can be updated, but always keeping its essence intact. Each step is taken with extreme caution.
• Roles and processes. The boundaries of job roles within a startup are often not well defined. Of course, the founders give themselves titles, CEO, CTO, CFO, but there are many times they find themselves wearing different hats. This is to encourage brainstorming and find new solutions through different points of view. Process management is also rather unstructured and proceeds fairly rudimentary. These work dynamics are no longer found in a scaleup in which roles become well defined and everyone has to focus on their part. This is to increase the efficiency and therefore the speed of growth. Of course, the number of team members has also increased and therefore it is possible to allocate human resources more specifically. Processes are documented and managed so that effective ones are easily reproducible. The topic of leadership becomes more important and managers are also hired to manage large groups of people. The company now has a clear brand and also a well-defined culture.

I hope this article has been useful to clarify the several phases of startups business life cycle. If you liked it, clap your hands and follow me to stay updated on the topics of startups, venture capital and data science.

For any curiosity or information, feel free to reach out! Here you can find the link to my website and my other online content.

| francescoferrati.com | linkedIn | google scholar |

Cheers