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February 16 | Innovation

How startups can increase the price of business

How much the startup that I possess, and why not so much - these two simple and natural questions have recently begun alarming not only venture capital investors, thinkin on the problem of business exiting, but also startups facing the challenge of getting real money for their shares or stocks. Why they probably won’t get what they want? STRF publishes an expert’s opinion who for a long time have worked in this part of the investment business. STRF invites all interested participants of the innovation community to the discussion in the comments section.

Basing on the theory of venture investment startups are hoping that their company can cost exorbitant sum, if the buyer or investor becomes assured of the existence of a billion market for their products. In our experience of investment deals with early stage start-ups, the first attempt to sell a share for real money in the domestic market results in major depression for 90% of startupers.

Firstly, no exorbitant costs at the domestic market. Large domestic companies and state-owned corporations, for which is much more profitable to buy technology startup at a good price than to develop the technology in house, normally do not purchase such companies whereas private buyers (or investors), according to current statistics are ready to consider the transaction for an amount not more than 200 mln. rub., and the company should have a decent turnover by Russian standards (50-100 mln. rub. per year) and, more importantly, the transaction must bring to owners an annual income sufficient to recover the investment within maximum of 5 years.

There is, however, another problem that is not noticeable at first glance -

it turns out that the vast majority of Russian technology startups have little or no cost, and all of their "value" lies in the minds and commercial communications of the major developer and "essential" employees.

Ask a  question: will the hired staff of your startup on their own, without your help, be capable to produce high-quality products (or prototypes) in the right quantity, at the right time and sell it? From my own experience and the experience of colleagues from venture capital funds we know that in almost 100% of cases you get a negative answer. The reasons will vary, but the principle is the same - a startup as an organization, has no in house technology, authorizing or marketing and sales information of a sufficient quality (to put it simply there are no instructions on how to produce the product, certificates, permits for use of the product, customer base, or customers).

In this case, for any business purchaser ( who spends his own money, and who plans to earn more) to acquire a start-up is meaningless because the market value of a company is not very different from the costs for registration of a legal entity, whereas one should buy a key business value - those who know how to produce and sell the product, ie developer and key employees that is much cheaper.

Summing up the experience of managing and investing in start-ups, as well as interaction with investors and developers (about 30 start-ups), we can name the two main reasons for the low capitalization of domestic start-ups.

External one: none of those who give money to startups at the initial stage would set a task of increasing the value (capitalization) of the company. The parents who gave the money to the first offspring’s-startups? No. Funds handing out grants and subsidies to small innovative enterprises? Also no. Strartaper himself? It usually does not even know that such a problem exists.

Internal one: - a deep conflict of interest between the parties of a startup - developers, managers, early stage investors. It is noteworthy that regardless of the human and professional qualities of the team members the conflict does not manifest itself at an early stage (about a year), but it becomes obvious, sometimes leading to scandals and feuds between the parties after two years.

The developer having fulfilled his main role in the stage of prototyping and pilot production batch, becomes passive owner of the share of passive startup, the cost of which mainly depends on someone else, i.e. success of the leader in the organization of production and sales. The question when and how much the developer will receive for his share remains for him unanswered, but a clear and reliable alternative is to obtain income from the startup activity in the form of dividends or from consulting services.

That is, the developer becomes interested to remain the owner forever and keep know-hows at as a guarantee and not to transfer them to employees of a startup.

Investor of the early stage  on the contrary wants to sell its share as soon as possible after his money spent on the creation of the prototype and pilot production batch, and therefore interested that all the secrets (technical, marketing, sales) were owned by start-up itself in the form of documents or electronic files rather than individuals in their minds and computers. The cost of the share in the sale, of course, should be substantially higher than the cost of its acquisition, but the main thing for him is to sell quickly.

The owner of startup and its leader takes an intermediate position - on the one hand he is interested to sell the company, but for him the main thing is the high price, which he is willing to wait a long time for, because, as a rule, he receives a salary and has the ability to use the resources of the company. He votes to transfer technical secrets to the startup but he prefers to own the secrets of marketing and sales personally. It’s again a guarantee that no one will substitute him.

So, the conflict lies in a diametrically opposite approach of the participants to exit the business, its effects is that the money and efforts are spent, and the value of the company is in fact equal to zero – no possibility to sell a share or attract a private investor.

In the oases where venture is dominant conflict is resolved by, in particular, via a struggle of startupers and investors that took a shape throughout decades. This struggle was intented to harmonize interests with unwritten standards and rules of early stage businesses one of which is «create and keep at the company’s safe» the following:

· high-quality technical and technological documentation, which can be used to produce the products and that can be upgraded without the participation of the developer.

· Actual marketing, sales, purchasing information, by means of which the recruited staff can promote products to local market, promote the production of components and materials. "

When the faithful execution of this simple rule, any start-up even without sales acquires a certain market value in the form of documented information, which guarantees to any of new owners the possibility of organize the production and sales of products with a certain margin.

Unfortunately, in Russia, such standards are not created and applied. The problem is not only in children's disease of the industry in general. The state finances the vast number of technology start-ups, by virtue of its enormity is unable to defend its own interests in smaller companies, the chief of which is that investment funds should capitalize the start-up, rather than individuals within it. Only in this case, the startup has a chance to become an independent, fast-growing and highly profitable business, and the government has the chance- to return the invested funds.

It is logical in this situation, using international experience and taking into account local conditions, to develop and implement standard of business in start-ups at the early stages at least, for those who receive grants, subsidies or investment from budgetary sources.

The standards to manage medium and large enterprises have long been developed (MRP II (Manufacturing Resource Planning - Enterprise Resource Planning, ERP (Enterprise Resource Planning - Planning Resource Corporation) and ar successfully applied in practice in Russia as well, but their use for early stages startups where the manufacture and sales are just being established or has not yet begun is too expensive and burdensome for its shareholders and staff.

One need an adapted standard aimed at ensuring the capitalization of start-up in the course of development, which should contain the requirements and rules for the core business management, management accounting, legal documentation paperwork, protection of confidential information, managing technical, technological and licensing documentation.

The introduction of such a standard would solve a number of important issues. First, it might increase the efficiency of use of budgetary funds allocated for the development of innovation and of import substitution, and second, it might create many highly profitable small technology companies for investors and corporations at the domestic market.


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