Disruption versus macro growth

Dichotomy is always a risky approach for analysis. However, entrepreneurs shouldn't waste too much time fretting about certain topics as they face more challanges in more relevant subjects. I will therefore use dichotomy to save some time in answering a very important question:

What drives the VC investments in different countries or regions?

20 years ago the answer was more universal and exclusively "disruption". VC money went into startups that had the opportunity to disrupt different industries. Silicon Valley was practically the only place with a meaningful VC-startup ecosystem back then. Little surprise that most giant tech firms today come from that tiny piece of penisula strung by Highway 101 and 280.

Today it's a very different picture. VC investments are made in huge amounts in practically two geographies: the United States and the fast-growing emerging market.

 

United States – Disruption

Being an advanced country with relatively low (but still impressive by western standard), the United States see its money flowing into the good-old-fashion disruption-bound startups as it was 20 years ago. The only difference: because of the lean startup trend and the fact that we can do lean startups today, VC investments now spread beyond Silicon Valley and into metropolitan areas such as NYC and LA, where young urban entrepreneurs seek to improve the everyday life of the densely populated regions.

Note that despite being regarded as part of Silicon Valley today, SFC's rise to prominence (and to the hatred of its real local residents) coincides with this lean startup trend. Prior to such trend, starting a tech-heavy company in the expensive and distractive urban area was just not a good use of the investors' money. Today, on the contrary, hotshots like Uber and Airbnb have proven that urban populations in developed countries could trigger the largest and the fastest disruptions if they could provide the right tool. Tech startups are therefore no longer confined to geeks in the suburb garages.

 

Fast-growing emerging markets - Macro growth

The other geography where you see huge amount of money piling in is all the fast-growing emerging markets, particularly China, South-East Asia and India. Here the story is without a doubt macro growths.

When a country is growing annually 6% to 10%, there are just many opportunities for any type of startups. Disruption is part of such country's life and it does not have to be the Silicon-Valley type of disruption.

Think about China. It's not just a country with a huge population. It's also a country that has been growing super fast for a long time and even at a slowed-down rate it will still grow 7% annually in the years to come. With the growth comes the constant changes in the social structure, opening up doors for startups to try and jump on the changes.

More importantly, with growths it's much easier to envision an upside of a company for the financiers, whether it's a startup or a big enterprise.

Again, let's go back to the highly simplified Gordon Growth Model. Assuming a certain startup has a discount rate of 30% to reflect all kinds of risks. For Gordon Growth Model to work, we have to assume that the startup is already generating positive free cash flow (FCF) from its operations. This is apparently not true for startups but I'm simplifying the calculation here so that you could see the impact of the growths, which will have similar impacts with a full DCF valuation where most of the value for a promising startup comes from after Year 7~10.

Now assume that this startup generate $10M FCF for this year. In the two following growth scenarios it will have such valuations:

  • Growth of 10%: Valuation = $10M*(1+10%)/(30%-10%) = $55M
  • Growth of 20%: Valuation = $10M*(1+20%)/(30%-20%) = $120M

Note how sensitive valuation is to growth rate: a doubling of growth from 10% to 20% gives $65M more paper value to the entrepreneurs here. It goes without saying that it's much easier to generate such a growth figure of 20% in a country where the macro is growing 7% compared to 3%.

This explains why you often heard news of international and local VCs are pouring in $10M, $25M or $50M of Series B or Series C into startups in China or Indonesia but when you take a look at the startups' business models, they look like copycats – and sometimes they're really certified and proud copycats such as Rocket Internet, which has been investing heavily in South East Asia by cloning Amazon and Airbnb.

There's no point of accusing the VC investments in these regions short-sighted or anti-innovation.  Fundamentally VCs are money managers just like their counterparts in mutual funds and hedge funds. Their job is to generate the expected return for their cost of capital. And if any geographical macro growth makes their job easier, they will surely go that distance.

 

What about Europe?

There's no doubt that Europe startups has to go for disruption as growth figures here even lag that of the United States.

Sadly despite – or maybe exactly because of – the huge amount of government funds pouring into R&Ds, we don't see a lot of disruptions here, at least not in the business models. This is why VC investments here, as of today, tend to be smaller amounts and at lower valuation compared to the US and the emerging markets. I personally have seen a great serial entrepreneur almost begging for $8M for 3 months. During the sames time frame copycat startups in China getting $20M+ rounds hit the news headlines almost weekly.

I guess the takeaway here is that if you're an entrepreneur in Europe, you shouldn't be questioning why your Asian lean-startup colleagues are getting big rounds while you're struggling to get your patented technology born in the Ph.D program seed-funded by the European VCs. When you don't have the macro growths to back you up, your product has to be 10X better, quoting Peter Thiel, for it to have the chance to grow as fast as required by the VCs.

In other words, go for the disruption however difficult it is. That's the only way out here.

A movie for entrepreneurs – The Maze Runner (2014)

Quick thoughts about Uber's recent fundraising of $1.2B at $40B