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Even Formula 1 slows down in rainy weather

Market analysis
OXO Team 2024.06.21.

It is no coincidence that there is now a public debate about what strategy a technology startup should choose for growth and raising capital. The opinions published so far in the context of the so-called Great Startup Debate have analysed the accumulated experiences, successes and failures, and drawn lessons within their own domain of interpretation. In doing so, they have largely all ignored the new economic, growth and investment strategies required by the radically changed macro and financing environment since about 2022, and the growth patterns that could result from the embedding of all these economic effects. But if we are wondering what the fastest speeds and acceleration of a Formula 1 circuit are, and what the risk of derailment is, it is also worth considering whether the circuit itself has been soaked by rain, whether there is any persistent dirt on it, and whether, if all this is misjudged or ignored, we are causing a mass accident.

The magic word of the startup world, the unicorn, which has been repeated for a decade and a half and applied to companies valued at $1 billion or more in the private investment round, is fading. The only way to get into this closed elite club was not by revenue, growth or profit performance, but solely by whether there was an investor who had put his signature on a company valuation of up to $1 billion in sequential investment rounds at ever-increasing valuations, shows that this whole phenomenon is far from being caused by accelerating technological development, but rather by the tsunami of capital available in ever more brutal masses and at ever lower prices from the 2010s until the end of the covid period. That is why the list of unicorns that have irredeemably closed down after their last round of investments, even billions of dollars, or at least lost a significant part of their goodwill, is growing fastest these days.

However, the Hungarian professional discussions seem to be still in a bubble, discussing what would be better for the development of the Hungarian startup sector, what would result in a broader accumulation of knowledge and reinvestable capital gains: more small or medium sized startups or a long-awaited domestic unicorn?

Well, the fact is that even in favourable macroeconomic and financial market conditions, this quetion is wrong. It is a relatively simple mathematical principle that the return on investment does not depend on the amount of capital invested in a project, but on how successfully and efficiently that capital is used for growth, regardless of the number of projects involved. Even a $2-3 billion exit, i.e. a sale of a company, does not leave much profit for the founders if it was only achieved from a previous investment of a billion dollars, because the investor expects a minimum return on its investment and if the exit sale price of its stake does not come out of that, its expectation of return will reduce the founder’s exit share. And such rounds of investment invariably come from international institutional investors who have no sense of mission to reinvest profits back into the domestic startup sector, and if overinvestment reduces the profit share of domestic founders, these founders may also have less capital to invest in the revitalisation of the domestic tech sector. By contrast, a dozen $100 million exits can always result in dozens of successful founders with $30-40-50 million in assets, if they raise capital in a well-planned, conscious way and use it to best effect. They are also likely to be larger in number and may even have more useful experience to share with future entrepreneurs in the sector. This does not justify the logic of raising capital as quickly as possible at the highest possible valuations (and certainly not from abroad), but only the well-targeted raising of capital that can be used efficiently for growth, while channelling all the knowledge, experience and cooperation opportunities to achieve the highest possible growth through efficient use of capital. But of course it is not easy to accept this simple logic in an environment where a significant part of professional organisations and the business press does not even consider traditional financial metrics such as revenue and profit to be worth mentioning, is deeply silent about how much of exit revenues went to foreign institutional investors and how much remained with domestic founders, but only fetishises the raising of capital at the highest possible valuations and presents the raising of capital as a success story.

That said, it is a fact that the Hungarian startup sector has not even achieved a dozen of the $100 million exit. In addition, although the financial data on domestic exits that have so far been presented as successes are not generally public – i.e. how much of the money is stuck with foreign institutional investors, how much of the profits were realized by local investors and how much could have remained with the founders – in many cases it is easy to calculate, that even these domestic success stories often have the unfortunate feature that the founders did not receive exit proceeds in proportion to their ownership, because investors took a larger share of the exit due to the expected return on their capital. In other words, the founders had previously raised more capital than they could effectively and successfully deploy for growth, which they saw the detriment of on exit. They would have had more left in their pockets with less capital financing misspent, i.e. if they could achieve the same growth with less capital, or if they could achieve more growth with the capital raised. In fact, misspent capital only harms the investor in the case of total collapses; in other viable projects, it is the investor who gains the additional benefit of the higher capital raised and possible over-financing, necessarily at the expense of the founders. The inflated valuations and the unicorn cult are therefore in fact a trend fostered by large international institutional investors, which have been able to squeeze a much larger share of the profits from genuinely successful startup projects and thus to realise higher returns on the mass of investable capital that has been available in the recent past. This was true as long as there was still a large amount of capital available for investment and as long as these unicorns did not themselves start to fail in succession.

There has never been enough venture capital available in Hungary to finance such a dubious trend, and the fact is that the Hungarian startup sector’s capital funding is far below the European and even the regional average. At the same time investor activity has fallen radically in all markets, especially in the case of overpriced, giant-scale investment rounds, perhaps not by coincidence. But the comparisons that can be made also show that this is not the main weakness of the domestic startup sector, as it has underperformed not only globally or in Europe, but also in regional comparisons, in periods when there was a significantly higher volume of investable venture capital available (see for example McKinsey’s analysis of 2023 based on data up to February 2022). Ultimately, it is not surprising that the domestic startup sector lags behind just like the whole domestic economy in the same indicators: productivity and efficiency of capital use. And it is particularly piquant to offer as a solution what is the greatest burden on the domestic economy in general, i.e. that the growth opportunities available are only benefiting a narrow, closed elite and cannot bring about any meaningful progress among the wider economic actors. It is not clear how a professional approach of the same kind would help the domestic startup sector to catch up internationally.

In the light of the above, it would be a mistake to encourage all promising domestic startups to raise as much capital as possible from foreign players as soon as possible. In fact, a professional programme that only advocates this could not only harm a few misguided founders, but the entire domestic ecosystem. It would be an even greater mistake to simplify the current premise to the effect that the fate of the Hungarian startup sector depends on the amount of funding available, i.e. the amount of capital that can be invested in the period ahead. But the temptation is obviously strong, and we know this in practice: most failed startup founders argue that they failed because they did not receive enough funding from investors, and that their competitors received much more, and that if they had received enough funding they would have been at least as successful, or even more successful. In the meantime, we all know that this is mostly just a psychological coping mechanism for failure, because it is not because you get more funding that you become successful, but you get more funding because you were more successful, that is, you were able to demonstrate that you could successfully use your resources and the capital you had raised to grow. In such a case, investors will sooner or later queue up and, as explained above, will even try to impose a level of over-financing on founders who are prone to be driven mad by higher valuations, which, in more favourable economic circumstances, will not kill the project but will only divert a larger share of the profits to the investor.

Even if it is not easy to implement, it is at least easy to define in words the current task of the actors of the domestic startup sector: in fact, it is necessary to improve the overall performance, productivity and efficiency of the actors of the sector in terms of capital use, and then not only the scarce domestic but also the more abundant international private capital will queue up for investment opportunities to be part of new success stories. To this end, the cooperation, support, professional publicity, financial and professional collaborations, which are currently exclusive, selective and closed to investors and founders, must be made much more open and inclusive, as should be the case between all economic actors in the whole domestic economy. For it is not if a few selected players, who are pre-publicised in top lists, produce occasional success stories that will move us up the regional and European rankings, but if as many of them as possible are able to make the most of their potential. There have been other instances where such leaps in development have been achieved at a time when resources have become scarce, precisely because a more efficient use of resources has become unavoidable. At present, the scarcity of resources is a given, and the leap forward is up to us.

Originally published in Hungarian on portfolio.hu on 7 June 2024