A good friend of mine recently quoted a founder to say, “Startups are just glorified SMEs.” He also wrote an article on how we need to focus on creating jobs and revenue, and as much as I agree on creating value and not hyping companies to crazy evaluations, I think a startup really isn’t anywhere near what the business world refers to with the term SME.
Startups, in my understanding, are a privately funded metric approach of trying new business models in an environment where there is largely no one else that has tried the exact same — mostly made possible through an innovative way of implementing technology and sometimes disrupting old industries. After all, isn't that what we all look for? Isn’t that what created bloomer terms like the “unicorn”? The next big thing is what we commonly search for when thinking about startups, but let me dig a little deeper here.
1. Startups are not financed with debt
The most obvious distinction between startups and SMEs is the fact that most startups are financed through risk capital, not debt. There’s the Angel Stage, with the three F’s (friends, fools and family) contributing the first couple thousand; the Seed Stage, funded mostly through other professional founders, angels and sometimes venture capitalists; and finally, “crossing the chasm” to real venture capitalists — professionals who all know or should know the money is gone first of all, but if it returns, it returns in multiples.
Lately, it is noticeable that some late stage startups (some refer to them as “Scaleups”) are borrowing money from growth investors. This is when, by a classic definition, the startups become SMEs: when the money they use is not risk capital that everyone agrees is gone if the company fails, but money that can actually be sued for in court and needs to be paid back with interest when the startup’s path is foreseeable and non-risky, and once it can lend money that is guaranteed to be paid back.
2. Startups grow like crazy — or fail
Professional startup investors are looking for the “hockey stick” in growth — for something to go viral, for something that explodes in attention, users (recurring, monthly, daily) or revenue. But it is extremely important to understand that some investors encourage startups to burn money, to not go for revenue right away, but to actually develop a “defendable market position.” This is a position in which the company is leading a vertical, maybe even leading across verticals (Amazon, Google), that allows the startup to then become cash flow positive once it has reached that position. An example is Amazon, which only became profitable after burning though heaps of cash. Or Tesla, whose founder, Elon Musk, is not profitable, but threatening a whole successful industry (automotive) with his speed, crazy goals for growth and revolutionary ideas worth close to 30 billion on the stock exchange.
An SME, in contrast, having borrowed money to invest with a long term strategy in a mostly proven market or business model, is growing steadily, making solid revenues (mostly very early on or clearly foreseeable) and sometimes investing its own money in research & development or growth.
3. Startups are successful with extremely limited resources — or they fail
Some startups manage to create immense valuations and exits with very little resources. Resources in this case can be both employees and capital, and in the case of a startup’s success, the proportion of revenue to headcount is usually significantly higher than that of an SME. Where traditional production methods sometimes have a high amount of resources necessary to create a sustainable business with a low but steady profit margin, a startup’s margin can go through the roof with no resources at all. A good example is software as a service, where the Gross Profit Margin is sensational: The cost of adding new clients is reduced to creating a new login to the same software, accessed through the browser and some marketing and support. Once a SaaS works well, the customer development and acquisition cost (and churn rate, but let’s not go too deep here) is the only real cost to be contrasted with revenues. Or simpler said: The more clients that startup finds, the more profitable it becomes.
4. And actually, most startups fail
Another significant difference between SMEs and startups is the fact that startups embrace failure. My team and I at Factory have put in significant work to convince policymakers of this (with us to yet prove successful). Startups embrace failure, and there is a whole culture around that. From Fuckup Nights, to statistics on how your chances improve over multiple failures; from VCs looking for seasoned entrepreneurs that have been through the bad experience of failure, to entrepreneurs really admitting to their mistakes and taking them in as a learning experience — our culture in Europe is not yet fully embracing this very relevant part of startup culture.
Even worse is when you found a company in Europe, EVERYONE involved insinuates success. Your lawyers, your tax consultants, your bank that just has your account taking emergency measures when invoices are paid late to all credit rating institutions that try to evaluate whether you are credit worthy — they all almost demand success, for you to be an integral and functioning component of our society.
But — and this is the biggest but you will hear from me — startups are not taking public money, they do not take debt, they will know whether it all works and they grow crazily very early on. Or, they will embrace failure and stop, which couldn’t be more different to your standard Small to Medium Enterprise, sometimes kept alive with subsidiaries and credits, not realising the world around them is changing. (Of course this last bit isn’t true for all SMEs, don’t start trolling me just yet).
The European Commission, in its effort to support SMEs, created a definition of what an SME means, which was legally adopted by its member states in 1996 and 2003. In Germany, this definition made it possible to actually lower the VAT for hotels, to stimulate the sector of hospitality. The Italian government has introduced a piece of legislation with tax benefits, simpler setup procedures and many other benefits for “innovative startups”. And together with a few tech companies and startups we have proposed a legal definition for startups from Berlin, again to create benefits just for this new breed of companies, in order to create growth in the technology sector and stimulate more entrepreneurs to try and found a company. You can find our proposition here.
If it is acknowledged that 9 out of 10 startups fail (the old rule in venture capital), then policymakers responsible for the framework of our economy and the surrounding businesses we interact with (banks, lawyers, tax consultants, even corporates that could procure with us) need to accept that startups are not SMEs — and for the sake of the brave chosen few that made it regardless of the hurdles, for the sake of those that didn’t make it but still dare to try, for the sake of our European economy to have its own technology giants — acknowledge the difference, embrace it in the frameworks created, and help entrepreneurs build a diverse, sustainable and future-compatible version of capitalism that still has to prove it is worth maintaining.
If we treat startups as SMEs, we kill the ability of Europe to create real world-shifting technological and societal innovations — something Europe is just starting to figure out how to do. In the end, we’ll just be left with a handful of nice e-commerce platforms and food delivery services.
But with successful founders reinvesting in the startup economy (not buying yachts on Cayman Islands, but funding entrepreneurs or “doing it again”), creating value in a highly diversified and international context, embracing different cultures and embracing parenting and education, at least there is hope. That’s what makes me want to work with startups. That is my motivation to build Factory.
But pretty please with a cherry on top, don’t tell me startups are the same as SMEs and that it all goes back to “just” optimising for profit. We have the chance to change something, if all involved understand what’s happening. If you are a founder or entrepreneur, go tell your story and highlight the differences. Let’s create the next big thing in Europe.