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Friday, July 19, 2024

SMEs and Startups: What really separates those?

There’s a debate raging in the Bangladesh ecosystem on what makes a startup different from an SME. Personally, I think this is a healthy debate that’s long overdue, as the word startup has been over aggrandized to be the end-all, be-all for those aspiring to entrepreneurship, without sufficient disclaimer on what it truly takes.

But there’s also a natural rebuttal – why does it even matter? Isn’t the purpose, at least of angel investing, to find the best companies that can generate value, create jobs and remake the economy? Yes and no.

First, What Makes a Startup Different from an SME? They Aim to Win a Growing Market through Technology and Capital

Target Market–A startup aims to win over a large, almost monopolistic part of a fast-growing market segment that is often emerging, being created through demographic, policy and technology changes in a society. For example, think of the size of the social media industry, which is really a segment within the much larger media industry, in 2004, when Facebook was launched, versus 2021.

Market incumbents will often ignore startups and their niche segments for this very reason – the specific niche they are playing in is too small for the incumbent companies that derive their revenues and profits from more established segments, until it grows much larger and they are playing catch-up, or worse, try to use their powers of incumbency to go after the startup rivals, though often too late and at the expense of consumer choice. The smarter ones play ball and buy into these startups.

This market segment is at the very least national, but can also be international in scope. An SME, on the other hand, finds a niche often with a local or even hyper-local setting.

Business Model & Technology — As I have written earlier, a startup is a business in search of a repeatable and scalable business model, abetted by the creation of proprietary technology be it hardware and/or software. An SME, on the other hand, may or may not be developing technology, and when it does, may be using something off the shelf. Their business models tend to be tried and tested in other contexts, and applied within their own highly specific, very localised niche.

Profitability–Because a startup is in search of a business model, its first years are defined by the search for product/market fit, as well as revenue and user traction, which means running losses are more likely than not. This is only made possible through multiple rounds of equity fundraising, from investors who make those bets based on the prospect of the startup reaching scale and potentially owning a major chunk of the market it is in down the line. An SME, on the other hand, has the pressure from its investors to make profits as soon as possible, though it may start with an initial capital outlay.

Customer Interface— In order to scale, a startup seeks to interact with customers through digital and self-service interfaces if it’s B2C, and if it’s B2B, there might be some sales support. An SME on the other hand tends to be more hands-on with customers, often through brick-and-mortar set-ups.

Employees— This is probably the best way to differentiate a startup from an SME. As a startup grows, the team size will remain stable or increase only slightly, to make improvements in the product. Whatsapp is probably the best example of this – millions of users and only 55 employees when it was acquired. On the other hand, as an SME grows, it needs to invest in growing its employee base, in order to support a growing customer base. As the Slidebean video says, “If you’re replacing an existing manual process with tech, then you might be on your way [to being a startup].”

Competitive Differentiation— A startup is defined by the intellectual property it generates, namely the tech, which creates unfair advantages such as economies of scale, network effects and a 5-10x improvement in user experience. An SME might have a strong brand, though its most enduring competitive advantage tends to be localized within its geographic footprint.

Types of Financing – Startups will require equity funds from investors who seek to make an outsized, multi-fold (often 10x plus) return on their investment. SMEs, because they generate revenues and are profitable faster, can take on debt and quasi-debt finance such as revenue and profit share. Because of the unpredictable nature of their growth trajectory, startups cannot make guarantees on returns. SMEs can use their predictable cash flows to obtain and pay back capital that requires mandated returns.

Exit for Investors— Outsized returns in startups really come in two ways: an IPO, or a strategic buyout. An SME can generate dividends, can be kept forever among the promoters (and their descendents), liquidated or if it’s at a certain size, bought by private equity which seeks smaller, single-digit multiple returns compared to venture capital which seeks double digit multiples.

Second, Why Should Founders Care? So They Are Aware of the Companies They Are Starting, and the Fundraising and Growth Trajectories That Are Possible

Founders need to be cognizant of the kind of company they have, and are capable of building. Not every company has to be a startup, and not every entrepreneur needs to create a startup.

This is important, as we often see in Bangladesh hyper-localised or highly niche versions of major startups that have scaled and raised millions of dollars in capital, pitching for their own funding. It can be a fruit and vegetable delivery e-commerce site that mimics Chaldal, the dominant e-grocery platform that is now at Series B stage, with backing from major institutions such as the International Finance Corporation.

It can be a micro-services marketplace that is strong in a certain neighborhood in Dhaka or in one or two service verticals, that mimics Sheba, which is going national and is strong across multiple verticals. It can also be a restaurant delivery app that has brand value within a certain part of Dhaka or in a secondary town, that competes with nationwide players such as Pathao, Shohoz and Foodpanda, which happens to be part of a multi-billion dollar, publicly-listed global company called DeliveryHero.

It can also be a last mile delivery service for e-commerce that mirrors the work done by the likes of Paperfly, which recently received investment from an Indian startup in the same realm, which in turn has raised 100’s of millions to date.

The harsh reality in the startup game is that capital and scale matters, especially when combined with first mover advantage. While niche players can survive within their own pre-defined areas, moving against incumbents nationally at this stage will require significant amounts of capital, in the tens of millions of dollars.

And that capital, if it is to come from institutional investors, will favor the incumbents, because they are more likely to survive and grow because they’ve proven they can. Our advice to founders creating niche models is to work for founders who have successfully fundraised for and scaled businesses, and develop their managerial expertise and apply those into new and ambitious ideas that are still wide open in Bangladesh.

Even better if you can get those founders to be your angel(s). Or, you may have to realize that your best shot is staying within your hyper-local or -specific niche, which means you’re become an SME, and you can work with these national players as their distribution and fulfillment partners.

Even if an entrepreneur is not in a market where there is a strong incumbent startup, it is important to understand just what the expectations of investors are. One institutional VC said in a forum with me that whichever investment he makes, that investment on its own should be able to return the entire fund, in order to compensate for the risk of the rest of the portfolio not working out.

Using a very simplistic example, if a VC has a $20 million seed stage fund, which writes investment checks between $250K – $1M, that means that each investment has to try to return $20M within 5-7 years of the investment. Let’s assume that the VC took 10% of a company for $500K, and is diluted down to 3% after 5 years and at least 3 rounds and is looking for an exit.

This means that the enterprise value of the company has to equal $670M by year 5, in order for 3% to be worth $20M. Assuming a 20x price over sales multiple, that means the company needs to be generating $34M per annum in revenue by that time, when at the seed stage its annual run rate might have been $500K-$1M. That’s a compounded annual growth rate of 100-130%, over five years.

How many businesses, and founding teams, can achieve that kind of scale, that fast, that consistently? More importantly, how many would want to take on such pressure? Especially if they cannot concentrate solely on company building but have to constantly fundraise, each step of the way, for bigger and bigger amounts that may or may not be possible in an early ecosystem like Bangladesh?

There is a reason why the most successful startups are called unicorns – it’s a near miracle when one is found/created. But VCs raise their money from massive, multi-billion dollar corporations, governments, endowments, family offices, foundations and the richest people in the world precisely because those investors want to and have the capacity to take a risk on such lowest-probability but highest return opportunities. Only exponential returns will do when it comes to venture capital, including venture capital investments in Bangladesh.

Once again, it’s important for a founder to understand what kind of business she wants to build, are capable of building and are building. It is perfectly fine to go for an SME business model that can grow steadily at 10%, 20%, 30% per year compounded. But founders need to raise accordingly, from investors who also understand what type of business they are in.

We often see a tendency and desire to raise money in the pre-seed and seed stages from angels at multi-million dollar valuations without understanding what drives those valuations, including the creation of intellectual property and demonstration of exponential scalability, or at least a vision and plan to achieve it, and founder credentials backing that vision and plan.

Without the benefit of these things, if a company raises money from angels at such lofty valuations, it may come at the expense of long term success by creating expectations from investors it may or may not be able to meet when follow-on capital becomes scarce because the company’s revenue and user growth has not lived up to its valuation. This is especially true when the company starts pitching to VCs who have exponential growth expectations.

I have personally seen companies and founders in Bangladesh having to pivot from a high growth startup-style business model and opt for a low-burn, SME-style model when they realized that either the market or business they’re in will not allow for the former, or they can’t raise further capital for it. By then they are stuck – they’ve already raised money from angel and early investors, who had expectations to multiply their original investment manifold.

The founders’ options are then to 1.) Convince investors to accept this new reality, 2.) Find a way to buy those investors out, 3.) Close/sell the company, return what money is left to shareholders and do something else or 4.) Continue running the business for years until investors can be paid out slowly through dividends. None of them are optimal.

Third, Why Should Angel Investors Care? So They Do Not Burden Founders with Impossible Expectations

Some investors want it both ways. They want sky-high growth, but also want break-even before the next fundraise. They want to take equity, but have guaranteed returns that mimic debt. Ultimately, you are either investing in a startup, with corresponding expectations and risks, or an SME, with an entirely different set of expectations about how it can be run and can generate value and returns. It may even make sense to create a portfolio of a mix of both models. 

Our advice is to be cognizant of the differences and invest accordingly. At Bangladesh Angels, our preference is for startups, as they have the highest potential of creating outsized returns and effects on the economy. But we are increasingly looking at private debt and quasi-equity opportunities for novel SMEs that are operating within a strong niche beyond just a hyper-local geographic focus.

This means they should have strong brand value and proprietary knowledge/processes, ideally augmented by the adoption of digital technology, and a recurring and growing customer base. These businesses are also struggling for capital, which is a whole another issue in Bangladesh and worth dissecting in another post.

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