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Investing in startups is not an easy job. As an investor, you are not only betting on a specific startup and team, but often on a market that doesn’t exist yet. Even the best team in the world is doomed to fail if it undertakes the wrong market. The opposite is not always true.
One of the biggest mistakes venture capitalists (VCs) make is overstating “false signals”. False signals can be a hyped event, such as a large acquisition, or a huge financing round with skyrocketing valuation.
These kinds of events get lots of press coverage and become the main conversation among the tech community. What follows is that investors often assume this indicates a new market trend and start to pour money into the market trying to find the next Uber or WhatsApp.
The trouble is that often these “high flying” events are simply unique strategic moves by an acquirer, and don’t really signify a new market opportunity that will benefit many other startups. Moreover, even when it does indicate a new large trend, it is often too late for new startups to enter the space, so new clones and copycats are destined to fail.
This gets even worse as these hyped markets tend to command high valuations as the classic anchoring effect takes place. It’s easy to think, “If Facebook acquired WhatsApp for $22 billion, then this new messaging app is worth at least $100 million,” particularly when there are not a lot of other public reference points.
Below are three industries that have or will cost investors a lot of money.
Messaging apps
Mobile messaging apps were among the biggest successes of the past decade. There is no doubt that mobile messaging was a huge trend, as more than a billion people worldwide adopted it as a primary means of communication. In Feb 2014, the tech world went nuts when Facebook announced it was acquiring Whatsapp for $22 billion, the largest VC backed exit of all time. Money began pouring into the mobile messaging space as investors attempted to find the next big thing. This included a 1.5 mil investment in an app simply called “yo”.
Mobile messaging investments grew to 4 times their size the previous year.
Mobile messaging is indeed a real trend, but by the time Whatsapp got acquired, the winners were already identified and competing over new mobile messaging apps is very difficult.
Connected home
The connected or smart home (part of the Internet of Things) has become a favorite market for investors in the past few years as the prices of building hardware have plummeted and and the emergence of crowdfunding platforms created the ability for new companies to rapidly assess market needs.
In January 2014, Google announced it was acquiring smart thermostat startup Nest for $3.2 billion and the smart homes market went crazy.
I believe the issue with this market was that many investors never stopped to think about weather there were good use cases for some of these new smart home devices and weather they are ready for mainstream adoption.
On demand services
Uber is among the most celebrated and imitated startups. The company set a record recently, surpassing the highest valuation reached as a private company. As soon as the tech community saw Uber’s skyrocketing valuation, many new “Uber for X” companies emerged. There’s an uber for everything: groceries, housecleaning, moving, lawn mowing, doctors, massages, haircuts, flowers, reservations, booze, marijuana, dog walking, cat sitting, and pizza.
It turns out that out of all of the “Uber for x” companies, Uber is probably the best one.
In addition, many investors never stopped to think that if Uber has to burn tens of millions per quarter to grow its business, what does that mean for the countless startups that followed using Uber’s business model?
Today, we are already seeing the cracks, as many of these companies such as Homejoy and Zirtual have shut down, downsized, or paused operations.
That doesn’t mean that every large acquisition is a false signal. Quite often, large financing rounds do indicate that there are opportunities for new startups to grow in the space. But investors should fight their natural instincts be even more cautious when investing in a space that recently experienced hyped acquisitions.
Amal Karp is a VP at Bessemer Venture Partners in Israel. This article was originally published on his blog.
