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Novel business models don’t always mean sustainable businesses

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There seems to be nothing that VCs and the start-up community love more than a novel business model. Ride-sharing, subscription meal kits, peer-to-peer lending, freemium games, bots… the list goes on, and the press loves a story about how a new approach is disrupting incumbents.
It’s in the name. Consumers find novel business models, well, novel. There are always consumers willing to try out a novel approach, providing the early traction for a company and helping a start-up make the case for it being the next unicorn. The usual reaction to a novel business model showing early signs of traction is to fund it up, power up the marketing team and go all out for growth. But just because it’s novel does that mean it’ll turn into a sustainable business?
Many moons ago the hot novel business model was daily deals, and Groupon & Living Social were the leaders in the space. This week though Groupon acquired Living Social, for a non-material amount, following a restructuring and move away from email deals. The problem was that just because daily deals on email was novel didn’t mean it held lasting appeal to consumers.
Don’t get me wrong. If you pick the right novel business model the rewards are big. Just look at Uber or Airbnb. The challenge for investors is not to get dazzled by the novelty of the approach and accompanying buzz, but to work out if it really has lasting appeal and is solving a genuine problem.

Estimated reading time: 2 min

 

Due to the potential for losses, the Financial Conduct Authority (FCA) considers this investment to be high risk.

What are the key risks?

  1. You could lose all the money you invest
    1. If the business you invest in fails, you are likely to lose 100% of the money you invested. Most start-up businesses fail.
  2. You are unlikely to be protected if something goes wrong
    1. Protection from the Financial Services Compensation Scheme (FSCS), in relation to claims against failed regulated firms, does not cover poor investment performance. Try the FSCS investment protection checker here.
    2. Protection from the Financial Ombudsman Service (FOS) does not cover poor investment performance. If you have a complaint against an FCA-regulated firm, FOS may be able to consider it. Learn more about FOS protection here.
  3. You won’t get your money back quickly
    1. Even if the business you invest in is successful, it may take several years to get your money back. You are unlikely to be able to sell your investment early.
    2. The most likely way to get your money back is if the business is bought by another business or lists its shares on an exchange such as the London Stock Exchange. These events are not common.
    3. If you are investing in a start-up business, you should not expect to get your money back through dividends. Start-up businesses rarely pay these.
  4. Don’t put all your eggs in one basket
    1. Putting all your money into a single business or type of investment for example, is risky. Spreading your money across different investments makes you less dependent on any one to do well.
    2. A good rule of thumb is not to invest more than 10% of your money in high-risk investments. https://www.fca.org.uk/investsmart/5-questions-ask-you-invest
  5. The value of your investment can be reduced
    1. The percentage of the business that you own will decrease if the business issues more shares. This could mean that the value of your investment reduces, depending on how much the business grows. Most start-up businesses issue multiple rounds of shares.
    2. These new shares could have additional rights that your shares don’t have, such as the right to receive a fixed dividend, which could further reduce your chances of getting a return on your investment.

 

If you are interested in learning more about how to protect yourself, visit the FCA’s website here.