Innovation
Venture capital is exception as funding source for tech startups
By Michael Hennigan, Finfacts founder and editor
Aug 6, 2014 - 7:30 AM

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Venture capital is the exception, not the norm, as a funding source for even tech startups. More VC-backed new companies fail than succeed, and since 1999 US VC funds have barely broken even.

Those are just some of the myth-busting facts that were revealed by Diane Mulcahy, director of private equity at the Kauffman Foundation, the leading US entrepreneurship think-tank, and a former VC herself, in the May 2013 issue of the Harvard Business Review (HBR) that focused on entrepreneurship.

"For someone who's starting (or thinking of starting) a company, the myths surrounding venture capital can be powerful," Mulcahy wrote. "In this article I will challenge some common ones in order to help company founders develop a more realistic sense of the industry and what it offers."

John Mullins, an associate professor at London Business School and the author of The Customer-Funded Business: Start, Finance, or Grow Your Company with Your Customers’ Cash, writes in the HBR blog this month that that more than two generations ago, the venture capital community  - - VCs, business angels, incubators, and others - - convinced the entrepreneurial world that writing business plans and raising venture capital constituted the twin centerpieces of entrepreneurial endeavour. "They did so for good reasons: the sometimes astonishing returns they’ve delivered and the incredibly large and valuable companies that their ecosystem has created.

But the vast majority of successful entrepreneurs never take any venture capital."

About 76% of US tech companies acquired in 2012 had not raised institutional investment (VC/PE -private equity) prior to acquisition.

Prof Mullins says that venture capital financing may even be detrimental to a startup's health. As venture capital investor Fred Wilson of Union Square Ventures puts it, “The fact is that the amount of money startups raise in their seed and Series A rounds is inversely correlated with success. Yes, I mean that. Less money raised leads to more success. That is the data I stare at all the time.”

Finfacts:

More US VC-backed new companies fail than succeed

Venture Capital 2013: US financing at $33bn; Europe $7.1bn; China $3.5bn; Israel $2.3bn

Irish Venture Capital: Call for pension investments; Government provides 40% of annual funding

These are Diane Mulcahy's six VC myths:

"Myth 1: Venture Capital is the Primary Source of Startup Funding
VC financing is the exception, not the norm, for startups. Historically, less than 1 percent of U.S. companies have raised capital from VCs, and the VC industry is contracting. But less venture capital does not mean less startup capital since non-VC sources of funding, such as angel capital, are growing.

Myth 2: VCs Take a Big Risk When They Invest in Your Company
VCs take risks with investors' money, not their own. The typical VC commits only 1 percent of partner capital to a fund while investors commit the remaining 99 percent. The VC revenue model that generates guaranteed and cumulative management fees regardless of investment performance insulates VC partner personal compensation from the risk of poor returns.

Myth 3: Most VCs Offer Valuable Advice and Mentoring
VCs differ in how much effort they put into these nonmonetary resources, and the quality of advice and mentoring from VCs can vary widely, so founders who want more than capital from their investors should conduct a thorough due diligence on a VC firm they are considering.

Myth 4: VCs Generate Spectacular Returns
Mulcahy cites the data and findings from the Kauffman Foundation report she and her colleagues published in 2012 about the under-performing VC industry. The report provides data on historic VC industry returns, and the Kauffman Foundation's experience as a long-term investor in VC funds.

Myth 5: In VC, Bigger is Better
The contrary is true for both the industry and individual funds. Industry and academic studies show that VC fund performance declines as fund size increases above $250m.

Myth 6: VCs are Innovators
VCs may be well known for funding innovation, but the VC industry and business model have not seen significant innovation in two decades. The VC fund structure, fund life and economic terms have remained the same for more than 20 years. Note to GPs: Increasing the standard 2 and 20 compensation model to 2.5 and 25 is not innovation.

VCs will continue to play a significant, but smaller, role in channeling capital to startups, Mulcahy concludes. The contracting VC industry and new funding sources now available to founders are finally "shifting the historical balance of power that has too long tilted too far toward VCs."

Prof Mullins says that seeking VC support early in the life of a startup can be a distraction and too much of the company can be given away before it establishes itself

"But the best news is this. If you raise money at a somewhat later stage of your entrepreneurial journey, you’ll find that many of the drawbacks have largely disappeared. Why? Because with customer traction in hand, you’ll be in the driver’s seat, and the queue of investors outside your door will have to compete for your deal."

He highlights that in the typical successful fund, on average only 1 or 2 in 10 of the portfolio companies - - the Googles, Facebooks, and Twitters of the world - - will actually have delivered attractive, and occasionally stunning, returns. "Facebook alone accounted for more than 35 per cent of the total VC exit value in the United States in 2012. A few more portfolio companies may have paid back the capital that was invested in them, but most of the rest are wipeouts. In the VC game the very few winners pay for the losers, so most VCs are playing a high-stakes all-or-nothing game. Are these the kind of odds with which you’d like to put your new venture into play?"

About 75% of venture capital-backed US startups do not return investors' money

About 75% of venture capital-backed US startups do not return investors' money. The common rule of thumb is that of 10 startups, only three or four fail completely. Another three or four return the original investment, and one or two produce substantial returns. However , the National Venture Capital Association estimated that 25% to 30% of venture-backed businesses fail outright.

The Wall Street Journal reported in 2012 that research by Shikhar Ghosh, a senior lecturer at Harvard Business School showed that venture capitalists "bury their dead very quietly." Ghosh adds: "They emphasize the successes but they don't talk about the failures at all."

Ghosh’s study was based on data from more than 2,000 companies that received venture funding, generally at least $1m, from 2004 through 2010. He said that he also combed the portfolios of VC firms and talked to people at startups. The results were similar when he examined data for companies funded from 2000 to 2010, he said.

There are also different definitions of failure. If failure means liquidating all assets, with investors losing all their money, an estimated 30% to 40% of high potential US startups fail, he said. If failure is defined as failing to see the projected return on investment -  -- say, a specific revenue growth rate or date to break even on cash flow - then more than 95% of start-ups fail, based on Ghosh's research.

The Journal says that of the 6,613 US-based companies initially funded by venture capital between 2006 and 2011, 84% were closely held and operating independently, 11% were acquired or made initial public offerings of stock and 4% went out of business, according to Dow Jones VentureSource. Less than 1% were in IPO registration.

Finfacts 2014: Up to 90% of US high tech startups fail; System of failure by design?


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