Some things to think about when seeking outside financing
Many investors want to take an idea to a venture capitalist (VC), have the VC invest a boat load of money but only take a small fraction of the company in exchange, and then make billions of dollars after the idea takes off. There are many reasons why there is a greater chance of getting hit by lightning than this scenario happening. So I advise you, if possible, to keep your day job until you have proven your idea works.
One of the first realizations an entrepreneur makes when seeking capital is that VCs and angel investor groups usually invest in home run ideas.
DFJ Gotham’s website has a fairly typical quote:
“We invest in category leaders; companies that are positioned to both become large (with at least $100M of revenue) and blaze new trails in their markets. Category leading companies transform their marketplaces, creating fundamental shifts in their industries and leveraging unfair competitive advantages”1
The problem with this “home run” screening of business ideas is that when you try to hit a home run—as in life—you often strike out. I mean how many companies do you think become category leaders? The answer is one for each category, right?
VCs that have DFJ Gotham’s strategy, want each of their many investments to be something only a handful of companies in the world can become. They want the next Google, Facebook, or Yahoo.
Scott Shane, a professor at Case Western University and the of author of The Illusions of Entrepreneurship (BusinessWeek.com, 1/23/08) put it yet another way, “It’s incredibly rare for a company to hit the sales targets that venture capitalists have,”. He goes on to suggest that most VCs want businesses to hit $100 million in sales within six years (a goal only 200 companies each year reach).
How successful do you think VCs are at meeting their goals, given the lofty investment criteria?
VCs tend to keep their failure rates private, however a study by the National Venture Capital Association conducted with over 11,686 companies showed that nearly 57% of the companies failed. 3
3 National Venture Capital Association in its 2011 Yearbook, Page 8.
In fact, VCs acknowledge a general rule-of-thumb that states that one-third of investments go out of business, one-third under-perform, and the remaining one-third are considered big hits. 2
An article published by Business Week had the following excerpt from David Kirsch, director of the Business Plan Archive at the University of Maryland. http://www.businessweek.com/smallbiz/content/feb2008/sb2008021_536847.htm
Kirsch and Goldfarb also found that 48% of the companies they sampled—mostly dot-coms founded between 1994 and 2000—survived the bursting of the tech bubble in 2004. The number, Kirsch says, is consistent with survival rates in other emerging industries. Getting venture funding did not improve a company’s chance of success. “What that tells us is that those firms didn’t need venture capital. What they needed was 10 grand for some servers and a few customers,” Kirsch says.
The conclusion should hearten entrepreneurs. Abandoning the chase for venture capital frees business owners to concentrate on bootstrapping or raising smaller amounts from informal investors or lenders. The average start-up is financed with $25,000, and that usually comes from the entrepreneur’s savings or from a personally guaranteed bank loan, according to Shane. While that’s less seductive than big checks from venture investors, it’s easier to find.
To further illustrate the point that VCs may not be the best route for entrepreneurs, look at statistics from the Small Business Association (SBA).
What do you think is the survival rate of just any new firm (not necessarily VC funded businesses with well thought-out business plans)?
According to the SBA, seven out of ten new employer firms lasted at least two years, and about half survived five years. More specifically, according to new Census data, 69 percent of new employer establishments born to new firms in 2000 survived at least two years, and 51 percent survived five or more years. Firms born in 1990 had very similar survival rates. With most firms starting small, 99.8 percent of the new employer establishments were started by small firms. Survival rates were similar across states and major industries.
Doesn’t these statistics contradict what you’ve heard from other sources? I know I had always been told that only 1 in 10 businesses survive. By the way I heard the same statistic for companies that had been VC funded.
According to Michael Ames in his book Small Business Management, the two biggest reasons why business fail are:
1) Lack of Experience
2) Insufficient Capital
Here’s what the SBA states:
So VC funded companies and non-VC funded companies have around the survival rate despite the fact that VC Funded businesses have a lot more initial capital.
And the chances of being VC Funded is not great either
There is a 1 in 1,000 chance of getting funded by a VC– all things being equal. But all things are not equal.
People who have had success before (been part of the founding team for another successful VC backed company) are more likely to get funded then someone who has not.
Someone who graduated from Stanford or Harvard will get a much better look than someone who graduated from Chico State. This is partly due to people from Stanford and Harvard having strong network connections to VCs. VCs tend to invite entrepreneurs who they have been referred to or know through networks. http://www.businessweek.com/smallbiz/content/nov2007/sb20071128_805700.htm Most VC employees have graduated from the top two businesses schools in the country, so naturally many VCs have graduated from Stanford and Harvard.
Stanford has an additional advantage: The highest concentration of VCs are located in Menlo Park, Palo Alto area. This area, of course, is where Stanford University is located. So it is easier for Stanford graduates to have network connections to VCs then most other graduates.
Someone with an engineering degree has a much better chance than a business major (perhaps ironically). This may be due to the fact that engineers can develop their own ideas without hiring someone else, where business majors tend to know how to run a business but not necessarily create the product.
Knowing how to pitch to VCs is really important too. As soon as an entrepreneur goes to a few VCs, other VCs know about that entrepreneur. So if an entrepreneur does not send a pitch book and deliver the kind of presentation that is expected, they have little chance of getting funded. The fact that VCs see hundreds of ideas a year and have the attention span of a nat, ensures that they are easily distracted by presentations which do not conform to the mode operandi.
A technology idea will have 1,000 time better odds than another type of idea of getting funded.
The definition of scalable for VCs is very narrowly defined and only scalable ideas are funded by VCs.
Ideas that, in the judgment of the VC, will make $100 million or more are usually the ones that VCs find interesting. (They want the next Google, which in itself is astronomically difficult. VCs tend to go after the same type of ideas each year. One year it is crowd-sourcing ideas, the next year it is social media ideas, the next year it is green technology ideas etc. etc. And after an idea gets hot, it becomes passé’. Well if they are all going for the same ideas each year, what do you think happens to the terms for those deals? Yep, the terms become favorable for the founders and unfavorable for the VCs. But if you have an idea outside of the hot area, you’re in trouble.
Furthermore, how many ideas do you think can be number one or number two in their space, which historically are the only ideas that become $100 million + ideas? Answer: one or two. It’s no wonder VCs are less successful at picking investments than the national average at successful companies!
So an entrepreneur may start out with a 1 in 1,000 chance but after factoring in the particulars of the case, may have one chance in H double hockey sticks of getting funded.
Further exacerbating the problem for the poor entrepreneur is the fact that it takes about 40 hours a week to pitch the idea to VCs. This is because the entrepreneur has to meet with a lot of VCs before she will get funded. Even Google and Facebook met with several VCs before they were funded. What happens when an entrepreneur spends all her time raising money? Answer: She has less time to spend on the company. And this is important because VCs want (especially now ) a concept that has been proven through the customer i.e. revenue has to be coming in already proving that people are willing buy the product before a typical VC will invest in the company.
This latter issue really frustrated me when I started Tailor Research. I thought to myself, if the idea was proven already I wouldn’t need you would I??
Big Idea: So the natural question is whether VCs are needed at all? They are of course. VCs should be used to grow a company, not to establish its viability. This is a really important point for most entrepreneurs because what it means is that an entrepreneur (and some seed investors) take on almost all the risk of proving the concept. However, the advantage of this approach is it allows the entrepreneur to get better terms since he does not need the money to keep the business running but rather to leverage (speed-up) the growth of the business.