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Tuesday, September 25, 2012

VC is no panacea for startup success

One of the major messages taught in entrepreneurship classes is the importance of winning venture capital. Now research by a retired entrepreneur suggests it’s no panacea, according to a report last week in the Wall Street Journal:
About three-quarters of venture-backed firms in the U.S. don't return investors' capital, according to recent research by Shikhar Ghosh, a senior lecturer at Harvard Business School.

Compare that with the figures that venture capitalists toss around. The common rule of thumb is that of 10 start-ups, only three or four fail completely. Another three or four return the original investment, and one or two produce substantial returns.
The latter matches the famous Bob Zider article in HBR that we entrepreneurship faculty have all used at one point or another.

Based on Ghosh’s study of 2000+ firms that received VC from 2004-2010, approximately 30-40% end in liquidation with investors losing all their money. As Berkeley entrepreneurship scholar Toby Stuart notes, failure is even harder on those who bootstrapped their company using their own or family money (rather than drawing a salary at a VC-funded startup).

Of course, the risk/reward profiles are different between the venture and non-venture backed startups:
"People are embarrassed to talk about their failures, but the truth is that if you don't have a lot of failures, then you're just not doing it right, because that means that you're not investing in risky ventures," [said David Cowan of Bessemer Venture Partners]. "I believe failure is an option for entrepreneurs and if you don't believe that, then you can bang your head against the wall trying to make it work."

Overall, nonventure-backed companies fail more often than venture-backed companies in the first four years of existence, typically because they don't have the capital to keep going if the business model doesn't work, Harvard's Mr. Ghosh says. Venture-backed companies tend to fail following their fourth years--after investors stop injecting more capital, he says.

Of all companies, about 60% of start-ups survive to age three and roughly 35% survive to age 10, according to separate studies by the U.S. Bureau of Labor Statistics and the Ewing Marion Kauffman Foundation.
As the article alludes, there is a larger question of why the firm failed, which could include:
  • VCs pulled the plug
  • ran out of money
  • entrepreneurs decided to fold their hand
These are often correlated, but it’s hard in a large-scale study to determine the direction of causality between them. In many cases, the best strategy is the fail fast and live to fight another day (particularly if you haven’t bankrupted yourself in the process).

Ghosh has a Harvard MBA, spent his earlier career as a partner at BCG and before becoming a serial entrepreneur founding a series of IT startups including Appex and Open Market. Alas, there’s no paper on his website to share the ful details of his study.