The dazzle of the rainbow does not always lead to the glint of gold.
Venture Development (or Venturing) is an extremely risky activity for the entrepreneur or investor (be it a graduate, manager or professional). There are better odds to be had from gambling. Despite the facts, individuals and investors continue to put their financial and personal capital at risk. Getting the economics rigth is a challnge. There are some aspects to consider that may improve the odds in search of that 10x bagger or billion dollar listing.
For clarity ventures are defined as being “startups” on their way to some form of exit by the original investors. Thus ventures encompass seed and early stage enterprises; funded by Friends & Family, Angels as well as Venture Capitalists, VC firms/funds.
Venturing, like other fads and bubbles, is cyclical. Venturing’s popularity is due to a confluence of forces. The story of being a successful entrepreneur, backed by shrewd and supportive investors, makes for a compelling romantic narrative: riches at the end of the rainbow. The facts suggest it is misleading one. Many ventures fail and their performance are below market alternatives. For the very few, it is rewarding. The current wave of ventruying is being generated by the: continuing economic recession; the surplus of funds available for investment – seeking above QE market returns (2%) as well as continuing technology advancements (particularly digital and related to smartphones). Hope springs eternal; fueled by regular media coverage of those successful 20-somethings.
One needs to see through the marketing hype of the VC industry, ocean of easy money and institutional investors seeking alternative investments to calibrate the varying perspectives, motivations and rewards to embrace an appropriate mindset and approach that creates value from ventures. Anecdotes make great press and promote the myth; yet the plural of anecdote is not data.
There is a great deal of data available, but little information. Much of it remains ‘hidden’ due to confidentiality and the privately held nature of ventures. Also, as with any good sales effort, the industry wants to talk up the successes and ignore the failures. Various studies, such as those from Kaufmann and Harvard, have been conducted. The discernible facts are sobering, the dynamics are scandalous.The US based data is the most comprehensive (during the period 2000-2012).
- In 2012, USD 27 billion was invested in 3,720 recorded ventures. Yet there were only 49 IPOs and 449 transaction (M&A).
- The average startup received a total investment of US$ 7 million and had a 10 year duration75% of ventures never return cash to their investors
- Over 50% of ventures lose all their money.
- The top 10% generated over 60% of the value. The exit value was a 4-5x return on invested capital.
- The bottom half had negative returns or less than 0.5x
- The average return was 2x.
- The probability of realizing a one billion dollar app is 0.07%
The data suggest some interesting take-aways. The amount of capital was not a differentiator of success (the amount invested being similar between average and top performing ventures). Also, while “fail fast” is a mantra, it is not widely practices: failures continue to be funded for too long. As to sectors, “biotechnology” rather than “technology” had better performance.
Too often wishful thinking, an exciting idea and poor valuation metrics cloud investor decisions and common sense. Newly minted graduates are turning to ventures, as employment opportunities elsewhere are scare; despite the risks. More seasoned individuals and institutions may not be taking a sufficiently hard look at ‘too good to be true/easy money’ opportunities.
Some importnat questions need to be asked.
From the ‘get-go’, does the concept really satisfy a genuine need? A good idea is more than just packaging, knowing the right people and VC firms. The average period from inception to exits is seven years. The product offering of the past successesful ventures tends to go through many iterations and several false starts. For example Pinterest went through 300 iterations before its final form, according to McKinsey. Billion dollar app entrepreneur and MIT graduate, George Berkowski, underscored the point. For example in the mobile app world, the business case for being one of the 26 apps one has on a smartphone, and used regularly, must be compelling. There are over 2.5 million apps currently available. The difference between success and failure is: ‘must have’ vs ‘nice to have’. For example, in the online dating industry, the recent example of the ‘failure’ of Cupid compared to the continuing successes of Tinder (and the more traditional Match.com) reveals this must/nice difference.
The behavioral conclusion amongst users (ie consumers) will become manifestly and rapidly apparent in the early stages. The successful venture must build not only the user base but also the frequency of use. Then a non-threatening pricing model can be applied. Too often ‘Series B and C’ financing rounds go to funding a damp squid. Again the data shows that less than 60% of ventures reach their targets after their first ‘A’ series of financing.
One of the observations from the Tech bubble was that valuations and metrics were inappropriate. That lesson has not been learned by today’s investors. Growth and positive cash flow remain the hallmarks of the successful 5x ventures. Questionable metrics, such as ROI and IRR, continue to be applied to capture future risk; relying on a single point discount rate. How is this discount rate calculated in a world of QE money? To strengthen this metric a common VC compensating method is to apply probability theory to an IRR return (so-called “adjusted present value”): a 12% IRR, with a 50% probablity transforms into a 24% APV. That metric seems inappropriate for many reasons. The billion dollar valuations (IPOs and acquisitions) are based on defensive plays to buy lists of 50 million active monthly users. It is a matter of staking-out territory rather capturing revenues.
As to costs there are some unpleasant truths. Strip away those costs (and efficacy) related to: build-out; marketing and communications which leaves VC related fees as a major drain on cash flow and returns for all investors. The data suggests that the Limited Partner model of 2/20 is asymmetric and self-serving. VC partners only risk about 1% of their own capital in any fund. Their fees are paid regardless of performance. Also the medium /long term tenor of most fund means that there is little direct accountability for performance. Fees have little to do with interest and lending rates.The VC industry argues differently. Yet many entrepreneurs are unwilling tochallenge the LP model and negotiate more appropriate terms & conditions, for fear of “ruining the relationship”. The fact remains that capital is available and the strength of the relationship can only be gauged by above average returns. Other VC myths that need to be examined are: the impact of mentoring, the value of VC network and the innovative and risk-taking nature of the investors.
It is important to consider that VC funding is not the main source of startup finance. In the US, less than 1% of firms utilized VC funding. Interestingly the face amount has collapsed since its heyday in 2001, from US$ 39 to US$ 19 billion in 2012. VC funds have been a channel for institutional investors to find alternative investments. In reality, a large portion of entrepreneurial funding for ventures comes from business angels. In the US for 2012, Angels invested US$ 22 billion in 65,000 ventures (compared to VCs into 37,000 ventures). The third source is crowd-funding; which is growing rapidly tripling since 2011. As one commentator describes crowd-funding, it is the “democratization of investing”. Kickstarter (a sector broker) reported it had over US$ 320 million being invested in 18,000 ventures. The critical but unreported role is of Friends & Family funding. It provides that initial capital, albeit in small amounts (say US$ 50,000), to take an idea from paper to initial incorporation and prototyping/proof of concept.
Venture Development is an important funnel. For the cynical it provides a steady stream of fee income for VC funds; for institutional investors a seemingly attractive alternative investment. For banks and corporations a possible source of success but certainly a low budget/high profile recruiting tool and Corporate Social Responsibility initiative.
Despite all these caveats, the base economics suggest that the tiny number of VC startups that succeed do provide extraordinary returns (in relative and absolute terms). This return are manifested at a primary level to the investors and venture as well as at an secondary level to them market, economy and society (viz Facebook). Successes are to be celebrated and encouraged. For example, Ms. Hayley Parsons has entered the pantheon of venture stars. She recently sold her remaining 50% stake in gocompare.com for UK£ 44 million; creating a viable enterprise in Wales as well as receiving an OBE and Ferrari in the process. Parsons started the firm from her kitchen table eight years ago, having been rejected by her then employer, Admiral Group. She was funded by an angel.
The message is: try, but wisely.
Actual and would-be entrepreneurs as well as individual and institutional investors may find the following practical points of use. They are worth bearing in mind to avoid unnecessary (or prolonged) investments as well as improve the odds for success. The points apply to any venture; in the app/web world, the allure is greater and the pace is quicker. Knowing how to swim before entering the pool would seem wise.
- Ensure that the Unique Selling Proposition is unique. Too often ventures rely on well packaged concepts and services that don’t actually provide for a need.
- Brand equity: this comes from a combination clever name, personality, actual adoption and productive promotion.
- Be wary of “J – curve” growth; blow-torch the assumptions.
- Understand and nurture the team. Be clear and enforce roles, responsibilities and accountability all around. The entrepreneur should be doing the heavy lifting but if she/he is unable take the necessary actions.
- Use 360ᵒ enterprise models, Public Market Equivalents as well as Impact analysis and scenario modelling to keep the operating plan credible.
- Clarify and monitor the operational metrics: growing the number of users and increasing the frequency of use.
- Once demand is proven ensure that the applied pricing strategy is supporting revenue growth. One price point is “free” (for trial) but it needs to be anchored elsewhere for revenues
- Manage Top and Bottom line sto preserve funds for dividend and investments
- Keep tight control on cash burn and investment
- As entrepreneur/enterprise negotiate from a position of equality with Investors – the entrepreneur is their platform for success.
- Develop and stick to milestones – acting decisively. In the app world weeks matters; three years is an eternity, yet seven year gestations (idea to exit) is the average.
- Keep dialogues and communications based on objective facts and robust assumptions.
- Do review, challenge, adapt and if needed: “fail fast”.
Rainbows, like many ventures, are an optical illusion; the road to riches is based on hard graft and grind as well as good fortune.
Gaze, but don’t stumble.
Feel free to contact us at Raktas or check out related posts at justinjenk.com
Justin Jenk is business professional with a successful career as a manager, advisor, investor and board member. He is a graduate of Oxford and Harvard. Justin can be found at justinjenk.com or justinjenk.se