Growth Times

ReadWriteStart, the entrepreneur’s channel of ReadWriteWeb, nicely published an article I wrote for them called 10 Principles For Not Killing Your Startup.

With the new wave of entrepreneurs brought about by the financial crisis, I suspect the mortality rate of startups is at an all-time high. I didn’t find robust data to back my observation yet, but I did come across a page that points out that, before the financial crisis:

• the chances were six in a million that an idea for a high-tech business eventually would become a successful company that goes public;
• a venture capitalist financed only six out of every 1,000 business plans received each year;
• and bankruptcies occured for 60% of the high-tech startup companies that succeeded in getting venture capital.

Wow. Persistence is paramount.

As you know if you have visited my “corporate” blog, my mission in life is to change that. Start-ups shouldn’t die. They should live, prosper, and grow into healthy businesses that make people happy.

So I tried to identify the most frequent root causes of death, and for each, I created a principle. You will find the result here: http://www.readwriteweb.com/start/2010/03/10-principles-not-killing-startup.php#comment-195260

Please help make the list stronger by commenting and offering additional principles.

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Josh Kopelman, Managing Director of First Round Capital, wrote a great post today building on Fred Wilson’s VC math problem, and call Why VC Performance Has Fallen Off A Cliff.

I argued in a recent post that in parallel to the “moonshot” approach Josh rightly describes as the norm for VCs,  there must be a model that focuses on extracting revenues from a portfolio of tech companies with lesser risk.

Overall, it’s pretty clear to me that what we call VC companies should cover the entire risk-return frontier for any early-stage tech company, because that would allow large investors to place their bet as they like in this category. I’m not suggesting VCs turn into bankers or private equity investors, but there is a clear case for filling the early-stage funding gap towards tech ventures that hold less risk and more proven revenue models than moonshots.

For all the analytical firepower of VCs, it feels a lot like playing this field is still an art not a science. If really, VCs take a classic portfolio approach to early-stage returns, like I’d argue they should, then risk-return is a continuum and the industry ought to cover it entirely to offer interesting options to large-fund investors.

Which brings me to this: the expectation of a 20% return yearly is completely unrealistic, when the average growth rate for the world economy is 2-3%  (tidbits from my finance classes at Stanford – I don’t think our average growth rate has gone much above that since I finished my degree there…) If VCs as an industry grows faster than that rate, then by definition it will have to return to the mean (back from the moon) sooner or later, hence the cliff. Risk has nothing to do with this, since we are talking about a risk-return continuum in a vast portfolio managed by the entire VC industry – over time the failed companies bring you back to that 3% mean.

If you can do better than 2-3%, or say 5% to be a bit more optimistic about the growth capacity of our system, then you’ve nailed some distortion in the market and/or you’re taking more risks than you should. It’s hard but possible to do that as an investor, but impossible to do it sustainably as a large industry. Sooner or later, the industry will lose big, just like gamblers. Keep in mind again that I am talking about the VC industry as a whole, not individual players here – there is much variability there.

The problem with promoting those 20% rates is that it fuels hype and bubbles – the only viable mechanism to achieve those returns for the entire VC industry, if not a sustainable one. So I think it would be great if VC as an industry could stop pretending it can do much better than the mean, and focus instead on offering a decent continuum of risk-return options to their investors based on early-stage plays. From that angle, VCs are just expanding the range of investment options available and that, I think, would be good enough for everyone.

Unfortunately, the current system is set up to create monopolies of sorts by maintaining a complete imbalance between money pools and money needs. VCs are encouraged to bet on moonshots because that’s how, individually, they can make it and retire (with that feeling of intellectual superiority one gets for betting on the right horse at the tracks). They don’t lose much money on failed investments, but they make tons on successful ones, so of course they swing for the fences. The first thing VC firms should do is take a good look at their compensation system and rehaul that.

As things go well and returns grow, a few investors that actually beat the mean quite consistently (there will always be some – they are the right dots in the normal distribution of investors) make everyone hope over time that they can too – and thus the system as a whole progressively takes more risk without realizing it.

Meanwhile, companies with a lower risk-return ratio – but not low enough to warrant a bank loan – have a heck of a time finding money. Angels fill some of that gap, but while they’ve structured themselves greatly in the past few years, they don’t have the discipline a VC firm could bring, which only would attract the big money from the big funds.

Unlike what some observers think, I’m convinced the VC system is here to stay. But not without adjustments – either angels will structure themselves more and more to fill the void VCs left, or VCs will get back in there as they should. The overall lesson as a VC is that you can shoot for the moon if you wish, but keep your feet on the ground, because your industry will go back to the mean sooner or later.

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I will soon have another opportunity to test my beta talk on the Divide between Technologists and Business folks, and why that is the number one root cause of tech venture failures (see my slides – torn apart by Slideshare, here!). Communitech has kindly invited me again to speak, this time at their entrepreneur group in Guelph, where I currently reside. It will take place from 6-8pm at SYNNEX Canada Ltd, 107 Woodlawn Rd W.

As a preamble to this talk, I just came across a very interesting blog post, recommended by Guelph’s very own Brydon of start-up Brainpark, arguing for the need to shift from a product development mindset to a customer development approach. I added some comments there too.

I look forward to seeing many Guelphites and having a good chat about this topic. Bring your war stories!

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