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Hidden Risk

The Hidden Risks of Venture Capital

As both an entrepreneur and someone who spends a lot of time supporting other entrepreneurs in the startup world, I’ve seen a lot of different approaches to growth and investing. When it comes to venture capital investing, one thing has become very clear: change is coming. The venture capital world of tomorrow will look a lot different than the venture capital world of today.

 

Let’s start by acknowledging that today’s model of venture capital is broken. According to a May 2012 Kauffman Foundation Report, less cash has been returned to venture capital investors than has been invested in venture capital since 1997. Ouch. We continue to see and read how and why the current  model has failed and it’s tough to disagree that the industry is challenged in the aggregate (read about it HERE, HERE, and HERE).

 

Only a select few venture capital firms, mostly based in The Valley, have been able to deliver returns that match the high-risk stakes of venture investing. This small group of funds create the vast majority of value in the industry, while other venture capital firms and involved stakeholders remain in the game, but often on the losing end of the battle. Consider:

  • Limited Partners (the individuals or groups, like pension funds, that give money to venture capital funds to invest) lose because the average VC fund doesn’t return capital to its investors after fees. As the much-ballyhooed Kauffman Foundation study observed: Our conclusion is that the LP investment model is broken. Too many LPs invest too much capital in underperforming VC funds and on misaligned terms
  • The best VCs are punished by the paltry returns of the industry through negative press, increased scrutiny, and the potential of additional government regulation
  • Emerging Tech Ecosystems lose when venture capital performance lags. Poor returns create a negative perception about the entrepreneurial climate, making entrepreneurs more likely to start businesses elsewhere where stronger venture capital returns occur and a thriving entrepreneurial ecosystem already exists. Creating a new company is hard enough in the best situation, without trying to start a company absent a strong support ecosystem

 

Added Risk For Entrepreneurs

We’ve seen the risk to investors and cities, but the natural question remains: “What does this mean for the disciplined entrepreneurs of the world who are giving everything they have to create new businesses?”

 

The unfortunate reality is that by accepting capital from venture capital firms, entrepreneurs can unknowingly add significant risk to their business. Let’s say the typical seed-stage startup has a 20% chance of success. Besides the need for capital, entrepreneurs pursue VC funding to increase credibility, grow their network in the market, and establish trusted thought partners to solve the challenges of building a scalable business.

 

Let’s assume that this magic concoction of capital, credibility, connections, and brainpower increases the likelihood of success by 15%, giving the startup a 35% chance of success.  By accepting venture capital money, the entrepreneur is trading their equity for an increased chance at success. This, in theory, serves to de-risk the business.

 

But what if the investor’s other investments, totally independent of the deal at hand, start to struggle? For the unproven venture capitalist, this triggers an unhealthy – but entirely human – reaction to change their behavior and attempt to manufacture a bigger success from the remaining “healthy” companies in the portfolio. This is dangerous territory and when the investor starts to feel anxious, they often feel compelled to manufacture an immediate win. Much like the weekend gambler in Las Vegas that needs to make up all their losses on the Sunday night football game rather than waiting for next week or next season, the spooked investor starts to take on unnecessary risk.

 

When venture capitalists feel the need to prove something, they often get more hands-on with their portfolio and encourage unnecessary risk taking. Think of high returns as sand and investors as a hand holding the sand. Ego comes into play, gripping the sand desperately tighter, only causing the sand to slip through the investor’s fingers more quickly. The strong desire to achieve high-returns is literally squeezed out by the investor. While hands-on investor support can be a healthy piece of an effective working relationship, when the investor starts to feel anxious from other investments not performing, unnecessary risk comes knocking at the door. This counterproductive desire for success can take on many different forms – investors may push for expansion before a business model is flushed out. Perhaps it’s ramping up hiring before a product has truly been developed. There’s truly countless ways this can come to life.

 

By definition, entrepreneurs who partnered with VCs are looking to create scalable companies, but knowing when to step on the gas is more art than science and stepping on the gas too soon or too late destroys value. Step on the gas too soon and an organization falls apart. Step on the gas too late and competitors will erode your market position. Spooked investors are likely to step on the gas too soon, destroying the very value they are seeking so desperately to create.

 

Strong entrepreneurs can overcome this “riverboat gambler mentality” from investors by explaining the true needs of the company and fighting the good fight. In this scenario, the entrepreneur and investor engage in a healthy discourse –  and the only downside is the opportunity cost of everyone’s time. In many cases, however, this can turn into a fundamental disagreement on growth strategy or worse – eroded relationships or a company derailed.

 

A spooked investor does not magically become an engineer, designer, or internet marketer – but this does not stop them from getting their hands on the business. Quickly, the entrepreneur who could have increased his odds of success to 35% by partnering with the right investor has seen his odds dip below 20%, all the way down to 15%.

 

Other Hidden Risks of Venture Capital

 

Follow-On Investment Constraints

Entrepreneurs also lose when a venture capital firm’s lack of capital prevents them from investing in future funding rounds. If  a VC chooses not to participate in follow-on funding, a clear negative signal is sent to the market…even if the lack of funding has nothing to do with the companies and has everything to do with the current situation of the VC. Markets with emerging startup and investor communities often face this cash-starved investment scenario between years 3 and 5, when cash has gone out the door of the VC, but returns are have not come in – creating a cash starved environment.

 

Restricting Entrepreneurial Ecosystem Growth

Entrepreneurial success is strongly correlated with a deep bench of mentors, investors, and support organizations. Venture capitalists wisely prefer to invest locally so they can personally know the entrepreneur. Successful local investments lead to more local investments and more venture capitalists in the local market – a key element in any entrepreneurial ecosystem. So, when the guy writing the checks loses, the next wave of entrepreneurs also loses. Without a strong investment community it’s tough to have a thriving entrepreneurial ecosystem.

 

The good news is that the opposite is also true: as the number of successful entrepreneurs in a community grows, so too does the quality and number of investment options. VCs with a positive track-record will expand to areas with successful startups and new local funding options will emerge to help proven entrepreneurs.

 


 

All of this is to say that entrepreneurs are best suited to work with investors that have a track record of success. Investors with a strong history are less likely to tighten their grip on the sand they hold in an attempt to force  big returns, leaving entrepreneurs free from unnecessary risk in an already risky world.  Riverboat gambling is fine, so long as these gamblers stay on the river and don’t venture onto the dry land where entrepreneurs live.

 

 

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