The Failure of Venture Capital
Ayan Agarwal, Dartmouth Business Journal
The nature of venture capital (VC) investment is highly uncertain. When startup investors pick their investments, they may end up with a return anywhere from zero to 50 times what they put in. The National Venture Capital Association reports that companies financed in their early stages by VC account for over 20 percent of the US GDP today. The most successful investments of this generation have, in fact, come from VCs able to identify major industry disruptors before they fully reach market.
But while VC has grown in the size of capital investments, returns have not proved superior to those of other investment strategies. In 2012, the Kauffman Foundation released a report showing that VC returns (on average) had failed to beat public indices over the past 15 years. Hidden behind the impressive returns from unicorns, a colloquialism for startups with valuations exceeding one billion USD, the average VC firm does not return investor capital after transaction fees.
These findings have led to the question: is venture capital failing and ultimately in a position to be disrupted?
The first possibility to potentially explains the woes of VC is competition. The past few decades have seen an influx of capital into VC firms from a variety of sources. Independent investors, foundations and pensions have all been pouring money into the black box that is venture investment, especially in the United States. As a result, the number of venture funds has grown substantially. Assuming – albeit, somewhat simplistically – that the number of great startup ideas or unicorns each year stays constant, supply and demand easily explain the lower returns on venture capital, as there are many more VC firms each year vying for the same number of targets.
There is also a rising number of angel investors who overshadow VC firms when it comes to smaller investments. Angels are individuals who invest relatively smaller amounts of capital than VCs into early stage startups. These affluent investors fund over 15 times more companies than VCs. In fact, in 2011 venture investments totaled roughly $28 billion across 3,700 companies. In contrast, angel investment totaled $22 billion across 65,000 ventures.
Adding to the pressure on VCs is the fact that founders can now also pursue crowdfunding as a means to fund their venture. In crowdfunding, entrepreneurs receive very small amounts of capital from a wide range of people. In exchange, these average consumers receive rewards or products from the company at a later stage. Kickstarter, the world’s largest crowdfunding platform, has raised over three billion USD $3 billion for over 138,000 projects. The number of projects funded each year continues to grow as increasingly more consumers back companies they believe in. Crowdfunding has seen growth in part due to legislature like the JOBS (Jumpstart Our Business Startups) Act, allowing equity to be exchanged and more people to participate in this process. Thus, a rising number of avenues for innovative companies to find investment paired with lower barriers to entry for entrepreneurs and an increased supply of VC firms may be the reason behind lower returns for the average venture capitalist.
While this reasoning makes intuitive sense, there is another, far more troubling explanation for the reduction in VC returns. Perhaps today’s venture investment is inherently flawed. Certainly, the industry has had successes, as nearly every ground-breaking company that comes to mind has been backed by venture funds: Google, Facebook, Microsoft and more. The worrisome fact, though, is that the venture process has remained relatively unchanged since the early days of these older companies. Perhaps VC investors have not evolved to or adjusted their approach to identify winning companies over time.
It may be that the characteristics that most VCs look for in successful startups are flawed and outdated. Successful VCs often claim their key to incredible return is based on more qualitative, instinctual assessments of an investment, such as backing terrific teams or assessing how they might disrupt open market space. Common VC investor philosophy also describes that startup founders who have failed in the past will be more successful in their future ventures. Yet, Google Ventures, a VC organization using data to drive decisions, found that nearly 30 percent of startups created by a past successful founder succeed again, as compared to the 15 percent success rate of ventures founded by a past failed founder, demonstrating that common investor philosophies used to make key investment decisions in VCs might very well be misguided.
With clear benchmarks set, venture funds often look for the same key elements in a startup’s narrative. Budding entrepreneurs may find themselves concocting false stories about their past in order to fit this narrative, making predictions and returns for VCs even more difficult. Along the same lines, hundreds of venture funds all follow the same funding schedule: get investments to approximately one-million-dollars in annual recurring revenue (ARR), raise an initial round of venture investments (A-round) and continue gathering funding until either an IPO or failure. With the simplicity of the VC playbook, founders find themselves modifying their companies to match the ‘accepted’ funding schedule rather than attempting to experiment or pursue their own path to success and innovation.
Time is a key constraint in every VC firm and another contributor to poor returns. The most telling performance metric for venture firms is . As opposed to hedge fund investors, who are easily able to expel their capital into massive liquid markets, VCs have trouble scaling their time efficiently. A fifty-thousand-dollar seed investment might take the same amount of evaluation time as a five-million-dollar investment, yet the latter has 100 times the capital return. As mentioned earlier, the declining cost to create a venture makes VCs even more stretched for time. These funds must therefore invest in more companies within the same timeframe to deploy the same magnitude of capital. While capital scales, time does not, and so VCs find themselves increasingly against the clock.
In light of these shortcomings and failures to produce returns, venture capital is prime for disruption. In recent years, many VC firms have consolidated, resulting in larger funds. This concentration of capital means it is difficult for VCs to rationalize smaller and early stage investments. With billion-dollar funds now commonplace, moving the needle requires large transactions and large wins, and so funds care less and less about companies seeking seed investments of fifty-thousand dollars. Soon, larger funds will begin investing only in companies with a track record of success, growth and momentum. The relative lack of risk allows these ventures to raise and absorb larger capital. This also leads to a generally more conservative investment process.
The move of VC funds to become larger means a change in focus. Funds now find their investment processes less driven by pushing innovation at an early stage. Rather, they are guided by financial metrics, providing careful investments to satisfy their institutional investors – pension funds, endowments, and sovereign wealth funds. While the result may be more substantial and consistent returns across the industry, venture capital may soon become more about investing in numbers than investing in people. VC deals shy of $10M fell to a decade low in 2017, according to the National Venture Capital Association. As VC pivots to a less speculative investment approach, and the industry moves away from fast-moving, young and highly innovative companies. Today, three of the five largest companies in the world were funded by VC in their early stages. While these companies may have become giants without venture capital, the impressive number of successful startups that initially choose VC funding shows its pivotal role in the ecosystem. The question is whether, with industry-wide VC changes and more alternate funding sources for startups, venture capital will remain a dominating force in the entrepreneurial landscape.