Archive for the ‘Funding’ Category


By: Source:

An annual ranking of top start-ups suggests VC funding and success go hand in hand. That’s one huge mistake you don’t want to make.

hundred dollar bills

shutterstock image

Trying to identify the next big entrepreneurial thing? The Wall Street Journal has some implicit suggestions in its ranking of the top 50 start-ups. According to theJournal‘s third annual account, these are the top venture capital-backed young companies. One of the big takeaways this year is that business-to-business concepts are ahead of online consumer companies.

If you’re focused on consumers, that means it’s time to shift strategies and look at how to sell to other businesses, right? Not quite–because there are some mighty big assumptions and contradictions in this start-up compilation, and you don’t want to send your horse to the corral on someone else’s say-so.

Venture capital partners are subject to whim and fad

It’s fine to talk about which companies are getting the most venture money. As in any other part of human existence, there are fads and fancies. Right now, venture firms are looking more at B2B. There are some good reasons they might. For a long time, B2B companies often found themselves passed over for the flashier Internet consumer offerings: Facebook, Twitter, Foursquare, and so on.

Companies that sell to businesses typically are using proven business models with a twist, so it is easier to predict outcomes. A larger portion of businesses than consumers are willing to pay for what they need and get, because the lack of the right service or tool can make the difference between profit and loss.

But remember that not too long ago–as recently as earlier this year, in fact–VCs were all over consumer Internet companies. They literally poured money into the space. According to start-up database Crunchbase, Facebook pulled in $2.24 billion in investment. Twitter has received $1.16 billion. Foursquare, which looks like it’s in the low-rent district, by comparison, has $71.4 million. Zynga had $860 million and LivingSocial got $808 million. And let’s not forget Groupon at $1.14 billion.

VC-backed doesn’t mean successful

Notice that a lot of these companies have either had stock trouble since their IPOs because of concerns over revenue (read that as business success) or have raised questions about their ability to increase income–or even makeincome. It’s a clear demonstration that the whims of VCs don’t necessarily map to ultimate business success. In fact, according to new Harvard Business School research reported by the Journalthree out of four venture-backed start-ups fail. Compare that to the 30% failure rate that most VCs say they see.

VCs don’t necessarily depend on operational success

Although some venture capitalists seem to truly believe in the companies they back–Fred Wilson at Union Square Ventures comes to mind (and even he holds to the 30% will fail, 30% will under-perform, and 30% will meet expectations model)–a good many look to build up a business only to eventually exit, which is the polite way of saying buy low, sell high.

They create demand for a product and then unload it to someone else. Too often the VCs depend on the greater fool market theory: that you buy something and wait for a bigger fool to come along and pay more for the same item.

It’s a fact of venture money that the Journal did not mention in its ranking. Of course, the ranking also takes into account valuations. But remember what Facebook’s valuation was right before its IPO in May 2012? Right–much higher than now.

Forget the rankings and the implications of what will work in the real world. If anyone had such a lock on the truth, that person would be able to print money. And yet, that’s not happening. So, consider your idea, think of the best market for it, look at data, think long and hard, and work longer and harder. It’s a much more certain formula to success than watching for trends in lists of well-funded companies.

Erik Sherman‘s work has appeared in such publications as The Wall Street JournalThe New York Times Magazine, and Fortune. He is a blogger for CBS MoneyWatch and @ErikSherman


by Scott Anthony

A recent report by the Ewing Marion Kauffman Foundation raises serious questions about the degree to which venture capital deserves emulation.

The report, provocatively titled “We Have Met the Enemy and He is Us” [PDF], summarizes its findings thus:

Limited Partners — foundations, endowments, and state pension funds — invest too much capital in underperforming venture capital funds on frequently misaligned terms. Our research suggests that investors like us succumb time and again to narrative fallacies, a well-studied behavioral finance bias.

One of those narrative fallacies relates to the most basic thing that investors care about: results. Most of the funds in which Kauffman invested failed to beat public market indices, despite the higher-risk nature of their work. Kauffman found that larger funds in particular provided disappointing returns.

Kauffman didn’t say it was opting out of venture capital. Rather, it plans to seek smaller funds, shift some of its money towards public equities, and co-invest in later-round deals with seasoned investors. It also called on investors to work to better align investor and venture capitalist incentives.

Within Innosight, where I lead venture investing, the report led to an invigorating debate about the industry. We debated two possible stories behind some of the report’s statistics.

The first story relates to plain old-fashioned competition. Over the past decades, foundations, pensions, and other investors have poured money into venture capital, particularly in the United States. The number of funds has exploded. If one assumes that the number of great startup ideas is relatively stable at any given time (a contentious but simplifying assumption), increased supply has to decrease returns. A result that is exacerbated by the simultaneous decrease in the cost of innovation and the rise of new approaches, like Y Combinator’s systematic incubation factory, Kickstarter’s crowd-funding platform, and super angels like Ron Conway. Barriers to entry are decreasing and disruptive entrants are surging, a recipe that both Michael Porter and Clayton Christensen could agree augurs poorly for industry returns.

The alternative and potentially more troubling story is that the venture capital approach is fundamentally flawed. The industry has unquestionably helped to support the formation of world-changing companies such as Microsoft, Cisco Systems, Google, Facebook, and countless others. Yet over the past decades, venture capitalists have shown signs, despite all their experience and skills, that they’ve not gotten better at what they do.

Maybe that’s just the way it is. You can’t know ex-ante which idea is the right one. If that’s the case, though, it would be far better to simple spur more Y-Combinator-like incubators that follow the Steve Blank gospel of getting out of the building and iterating to discover product/market fit.

A related possibility is that a majority of venture capitalists use flawed theories of startup success. Clayton Christensen likes to describe how, in the early stage of theory development, people make predictions based on observed correlations. For example, people observed that things that flew had feathers. So people hoping to fly created large feathered wings. More advanced theories pinpoint causal mechanisms. For flight, that was Bernoulli’s Principle, a theory that explained the concept of lift and why modern aircraft are not covered in feathers.

Much of the venture capital industry seems stuck in the feathers-and-wings stage of theory development. Many successful venture capitalists observe directional patterns. “Every time I have succeeded,” they might think, “I’ve backed an ‘A team,’ that has targeted a hot market space.” There’s no doubt that’s true, but that is a statement of correlation, not causality. Even worse, the narrative fallacy means that people are likely to construct stories about the past that might not have been precisely true, making future predictions even more dubious.

Google Ventures is an intriguing example of a venture organization putting more science behind its correlative analysis. As detailed in a recent Fast Company article, it has a team of statisticians crunching data to determine patterns of success in startups. For example, its team found the perceived wisdom that failure is beneficial isn’t backed by data. Almost 30% of businesses founded by someone who had succeeded once succeed again, versus 15% of businesses founded by someone who failed once.

The Google Ventures approach has its limits. Without understanding why a pattern exists, making reliably accurate predictions is hard, at best. This is where good business theory comes in. Work by Christensen and other innovation thought leaders has built a body of theory about why certain ideas succeed and others fail. Other academics, in particular Noam Wasserman at the Harvard Business School, have provided useful theories to inform the critical choices facing entrepreneurs.

It’s not hard to see the venture capital industry trifurcating. There will always be top-tier firms who give their seal of approval to a select group of startups. Expect to see continued growth among incubators that support fast-cycle iteration. And in between, look for a rise of companies that take the Google Ventures approach even further to approach the funding of startup companies scientifically. The rest? Well, Darwin has a way of working out such problems.

More blog posts by Scott Anthony
More on: Innovation, Venture capital

Scott Anthony

Scott Anthony

Scott leads Innosight’s Asian operations. His fourth book on innovation, The Little Black Book of Innovation, is now available (HBR Press, January 2012). Follow him on Twitter at @ScottDAnthony.