I sat on a panel last week for a Young Venture Capital Society event. While the event was tailored to young VCs there were quite a number of entrepreneurs in the room. I'm always impressed with the resourcefulness of entrepreneurs to get in front of VCs even if it's not their venue. After the panel I was approached by 15-20 entrepreneurs all looking to pitch me their business and is typical at events like this only a small percentage are a fit for venture capital at all. I find this happens more here in NY than in larger venture markets like Silicon Valley or Boston that have a more mature, venture ecosystem.
One of the biggest misconceptions is that venture capital is at the center of the startup/early stage funding world. The reality is venture capital is the cream - not the coffee. Just take a look at the numbers to prove this out. In 2006, angel investment in the U.S. totaled over $26 billion compared to $5.6 billion of seed and early stage venture capital. That's less than 18% from VCs and more than 82% from angels. (see these files for more info: Download 2006angelmarketanalysis.pdf Download 06q4mtprnewsfinal1.pdf). Also, since venture deals tend to be larger than angel deals my guess is VCs represent less than 10% of overall companies funded at the seed or early stage. Add all of the self-funded companies (cash, credit card, mortgage, etc) and that 10% number likely drops much further to perhaps 5% of all new company financing.
There are a number of reasons why this is the case but I'll mention the four reasons I feel are the most significant:
1. Most companies don't fall within the industry focus of VC firms.
Many early stage VC firms talk about how their investment strategies are unique or different than their peers. The truth is the differences between funds are within a relatively narrow niche of the new business creation market. Most VC funds invest in companies that are tech or science centric. There are exceptions but 90% plus of the available early stage dollars are focused to tech or science related companies (web, software, hardware, life sciences/biotech, cleantech, etc.). If your company doesn't fall within this narrow band you're likely not a candidate for venture capital at the early stage. Areas where few VCs invest in seed/early stage include retail, consumer products, non-tech services based businesses (law, accounting, consulting, financial services, etc), health care services, restaurants, non-tech entertainment, government regulated industries, companies that sell primarily to governments and restaurants/bars/nightclubs and on and on. I think I'm making my point. Some of these industries represent a substantial part of the U.S. economy but just aren't candidates for VC investment because of point #2 below.
2. Most small, new companies don't have the potential to grow up and become big successful companies - and that's ok.
VCs invest millions of dollars into companies at the early stage with the expectation/potential to return 5x-10x on their capital and preferably over a 4-8 year time-frame. To use a simplistic example, if a VC fund invests $2 million for a 20% stake in a business the company is worth $10 million post-investment on paper. For the VC to realize a 10X the company needs to sell for $100 million. Very few types of businesses have the potential to reach a value of $100 million. VCs often talk about only backing companies that can create billion dollar markets. The reality is there are only so many billion dollar markets. The average entrepreneur can make a really nice living being successful in a $50 million market or in a $5 billion fragmented market with 100 companies.
I have a number of friends that run and own successful businesses that generate significant cash flow but can't grow revenues at the rate necessary to create a $100 million enterprise value in a relatively short period of time. Many VCs use the term "lifestyle business" to describe this sort of company. Some of these lifestyles are really nice. My friends that run businesses like these are very happy, make a lot of money and in some cases have homes that would qualify for MTV Cribs. The one common denominator of all successful VC investments is a business model that can scale revenues rapidly and in a nonlinear fashion. So if you're in a business that isn't capable of achieving that kind of growth pursue other sources of financing. How do you know if your business isn't VC backable? Research other companies in your space and if none of them received venture capital it's likely there's a reason.
3. You have no desire to sell your business or pursue an IPO in the next 10,20,30 years.
The best VCs are patient investors and are willing to work with an entrepreneur over a number of years to create significant value. Despite this fact VCs need to return capital to their investors to stay in business and raise new funds. LPs in venture funds look for returns over a 4-8 year period and VCs work hard to make sure this happens. If you want to own/run your business for your entire career or hand off your business to your son/daughter (and an IPO isn't a possibility) then venture capital is not for you.
4. Your company is geographically undesirable.
This has become less true over the years but the reality is most early stage VCs are based in only a few areas: Silicon Valley, metro Boston, metro NY, Seattle and N. Virginia/DC. Other areas of the country have some venture presence but rarely more than 3-5 VC funds. That's a small pool of VCs if you're not in a major market. There are newer groups like Village Ventures that are doing a great job trying to change this fact but we're still a long way from the VC industry being highly distributed throughout the U.S.
This is important since most VC funds insist on investing in seed/early stage deals that are local. VCs like to be close to their companies to provide the most value to the entrepreneur. It's also much easier to monitor an investment if it's local. Many Silicon Valley VCs have strict rules about investing only in companies that are a car ride away.
So before you decide to pursue venture capital think hard about these points. If you feel any hesitation it's likely you should pursue other methods of financing.
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