Six Myths About Venture Capital Offer Dose of Reality to Startups
Venture capital is the exception, not the norm, as a funding source for startups. More VC-backed new companies fail than succeed, and since 1999 VC funds have barely broken even. Those are just some of the myth-busting facts revealed by Diane Mulcahy, director of private equity at the Kauffman Foundation and a former VC herself, in the May issue of the Harvard Business Review that focuses on entrepreneurship.
April 25 2013 by ChiefExecutive.net
“For someone who’s starting (or thinking of starting) a company, the myths surrounding venture capital can be powerful,” Mulcahy writes. Aiming to empower entrepreneur founders in their negotiations with VCs, she states she “ will challenge some common ones in order to help company founders develop a more realistic sense of the industry and what it offers.”
Mulcahy’s six VC myths are highlighted below:
Myth 1: Venture Capital is the Primary Source of Startup Funding
VC financing is the exception, not the norm, for startups. Historically, less than 1 percent of U.S. companies have raised capital from VCs, and the VC industry is contracting. But less venture capital does not mean less startup capital since non-VC sources of funding, such as angel capital, are growing.
Myth 2: VCs Take a Big Risk When They Invest in Your Company
VCs take risks with investors’ money, not their own. The typical VC commits only 1 percent of partner capital to a fund while investors commit the remaining 99 percent. The VC revenue model that generates guaranteed and cumulative management fees regardless of investment performance insulates VC partner personal compensation from the risk of poor returns.
Myth 3: Most VCs Offer Valuable Advice and Mentoring
VCs differ in how much effort they put into these nonmonetary resources, and the quality of advice and mentoring from VCs can vary widely, so founders who want more than capital from their investors should conduct a thorough due diligence on a VC firm they are considering.
Myth 4: VCs Generate Spectacular Returns
Mulcahy cites the data and findings from the Kauffman Foundation report she and her colleagues published last year about the under-performing VC industry. The report provides data on historic VC industry returns, and the Kauffman Foundation’s experience as a long-term investor in VC funds.
Myth 5: In VC, Bigger is Better
The contrary is true for both the industry and individual funds. Industry and academic studies show that VC fund performance declines as fund size increases above $250 million.
Myth 6: VCs are Innovators
VCs may be well known for funding innovation, but the VC industry and business model have not seen significant innovation in two decades. The VC fund structure, fund life and economic terms have remained the same for more than 20 years. Note to GPs: Increasing the standard 2 and 20 compensation model to 2.5 and 25 is not innovation.
VCs will continue to play a significant, but smaller, role in channeling capital to startups, Mulcahy concludes. The contracting VC industry and new funding sources now available to founders are finally “shifting the historical balance of power that has too long tilted too far toward VCs.”