Startup entrepreneurs look eagerly towards the venture capital community, seeing the myth of a big pot of money ready to be given away to worthy ventures. Advisors, business school professors, and a lot of people who ought to know better, see VC funding as a given for far too many ventures, when in reality, there are a lot of great ideas that never get a single dollar in funding.
It’s true that venture capitalists are still raising big money, having taken in about $13 billion in the first quarter of 2016 alone. But they are a lot less eager to send that money out into the world than ever before, and VCs are more focused on setting aside funds to keep the companies already in their portfolios moving forward. They need more reserves on hand for follow-on funding for their existing companies which haven’t yet turned a profit.
Those VCs who put money into those high-profile unicorns that had big exits when they went public just aren’t taking the same risks they used to take when every dotcom was planning an IPO before they ever made a nickel of profit. And those VCs aren’t making the same returns, either. Cambridge Associates measured a -0.4 percent return on the US Venture Capital Index for the third quarter of 2015, and only 1.95 percent in the fourth quarter. VC funds have consistently been outperformed by the stock market ever since the late ‘90s – and the stock market isn’t doing so great either.
Do VCs really want innovators?
VCs are not really risk takers, and despite what it may say in their brochures, they are not innovators themselves. The only real innovation in startup finance has occurred outside of the VC community, with new concepts like crowdfunding. Most VC firms are not investing the money of the principals, but rather, money from others who invest in their funds, and the VC firm makes money by charging those investors a management fee – so they get a paycheck whether their portfolio companies win or lose.
Even though VCs are not innovators themselves, do they look for innovators when they are deciding where to put their money? The answer may be surprising. They want something proven, they want consistency, and they want to do business with people who have delivered in the past, and with people who know the future. They make their decisions based largely on two things: What areas have delivered results before, and what guarantees they have that the startup will meet expectations in the future.
Adam von Gootkin, co-founder of Onyx Spirits Company, makes tasty booze, a skill that runs in his family, who during Prohibition ran a speakeasy on the Connecticut River. But Adam also understands that like a finely balanced moonshine, investors want a fine balance between mainstream and innovation. “I think VCs want to see a founder and team that can demonstrate the best of both worlds. An idea that takes mainstream up a few notches into the realm of innovation is arguably the best play,” says Adam. “They understand if a risk is too safe their return is commensurate with the risk, and if too risky it may outweigh the potential financial gain. Ideas don’t have value, only execution does. A healthy balance is a good idea, and as always a sound plan for execution is the most important factor.”
VCs Going Back to the Well
Venture capitalists consistently go back to the same well, tapping into narrow areas where they have made money before. Silicon Valley has paid off in the past, and so in 2015, Silicon Valley companies took $27.42 billion in venture money, representing over half of all VC deals in the United States. By the same token, software has paid off for VCs in the past, so in 2015, software investments represented 41 percent of deals. Have you had a successful startup before? Great, there will be no shortage of VCs who would like for you to do it all over again. Do you live near Silicon Valley where all the VCs are, and possibly play golf with them on weekends? You’re in luck. If you live in the Midwest, or you have a venture that has nothing to do with tech, chances are they’re going to take a pass.
We do live in the age of the videoconference, and the dotcom revolution erased many borders – but geography continues to be a strong factor in the venture capital world. Neil Patwardhan, founder and CEO of Skoop, notes the difference between a Silicon Valley VC and a Texas VC – “Silicon Valley VCs expect you to fail and bank no extreme disruption. Texas VCs expect you to succeed and bank more on proven entrepreneurs with revenue. The latter mentality can often be detrimental to startups looking to get seed to early stage funding.”
If you know the future, VCs want to know you
The game of venture capitalism, as well as the game of entrepreneurship, is based on guessing what is going to pay off in the future, and in a lot of ways, it’s only a slightly better risk than taking a trip to the blackjack table in Las Vegas. You can’t blame the VCs, who are putting large piles of money on the table, for wanting to do whatever they can to improve their odds. Doing so doesn’t involve wearing lucky hats, or having somebody blow on the dice before you throw them – but it does involve very precise methods of gaining foresight.
Those VCs may talk a lot about unicorns and innovators, but at the same time, they want to be able to put that insight into a formalized, quantified process involving predictive analytics. The foresight the successful VCs and entrepreneurs have is more than instinct, it is firmly based on numbers. “Predictive analytics is about formalizing and quantifying what many of us think we already know to be true, but we don’t, really,” says Nick Weber, Principal at 4i, a foresight analytics consultancy. Telling a VC that you have a great idea is meaningless. Telling that same VC that you’ve done the analytics to accurately predict the market is a big step towards nailing down that Series A.
Still no dice? Think smaller.
Innovative startup entrepreneurs have more choices today, and VCs aren’t the only player in the game. Historically and through the end of the dotcom boom, the VCs held all the cards, and for putting big money into a new venture, they were the only game in town. Today, entrepreneurs have more options, ranging from crowdfunding and angel investing, to loans against your personal assets. While advisors will recommend against the latter strategy, in reality, it is often a necessary part of the mix when the VCs aren’t interested. By the same token, banks have very little interest in making small business loans, but there are other options, such as factoring (taking an advance against invoices), leasing arrangements, secured loans, or even peer-to-peer lending options. Fees and interest may be high and electronic access to your bank account may be required, so if you’re going down this road, do some due diligence before taking advantage of these alternative funding methods.
When the VC says no, all is not lost. Take the example of Manish Sood, who in 2011, co-authored the patent that revolutionized master data management (MDM) and who architected some of the most widely used data management solutions used by Fortune 100 companies today. He saw a need that was not being met, and invested his own money into founding Reltio. He approached several VCs, but found only closed doors. Undeterred, he raised a small angel round to fund the development and business operations until he was able to land a Series A deal and officially launch the company in March, 2015.
VCs clearly don’t always know better than other people, they command authority only because they are in control of a large pool of money that will fund a few lucky startups who lived in the right place, targeted the right industry, or played at the right golf course. What’s important to know is that when the VCs say “no dice,” it doesn’t mean the idea has no value. More startups get launched without VC money than with – and increasingly, the VCs are no longer the only game in town.
image credit: quotesgram.com
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Dan Blacharski is senior contributing analyst at Compass Intelligence, a market acceleration research and consulting firm; and the founder and senior PR counsel at Ugly Dog Media, a thought leadership and public relations consultancy.