This article was written by Brian Hamilton, December 26, 2013, reprinted by permission
Venture capital is unlike anything else I've seen in American commerce. People are vigorously seeking something that's often unattractive. It's extraordinary because markets are almost always efficient, but this one is not.
In order to back-solve to how we got here, let's start with history. As a professional market segment, the venture capital industry is only about 40 to 50 years old. In its infancy, it was probably a good invention in that it gave entrepreneurs the ability to seek out investors more easily. Before that, it was largely about networking, informal contacts and merchant banking, which meant seeking capital was unorganized. Now, it's organized: We can go to Google and search "venture capital firm in NYC" and instantly get a number to call. From that perspective, venture capital as a model helped because it gave us an identifiable supply of capital and, as such, has provided some value.
However, from a practical perspective, that of someone who is starting a business today, there are three important dynamics that must be considered before accepting capital from this particular pool.
1) It's very unlikely that you will receive funding from a VC firm when you start a business or even if you are running a small, high growth company. Fewer than 300 start-ups were funded by venture capital in 2012 throughout the entire United States. Given that between 500,000 and 600,000 businesses are started each year, even in the best-case scenario, only 0.06 percent of businesses will get funded through this channel. Remember that when you're first starting a business, you only have your brains and your time to sell, so you have to put your chips where they will pay off. While the odds of getting venture capital are better than the Lotto, they are not great.
When I first researched venture capital as an option, I looked at similar statistics and thought, "Why am I spending a lot of time on something when the odds are so low?" Simply put, there is not a good risk-reward quotient. Every minute of your time, every second counts, and if you're chasing a pot of gold that doesn't exist, you're losing your most valuable asset.
2) Even if you're one of the very few people who do get VC funding, the average cost of capital from a VC firm is extraordinarily high, usually well in excess of 25 percent a year. Now, the VC guys will say, "If you're growing at 50 or 60 percent a year, then you still make money." But not many businesses know if they can sustain that rate of growth, so it's an extremely high cost of capital in most cases. If you borrow at X percent, you need to create value well ahead of that. Without getting into the financial complexities, I don't see venture capital as equity at all. It is high-cost debt from any rational perspective.
When we start businesses, most of us entrepreneurs are so desperate to get money that we don't even think about these costs, but believe me, if your business does eventually become successful, you will understand the cost of capital. And, it will be very painful.
In most venture capital deals, the firm requires in exchange for their investment something called preferred stock, which is dangerous if you're running a small company. Simply put, preferred stock gets paid out first from any liquidity event and therefore locks in a rate of return for the VC firm. It also gives the firm the option to convert to common stock and take advantage of the company's value if it has grown, so it's very expensive. I don't know if entrepreneurs truly look at the terms in the documents they sign when considering one of these deals. All money received is not good money.
3) You might not want the venture capital firm as a partner, but it definitely will be. Evaluate the venture capital firm you're considering very carefully because most entrepreneurs don't inherently get along with venture capitalists. Frankly, most VC guys give me the creeps. You have to think, "This is someone who will be at our board meetings." And, "I'm going to get a weekly call from this person."
Do I really want to hear from him? Because you will hear from him.
Venture capitalists are typically from good business schools, highly analytical and very professional. Alas, unfortunately, a lot of them haven't run businesses and don't really know what it requires, no matter what they may say. I realize these are blanket statements, but I'm writing for the benefit of entrepreneurs, and I'm sharing what I've found. I haven't found many venture capital firms to be very insightful in running a business.
So, venture capital has this weird dynamic where you might not get any money; if you do get it, it's at a very high cost, and, even still, there is a new person involved in the business who you might not want involved. Wow.
So, what do you do instead?
Start really small in a room by yourself, building a product. Get a partner. If you have to get money, get the minimum needed to go to market -- the very minimum. Typically, this is less capital than you may initially think. The truth is, almost all businesses in this country are started by bootstrapping, a family and friends round and then organic growth. The data supporting this is overwhelming.