Venture Capital: It's Not for Every Startup

SMITH BRAIN TRUST — Venture capitalists are stars in Silicon Valley, picking and choosing among potential tech giants and riding startups to riches (if they're lucky). But venture capital isn't for every startup, and the pursuit of VC can be a trap, points out Elana Fine, executive director of the Dingman Center for Entrepreneurship, at the University of Maryland's Robert H. Smith School of Business. "Companies should be looking at all the sources of capital that are out there, and they should be matching their companies with the most appropriate sources," Fine says. "They should not assume that because they are in tech that they should get venture money."

To justify the risks they undertake, VC firms often demand hyper-growth in a very short window — a tenfold or greater return in under a decade, say. And with each round of funding, the pressure on a new company for huge returns increases. Uber, for instance, raised at least $1.5 billion in venture capital last year, then added $3.5 billion this week from a Saudi sovereign fund, meaning investors now value the company at $62.5 billion — a high bar, indeed. Those who fail to meet the targets set by VC's are dubbed "zombies," and abandoned.

Plenty of respectable companies may be on target to make a healthy profit but not to clear the bar established by VC firms, Fine says. Other companies may have Uber-like scale in their dreams, but they foresee such growth taking decades. They, too, might be poor candidates for VC investment.

The pursuit of venture capital, when it’s a bad fit, can have two often-overlooked costs. One is lots of wasted time repeating the same pitches and getting "no" as an answer. Then there is the hidden downside of hearing "yes."  Landing VC funding, especially in multiple rounds, can mean giving up ever-larger slices of the company. "Some people spend all that time building their company to that dream exit, and in the end they aren't the ones making the money," Fine says. "It's the VCs."

What's more, as they cede board seats and dilute their stock they risk being losing control of their own companies. "Many people become entrepreneurs so that they can work for themselves," Fine says —and venture capital can undermine that goal. (This is the theme of the current season of the HBO comedy series "Silicon Valley," which is about the struggles and triumphs of a tech startup.)

Of course, for certain companies, VC is a perfect match. For the right company in the right market, venture capital is the absolute right path for financing, connections, market validation and advice, Fine notes. 

But even VC titans are realizing that, with their current approach, they are missing out on investment opportunities. The Wall Street Journal notes that Pierre Omidyar, the founder of eBay, and Fred Wilson of Union Square Ventures are backing Indie.vc, a new type of fund that seeks out profitable companies that are following a less dramatic trajectory than Uber or Snapchat.

In lieu of focusing exclusively on the payout from an IPO, Indie.vc will — after a certain period — take a portion of the founders' salaries. If a company wishes to stay private forever, it can elect to pay a portion of its revenue to the firm. To be sure, after an IPO Indie.vc can convert its investment into an ownership stake, but the price extracted is more modest than is typical in the VC world. The hope is that companies Indie.vc invests in will focus on growing revenue, through which it can fund itself, not on pursuing additional VC funding.

One company founded by Indie.vc is Fohr Card, which helps brands place native advertising on websites. Its founder, James Nord, told the Journal he "wasted" six months of his life making the rounds of the Valley's VC firms. Now he's glad he failed. Founders that secure venture capital, he told the newspaper, "look around three years in and they have 45 people and no real business model and own 4.5 percent of their business and are asking themselves, 'What happened?'"

Data from the Kauffman Foundation show that only about 5 percent of startups get venture capital. Even among high-growth startups, the figure is only 5.5 percent. However, 37 percent of companies that had IPOs between 1980 and 2005 received VC funding.

Fine says she's seeing a change in investment preferences among the Dingman Center Angels, who provide early-stage investment to companies in the Mid-Atlantic. "While the traditional path was to first raise seed funding from angel investors followed by several rounds of VC, investors are increasingly attracted to deals that won't require as much follow-on capital," Fine says.