Small Business

The Truth About Venture Capital


One expert estimates that VC firms fund only one of every hundred proposals they get. And certain industries have a statistical advantage

The possibility of landing a venture capital deal entices many aspiring entrepreneurs, but the reality is harsh. Although VCs invest significant amounts of money, the number of companies that get funded is tiny. In 2007 there were 3,813 deals that totaled $29.4 billion, according to the PricewaterhouseCoopers/National Venture Capital Assn. MoneyTree Report, which measures VC activity in the U.S. Data are scarce on what proportion of companies that seek venture funding actually get it. But anecdotally, National Venture Capital Assn. spokeswoman Emily Mendell estimates that of every 100 business plans a venture firm receives, 10 get a serious look, and one gets funded.

Does your company have a shot at being that one? First ask yourself whether your business can deliver the expected returns. "It's incredibly rare for a company to hit the sales targets that venture capitalists have," says Scott Shane, professor of entrepreneurial studies at Case Western University and author of The Illusions of Entrepreneurship (BusinessWeek.com, 1/23/08). He suggests that most VCs want businesses to hit $100 million in sales within six years (a goal only 200 companies each year reach), though Mendell says the expectations vary from firm to firm.

VCs Go for Fast Growth

Venture firms focus their investments on the handful of industries where explosive growth is possible. Biotech and medical devices made up 23% of 2007's venture deals, according to the MoneyTree Report. An additional 24% went to software companies. Retailing and distribution, consumer and business products and services combined accounted for 289 deals, or 8% of the total. Location counts, too. California is home to 41% of the companies VCs funded last year. An additional 13% were in New England. If you're not in a medical or tech sector and you're not located in a hotspot like Silicon Valley or Boston's Route 128 corridor, your chances of getting VC funding are virtually nil, Shane says.

But say you still think venture capital is right for you. You've shepherded your business beyond the startup stage. You're in a high-growth sector and located in a tech hotspot. You think you've got a shot at being one of those few thousand companies that will get funded this year. What else can you do to improve your odds?

Researchers say networking with VCs and people who know them (BusinessWeek,com, 11/28/07) is important. Without a referral from a mutual acquaintance, your chance of getting venture funding drops dramatically, according to David Kirsch, director of the Business Plan Archive at the University of Maryland. "It's almost impossible to get funding for a business plan that comes in over the transom," he says. Kirsch and UMD professor Brent Goldfarb analyzed hundreds of dot-com era business plans submitted to an unnamed East Coast venture firm. They found that companies were far more likely to get funded if their plans were referred to VCs than if they were sent cold. Their conclusion: "At the margins, an entrepreneur should focus less on perfecting the plan and more on expanding the network," Kirsch says.

Big Ideas Count

Other research suggests you should spend more time developing your idea than assembling your team. Despite some VCs' assertions that they'll fund "an A team with a B idea over a B team with an A idea," a new study suggests that your team matters less than they say. A pair of doctoral students at the University of Louisville found that entrepreneurs need to meet a minimum level of trust for VCs to consider funding them. But beyond that threshold, companies were funded based on their idea's potential, rather than the founders' credentials.

&quoIf I had a choice to allocate my efforts, I would have an O.K. team, but I would not spend too much time on putting up a star team," says Pankaj Patel, who wrote the study with Rodney D'Souza.

Entrepreneurs can also improve their chances of landing venture capital by getting angel investors on board. "The expectation is if you can't interest an angel investor in your company, that's probably a signal that it's not a great investment," Kirsch says. Angel funding is particularly important because venture firms are often wary of very young companies; just 11% of last year's VC deals went to startup or seed-stage outfits.

Living Without Venture Capital

While it's clear that venture capital is out of reach for the vast majority, that's not necessarily a bad thing. In their research, Kirsch and Goldfarb also found that 48% of the companies they sampled—mostly dot-coms founded between 1994 and 2000—survived the bursting of the tech bubble in 2004. The number, Kirsch says, is consistent with survival rates in other emerging industries. Getting venture funding did not improve a company's chance of success. "What that tells us is that those firms didn't need venture capital. What they needed was 10 grand for some servers and a few customers," Kirsch says.

The conclusion should hearten entrepreneurs. Abandoning the chase for venture capital frees business owners to concentrate on bootstrapping or raising smaller amounts from informal investors or lenders. The average startup is financed with $25,000, and that usually comes from the entrepreneur's savings or from a personally guaranteed bank loan, according to Shane. While that's less seductive than big checks from venture investors, it's easier to find.

Tozzi covers small business for BusinessWeek.com.

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