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Venture capitalists: do entrepreneurs still need them?

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money tree smallThis article also appeared in Finweek Magazine in their 11-April-2013 issue

Before World War 2, development capital was limited largely to wealthy individuals and families. It was only in 1946 that venture capital (VC) began to emerge. That year the first two VC companies, American Research and Development Corporation (ARDC) and JH Whitney & Company, were created in the US. Since then, entrepreneurs have pretty much depended on VCs to build high-growth businesses. But that could be changing. With the advent of crowd-funding and the dramatic drop in costs to launch an Internet start-up, do tech entrepreneurs still need VCs?

Firstly, what is VC? This is funding provided to early-stage, high-potential, high risk, high-growth start-up companies. VCs usually fund companies with an innovative new technology or business model in high tech industries, such as biotech, IT or software.

In 2008, Paul Graham, founder of seed-funding firm/accelerator Y Combinator, predicted that VC funding might dry up a lot in the global financial crisis. And dry up it did. A recent report from Thomson Reuters and the US NVCA (National Venture Capital Association) indicated that in 2008, US VCs raised $25.6bn from 215 funds. In 2009, this fell to 162 funds raising $16.2bn. That’s a 25% decline in the number of funds and a hefty 37% dip in funding.

But this drop is nothing new, you might be thinking. Money and appetite for investment often dry up when times are tough. Think back to the late nineties and the pinnacle of the Internet bubble, when the number of US VC firms ballooned to 1,022 in 2000. After the dot.com crash hit in early 2000, the number of companies in the US VC industry rapidly plummeted.

However the difference is that today’s post-recession world is very different from 10 years ago. According to ThomsonReuters, US VC fundraising in 2011 fell to 1994—1998 levels. The MoneyTree Report, PWC and the NVCA’s quarterly study of US VC investment activity, is based on data from Thomson Reuters. If the report’s historical data (of number of deals or amounts invested over time) is anything to go by, the shrinking VC industry may not bounce back this time. Here’s why:

  • It has become dramatically cheaper to get a tech start-up off the ground. When VC funding slowed to a trickle after the Internet bubble burst, start-ups also dried up. 2003 didn’t see many new start-ups being founded. Why? Because start-ups were much more dependent on VCs then. The costs of getting a start-up up and running were much higher, and start-up entrepreneurs needed VC funding to keep going until revenues kicked in. Internet advances have made our world a very different place since then. Unlike in the post-dot.com crash period, the number of new start-ups in 2008 didn’t seem to decline at the same time as VC funding declined. Y Combinator saw a record 40% more applications for funding in their April-October 2008 cycle compared to the same cycle in 2007. This was a strong indication that start-ups seemed to be becoming less and less dependent on VC funding.
  • Why have the costs of starting a tech start-up come down so much? There are a number of drivers at play here:
    1. Thanks to Moore’s law, hardware is getting cheaper and cheaper all the time. This law says that the number of transistors on integrated circuits doubles roughly every 18 months. Why is this important? Because it means that the processing speed, memory and pixel size of many digital devices are improving at dramatic rates. If a technological device becomes obsolete only a few months after it is released on the market, a common strategy is to drop its price. This encourages people to buy it even though a better, faster model is available;
    2. Open source means that software has become largely free. Open source is an IT term meaning that the source code is freely available.
    3. Thanks to significantly more powerful programming languages, we need fewer team members in web-development teams; and
    4. The Internet and social media has made marketing and distribution free for many industries.
    5. In the case of an Internet start-up, if the founders work from home or a garage, rent becomes trivially low or free.

    All this means that for many Internet startups, their biggest expense is the founders’ daily living costs. In the US in 2008, that could be as low as $3000 a month. Paul Graham gave examples of start-ups like TicketStumbler making it to profitability on funding from Y Combinator alone ($11,000 plus $3000 for each founder), not even needing angel or VC financing. Of course, this is only possible if the founders don’t take unnecessarily hefty salaries when their business cannot afford it. In this early make-or-break stage, any mentor will tell you: pay yourself as little as you can, but don’t starve.

  • Lower running costs mean the profitability threshold can be reached much sooner. And once you’re profitable, you can manage without investor funding. The days of start-ups needing sizeable VC-scale investments are coming to an end.
  • Many founders feel investors simply aren’t worth the time and effort, and they can make do without funding. The investor due diligence process is lengthy and time-consuming, and can distract you from running your business effectively. Also, investors have strict requirements. So deals often fall through at the 11th hour over seemingly trivial issues that crop up when investors have a lot of bargaining power. Paul Graham of Y Combinator gives an example of a deal being broken because the investors were uncertain whether a start-up’s founders had correctly filed an optional 83(b) US income tax form. And this despite the start-up showing exponential growth in traffic and revenue.
  • Only accept funding if you really need it. This is the advice of many experts nowadays. Jason Weaver, founder and CEO of Shoutlet, has helped raise close to $25m for his company, a leading social media marketing platform worldwide. In his words: “Rather do whatever you can to self-fund your start-up before accepting funding.” Why? Because once you take funding, your business will focus primarily on growing top line revenue and you’ll soon require more funding to sustain your growth. Having funding means you work for your board and your shareholders, and you have a responsibility to do what is best for the company. With or without you there.
  • Many believe crowdfunding and funding by angels, family and friends could replace VCs. Crowdfunding enables inventors to list their idea on a popular website such as Kickstarter.com, in order to raise the funds needed to take the project to market. A few hundred or thousand individuals will frequently invest or pre-order your product before you mass-produce it. So this can be a very effective process for testing your product on the market before you go big. The PWC and NVCA MoneyTree Report predicts two key trends:
    1. the amount invested in start-ups will rise almost 60% by 2020, compared to 2011; and
    2. by 2020, VCs will only be about one quarter of the capital invested in start-ups. This amounts to a sizeable drop of 41% compared to the 2011 numbers

So what does all this mean for the VC industry? For more and more start-ups, VC funding has become a nice-to-have. It is no longer the absolute essential it once was. This should be a big wake-up call for VCs.  If VCs don’t acknowledge that much of the power in the investor-founder relationship has shifted to founders, if VCs don’t invest more, start-ups may soon dismiss them as a nice-to-have that they’d rather do without.

Author: Colette Symanowitz

Director of FraudCracker. Passionate about entrepreneurship, personal branding and networking. I also tweet under @FraudCracker

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