University Startups and Spin-Offs: Guide for Entrepreneurs in Academia (2015)
Part I. Strategies for University Startup Entrepreneurs
Chapter 12. Venture Capital and Angel Investors
Students and researchers often misunderstand the function of investors, even if they have a business or finance background; they see them as a source of capital only. Entrepreneurs should consider investors in broader terms than that. Expertise, network, and influence are much more important than paying the next round of salaries. This chapter explains the most common sources of early-stage capital: venture capital firms and angel investors. It describes which other benefits these investors may have for startups and at what stage of development entrepreneurs should approach them (hint: much later than most people think).
Venture capital is funding invested in startups and small companies with the goal of long-term capital appreciation. It bears high risk, but the promise of large returns in the future compensates for the possibility of total loss. When a venture capital firm invests in a startup, this often entails more than just money. Because venture capitalists (VCs) often have an entrepreneurial background themselves, they can provide worthwhile advice to startups—for example, about how to negotiate partnerships or how to scale the business when it achieves certain milestones. Strong networks with well-connected law firms and investment bankers add to the lure of venture capital.
This model of investment is nothing new. In fact, it has been around since the end of the World War II. In 1946, the first two venture capital firms were founded in America.1 Yet it was not until the first dot.com boom in the 1990s that VCs made a foray into mainstream consciousness. Venture capital sounds very good in theory. But when I speak to startups with venture funding, a slightly different picture emerges. I often get the impression that there are two kinds of startups: those that desperately want venture capital, and those that want to get out of the deal they have with a venture capitalist. Let’s discuss this in a little more detail.
Venture capital firms often visit universities to look for technology and early-stage startups to invest in. More often than not, they leave without writing a check. This is largely because VCs look for low-hanging fruit: investible startups with capable management teams and promise in attractive markets, in which they can buy equity relatively inexpensively. Most university startups are too early stage for VCs. They lack business models and financial models, and often they are still unsure themselves what exactly they will do and whether they even want to do it. Venture capital firms look for a relatively painless 10X return. Unless your company can make a credible case that high returns are on the horizon, VC funding will go elsewhere.
Students and researchers should understand what venture capitalists are looking for. Then they will be less disappointed when the next one turns up and leaves without investing. Startups can save a lot of time if they learn to first develop their businesses ideas without any outside funding. Then all the VC visits could take place later, when their contribution makes sense.
Venture capital is a fantastic tool when a startup company already has a proven business model and a product the market wants. Capital then serves as an accelerator to expand the business and help it grow rapidly. The goal of this expansion is achieving higher revenue in the market, which results in a higher value of the company and a higher payoff for the invested capital. The Holy Grail is an initial public offering (IPO), where VCs can sell their shares to the public with a high multiple. This is the ideal scenario. But unfortunately, things seldom turn out this way in the real world. When the business underperforms or the founders have no desire to go down the path the venture capitalist suggests, problems begin. The once-friendly VC turns into a micromanaging control freak. More often than not, the original founders lose control of their own company, and the venture capital firm installs a new CEO at the helm.
Contrary to public opinion, venture capitalists rarely invest their own money. Just like any other investment fund, they raise capital from private high-net-worth individuals (HNWIs) and institutional investors. A venture capitalist with a sound track record can raise several hundred million dollars this way, which the VC then divides over several portfolio investments. The few blockbusters in the portfolio more than compensate for the failed investments, or so the story goes. In the tech boom running up to 2000, venture activity increased at a pace that was unsustainable. Institutional and individual investors—attracted by the returns enjoyed by venture funds—poured money into the industry at unprecedented rates. Many venture capitalist firms staggered under the weight of capital. As always happens in boom times, groups that should have not raised capital garnered considerable funds.2 We all know how it ended. After the boom came doom and many paper millionaires ended up with nothing.
The media only reports about the big winners in the venture game—the Googles, Facebooks, and Tesla Motors. This has imbued startup founders with the Hollywood version of venture capital. In reality, many small and medium funds implode and result in a total loss of investment. Successful portfolio companies usually go public with huge returns, so calculating a meaningful average return on investment (ROI) in venture capital funds is biased toward these rare blockbusters.
Looking at the actual numbers, venture capital returns have been less than stellar in the last decade. With selection-bias correction, the mean log return of venture capital during the first dot.com boom has been found to be about 7% with a -2% intercept and a standard deviation of close to 100%.3 This and the fact that some entrepreneurs have expressed frustration with the management style of their venture capital firms have earned them the unflattering nickname “vulture capitalists.”
Angel investors have the reputation of being the better VCs: less greedy; less complicated when it comes to due diligence, deal terms, and checking on progress; and altogether more willing to open their wallets. In contrast to venture capitalists, they invest their own money in startups: usually smaller sums, around $50,000 for a seed investment. Some successful entrepreneurs become angels after they sold their first company. Celebrities may become angels. Wealthy local business people may become angels. They often do this to remain connected with young entrepreneurs for image or networking purposes. Some also invest purely for the fun of it so they get to coach startups and help them avoid rookie mistakes. Angels would love to see a profit on their investment, but a large part of angel investing is giving back to society. Conversely, venture capital investing always aims at a financial payoff.
The link between angel networks and universities is weak. This may have something to do with the fact that university startups usually operate behind closed doors. Often they only enter the public light after they have collected grant funding. Because government grants are competing with seed investments, angels are being crowded out of the university startup game.4 This is not the situation with independent startups, and angel investing thrives in innovation hubs all around the world. Angels are often very engaged with the startups they invest in. If they have relevant experience, they can be valuable, trusted advisors in the early and later stages of a company.
Most recipients of angel capital are first-time entrepreneurs with no proven track record. They have exhausted the FFF round (capital from friends, family, and fools), but the project is still too small to be interesting to venture capitalists. Tech hubs in the United States, such as San Francisco and Austin, have large angel networks that entrepreneurs can tap into to get a small amount of cash to start. Smaller angel networks are sprouting up all around the globe. This is an alternative to grant funding: less bureaucratic and with less time between the first meeting and the investment.
However, just as grant funding gives a false impression of what entrepreneurship is all about, so does early angel and venture capital. When you have raised your first investment round, it will look to the outside world as if you have already made it. This is a cool feeling, no doubt. But reality will catch up with you, because the funding removes constraints from your startup. Constraints on both time and capital (human and financial) are the lifeblood of innovation. They focus entrepreneurs on profitability early on and cut out all the fluff that is contributing little to the creation of a sustainable business. If you cannot achieve some level of profitability on your own without external funding, you may have to shut down the business and move on to the next idea. It’s often as simple as that.
In a nutshell, entrepreneurs have to reach “Ramen profitability” before starting to fret about raising any outside capital. It is more comfortable to have funding than to work in a garage on a shoestring. But much more time will be available for the founders to work on their idea if they forget about raising capital. Dealing with a micromanaging investor can be a nightmare. Many profitable businesses you never heard of have been built without any funding. When you are just starting out on your entrepreneurial journey, stop thinking about venture and angel capital. Begin building a prototype today, and you will be in good company.
The Fallacy of Failing Fast
“Failing fast” is a paradigm loosely associated with the Lean Startup method.5 I mention this here with venture capital and angel investment because you should have some reservations before wholeheartedly embracing the notion of failing fast. They are related to the fact that a failed startup is completely at odds with the expectations of investors.
The idea that entrepreneurs learn just as much from failures as from successes is nothing new. Failing fast stipulates that the sooner entrepreneurs get business failures under their belt, the better. This will lead to faster learning and better entrepreneurship in the future, so the reasoning goes. I can second this, because my failures have always yielded bigger lessons than my successes. Still, there exists a fundamental misunderstanding regarding failing fast. Embraced by a prominent Stanford professor in her creativity class, failing fast has become a means to justify when a startup has gone belly-up after its fleeting life. “Celebrate your failures, and move on to the next idea,” is the way she puts it.6
The mindset of welcoming failure into your life is problematic. Suddenly, first-time entrepreneurs are urged to fail, as a means for them to graduate on their journey. If things in a startup become difficult, the first reaction is to fold the venture and celebrate, writing it off as a learning experience. However, here’s something that I find to be an even better learning experience: pulling a startup from the brink and getting it back on track to turn a profit. This process may often be far from elegant, but investors prefer it any time. Folding a startup at the first sight of stormy weather may be fine in an in vitro school experiment, but the real world works differently.
For every investor in their right mind, failure is not an option. To frame the total loss of capital as collateral damage on the startup founder’s learning path is not OK. If entrepreneurs like to celebrate their failing experiences on their own dime, that’s fine. Unfortunately, all too often, investors or the tax payer end up paying the bill for the entrepreneur’s education. Personally, I am wondering how failing fast can help create a sustainable track record of success and execution at universities. What looks like a failure at the beginning occasionally ends up being a massive success, if the entrepreneur can weather the storm. But if failing fast is an available choice, entrepreneurs will never dig deep enough to eventually strike gold.
About half of my own projects went under, some of them with a bang. In one case, external capital suffered; but in most cases I hurt the most of all the participants involved. Pivoting the business model can sometimes help avert a calamity, but still, every time a project fails, I feel miserable.
When a failure occurs, you need to analyze it thoroughly. Once you understand what happened, you can step up a notch to take measures and be sure it will not happen again. Lifelong learning to succeed is the goal, not looking for experiences to fail fast.
Investors and angels should screen diligently for the fail-fast mindset. As a founder, better avoid writing it on your flag that you are looking for opportunities to fail fast, just because you picked up the term in a startup book. When you become an entrepreneur, it is time to grow up. You need to use your creativity to pivot business and revenue models until they work, and never give up before you have tried everything to avert disaster. If you play with other people’s money, failure is not an option you can embrace under any circumstances—even if a professor from Stanford University tells you it’s OK to do so.
1Spencer Ante, Creative Capital: Georges Doriot and the Birth of Venture Capital (Boston: Harvard Business School Press, 2008).
2Joshua Lerner, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed, and What to Do About It, (Princeton: Princeton University Press, 2009), 41.
3John H. Cochrane, The Risk and Return of Venture Capital (Cambridge, MA: National Bureau of Economic Research, 2001). http://www.nber.org/papers/w8066?
4Kelly Tay, “Government Grants Seen Crowding Out Angel Investors,” Business Times (June 9, 2014).
5Eric Ries, The Lean Startup: How Today’s Entrepreneurs Use Continuous Innovation to Create Radically Successful Businesses (New York: Crown Business, 2011).
6Tina L. Selig, What I Wish I Knew When I Was 20: A Crash Course on Making Your Place in the World (New York: HarperCollins, 2009).