We’re on to lesson eight of the ten lessons we’ve learned since beginning our venture capital journey in late 2020.
Hopefully, you’ve had a chance to read our previous posts on The Power Law, why Entry Valuations and Graduation Rates matter, and the importance of retaining as much ownership as possible throughout subsequent rounds of financing.
This week’s post emphasizes how VCs need to become very comfortable with failure.
A VC’s role is to be a partner to our entrepreneurs and to play the role of catalyst to accelerate growth. This comes directly from the capital injection, and indirectly through the value-add that we make through introductions, partnerships, finding customers, and helping to raise the company’s next round of funding.
While this is the critical role that we need to play for our portfolio companies, in previous posts in this series we learned that:
- Harvard Business School reports that historically, only a tiny percentage (fewer than 1%) of U.S. companies ever raise capital from VCs.
- Crunchbase reports that for startups that raise seed funding, only 15% eventually exit.
- Experience shows that about 30% of companies in a VC’s portfolio will fail.
- One or two companies in a VC fund's portfolio need to generate 50x returns to compensate for the many companies that fail or simply break even. The success of a VC fund largely depends on identifying and backing these rare "home-run" companies.
As a result, a VC has to come to terms with the fact that many of the companies they invest in will ultimately fail. And conversely, entrepreneurs should understand what they’re signing up for if they decide to go down the venture-backed path.
As cold as it sounds, in many ways, the sooner that a company fails the better, so we don’t need to spend time/attention and bandwidth nursing companies that aren’t likely to make it otherwise.
Fred Wilson, from Union Square Ventures, has said, “The worst thing you can do in early stage VC is stick with your bad investments for too long and for too much money.” He goes on to say, “Getting clarity on your losers, getting them sold or shut down quickly (with dignity for everyone), frees up more time and money for the winners. And…a few really good companies can carry a fund to the moon. You must make sure you can get a disproportionate amount of your time and money invested in those great investments.” He goes on to say, “I am a big believer in “loving your losers” in the sense that you should not orphan them and you should work hard to get to the right outcome. Enabling them with good money after bad is not loving them.”
This can be counterintuitive for first-time LPs in a VC fund. The intuition is usually that we should work hard to make all of our companies succeed.
And of course, this can be really “tough love” for entrepreneurs and can cast VCs as being robotic and insensitive. But VCs and entrepreneurs should be aligned in getting to know sooner if a company’s product/business concept isn’t going to get traction. Refer back to our Power Law article. Data shows that ⅓ of the companies in a VC’s portfolio will fail. Isn’t it better for all parties to figure out which companies are going to fail earlier and speed them along that path?
The takeaway here? All parties (the VC fund, the LPs and the Entrepreneur) have to be aware of and be comfortable with the fact that when you sign up to take money from a VC, you are expected to run hard, test hypotheses, and understand sooner (rather than later) if the dog isn’t going to hunt.
Entrepreneurs who are considering taking money from VCs should intimately understand these aspects of their business. Like any good marriage, both parties should align on expectations in advance, and enter the relationship with eyes wide open, intimately understanding each others’ business models and motivations.
Join us on the journey,
Steve Greenfield
