Entrepreneur Beware | The Hard Truth About Venture Capitalism

From the shores of Silicon Valley to the sunny island of Singapore, I have sat through what must be a gazillion pitches from startup founders seeking funding for their ventures. In HBR’s the Six Myths About Venture Capitalists, Diana Mulcahy writes, “Steve Jobs, Mark Zuckerberg, Sergey Brin: We celebrate these entrepreneurs for their successes, and often equally extol the venture capitalists who backed their start-ups and share in their glory… The story of venture capital appears to be a compelling narrative of bold investments and excess returns. The reality looks very different.”

I spent last night in bed with the 2011 documentary film Something Ventured. The story begins in the late 1950s when venture capitalism in Silicon Valley was first set into motion. The cast featured a small group of ‘high rollers’ who fostered a one-of-a-kind business culture that encouraged extraordinary risk and made possible unprecedented rewards.

The documentary tells the highly romanticised story that laid the groundwork for America’s start-up economy, providing not just the working capital but the guidance to allow seedling companies to reach their full potential. The film focuses on a handful of success stories, paying close attention to how VC firms worked with entrepreneurs to grow world-class companies like Intel, Apple, Cisco, Atari, Genentech, Tandem and PowerPoint amongst others.

Risk and Return

In the film (and elsewhere), VCs are often depicted as big risk takers who back entrepreneurs and their bold new ideas. But is this really the case?

The very term ‘venture’ speaks of forging ahead despite the risk of danger. The term capital refers to the wealth invested to generate additional wealth. It is interesting to note that prior to World War II, venture capital was primarily the domain of wealthy individuals and families. Even today, the partners’ own money accounts for just 1% of the total that gets invested in VC funds.

Whilst the businesses that VCs invest in may well be risky, it isn’t exactly a risky venture as far as the VCs are concerned. At the end of the day, if the investment that a VC fund makes in a budding enterprise is but a small percentage of the total net worth of the VC firm; then despite the much-needed injection of cash for the startup, it is still the entrepreneur who bears the brunt of the risk for whether the business succeeds and manages to generate a profit.

The entrepreneurs profiled in Something Ventured are not businesspeople. They are largely professionals–engineers, medical researches, software developers etc–who had ideas they believed in. Even in tales of rags-to-riches stories–women and minority groups are largely excluded. The only woman featured in the documentary is Sarah Lerner, the co-founder of technology giant Cisco Systems.

I couldn’t help but wonder–where is the risk that was taken? Who took on the risk? And did they actually get their return?

Why Venture Capital?

If you were looking to get a loan from a bank, you would need assets as collateral. In the event that you defaulted on your repayments, the bank would repossess those assets. Back in the 50s–and even now–startup founders typically possess few (or even no) assets to use as collateral for bank loans.

That’s when the so-called knight in shining armour–the venture capitalist–sweeps in to save the day. Venture capital is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term and exponential growth potential. Put simply, the challenge is to earn a consistently superior return on investments in inherently risky business ventures.

But is the venture capitalist really a knight in shining armour? And will he really save the day?

For some reason that is still largely unfathomable to me, venture capital is still regarded as one of the most attractive and sought-after sources of financing for start-ups. Statistics from the National Venture Capital Association show that after peaking in the late 1990s, the number of active VC firms fell from 744 to 526 in the decade 2001–2011, and the amount of venture capital raised was just under $19 billion in 2011, down from $39 billion in 2001.

I reiterate that whilst the startups that the VCs are investing in may be inherently risky from a business perspective, it is not exactly a risky business for the VCs themselves. They can afford to lose the money they are investing. As an entrepreneur, it is worth asking yourself–what exactly am I giving up in exchange for this cash that someone can feasibly afford to lose?

In The Truth About Venture Capital Funding, Chad Wolpert writes, “From the perspective of the venture capitalist, one of the most important aspects is control. Although loss of ownership and control for yourself as a founder may be obvious, there are several implications to consider. First, a VC with less than 50% ownership of a company (which is often the case) does not necessarily mean they have no control in your firm. They usually have a variety of control mechanisms, which, in practice, give them control of many elements of the business. A VC can, under certain circumstances, replace the CEO or founder team, even if they don’t have majority control.”

Entrepreneurs getting chucked out (or should I say ‘retired’) from their own business is nothing new. The most famous example that has been immortalised in tech lore is Steve Jobs’ exit from Apple. Even Sarah Lerner and her husband, the co-founders of Cisco, found themselves handed the same fate as they were ‘retired’ from the company they started. Unlike Jobs, the duo never returned to run the business they founded.

I have often asked myself–is the only person who cares about how the business does the founder? Employees are content with a pay check. Investors are seeking a return on investment. Everyone seems to want something, something tangible. So what in the world is motivating the entrepreneur?

The Entrepreneur

All entrepreneurs have different primary and secondary motivations for doing the work they do. I can vouch for the fact that it is far easier being an employee than it is being an entrepreneur. Despite the risks and challenges involved, a true blue entrepreneur will simply not throw in the towel–no matter how tough things get. They may choose to alter the trajectory of the business when they realise they’ve made certain unavoidable blunders, but they still don’t bolt.

They stomach the considerable financial and personal risk that comes with starting their very own venture and they persevere when others throw in the towel. There is no such thing as a dead dream for an entrepreneur. Whilst not all businesses are destined to be the next tech giant, that does not stop an entrepreneur from being highly successful in his or her chosen field.

Sometime back, while musing on the ingredients of a successful business, I wrote an article about a popiah stall in one of Singapore’s ubiquitous hawker centres. It was a simple product with a simple idea. There was nothing ‘innovative’ about it. It did not require a degree from a prestigious business school. It definitely did not need a venture capitalist to get it up and running. And yet, one look at the line that stretched out from one end to the other quickly revealed that business was indeed good.

Ever since I started my business Mith Books, I have come to believe that the real destination for any entrepreneur is the journey. It is the journey across the rainbow for that pot of gold. Arriving is boring. Once you arrive at that pot of gold, there is no place left to go.

So my parting words to you: enjoy the adventure as you build your venture. It’s going to be one hell of a ride.

---

Dipa Sanatani is the Publisher at Mith Books and the author of The Little Light and The Merchant of Stories. In The Merchant of Stories, Dipa takes the reader on a personal journey–narrated through a series of candid journal entries–on what it takes for entrepreneurs and creatives to start their very first venture.