The conversation recently had started, “Why do venture capitalists invest in startups if many of them are losing money and destroying value?” and I had to pause when I heard the point of view because I couldn’t even rationalize how someone thinks that way. Then of course it dawned on me that lately there has been a horrific rash of *VC Bad* propaganda and misinformation; truly, take a look:
- How Venture Capitalists Are Deforming Capitalism
- Toxic VC and the marginal-dollar problem
- Why Venture Capital doesn’t build the things we really need
- An Unusually Candid VC Explains Why VCs Are a Bad Idea
- How venture capital is hurting the economy
Before you misunderstand me, read those articles because there is a tremendous wealth of knowledge and perspective in them, about what Venture Capital really is and the role that it plays. My point, is that in our era of twitter headlines, people are reading those kinds of headlines alone, frustrated that they can’t raise capital (often unwittingly for valid reasons), and are demanding that VC change; that it’s bad and not working.
With that point of view, I revisited the question and realized that it stems from a misunderstanding, start with just this, “Why do venture capitalists invest in startups if many of them are losing money?” Wait… do you think Venture Capitalists invest based on revenues in companies, or worse, profitability?? Who has been feeding you that line of bull?
Why do venture capitalists invest in startups if many of them are losing money and destroying value?
As in adventure.
Venture is a noun: a risky or daring journey or undertaking.
Venture is also a verb, to venture: dare to do something or go somewhere that may be dangerous or unpleasant.
I share that because society has grossly misled what Venture Capitalist means, in our era of being polite and accepting any use of word for any purpose. Venture Capitalist is NOT a business investor. It doesn’t refer to a partner. It’s not an Angel Investor (that’s something distinctly different).
So, why do venture capitalists invest in startups if many of them are losing money and destroying value?
Because that’s the role of venture capital in our economy.
Not to fund businesses. Not to finance R&D. Venture capital doesn’t pour into pharmaceutical research nor is it there so you can start a restaurant.
There is a type of “venture” that is incredibly high risk but which results in most wealth creation and innovation: the startup.
Those articles shared are not warning about Venture Capital, they’re warnings about people who claim to be VCs or Angel investors, they’re warnings about what VC is really about and what it expects; their provocative headlines are meant to teach by exposing the causes for caution – not that VC is actually destroying the economy.
A startup is NOT a new business nor is a new business a startup. A startup is a temporary venture for which the business model is unknown and needs to be trialed, validated, tested, implemented, and optimized.
The model! Not the tech. Not the product.
A startup is a new venture in which the model is unknown.
This can be tech, fashion, CPG, or really in any sector. The key distinction of startup is NOT that it’s new nor that it’s tech, but that the model isn’t known.
You want to start a ridesharing app in your city? That would NOT be a startup; because the model for that is now known.
Venture Capital funds the startup, not the new app.
And since the model is unknown, it is known and accepted that there is an exceptionally high rate of misfires. Fails.
That’s the work.
If we’re going to uncover new models, they have to be attempted; and since we can’t just R&D our way into new models that work, they have to be tried, and mostly fail.
And those efforts require resources: human and capital.
Thus, an opportunity for investors.
Venture Capitalist refers to the person who manages a fund comprised of many capital sources, intended for startups.
An Angel is an individual focused on startups. An investor or business partner is what we’d call people investing in businesses.
So Venture Capitalists take risks investing in such high rate of fail ventures because…
Wait for it…
Wealthy people, trusts, foundations, and other funds, pool their capital into Venture Capital Funds, and the General Partners and Principals of those funds are PAID to operate them; they’re called Venture Capitalists.
And why does anyone bother? Why do it at all?
Because startups have the potential of delivering 20x returns. Those are unheard of returns in almost any other investment opportunity.
The cost of those returns? That 90% fail.
Simple math, overly simplistic, but why it works:
- $1,000,000 invested in 9 startups
- $100,000 went to pay the VCs
- 9 startups got $100,000 each
- 8 of those will fail. Gone. Poof.
- 1 succeeds and on $100k in, kicks back $2,000,000 (20x)
Positive ROI. Yay! Everyone celebrates with a boisterous and over extended holiday party.
Now to be clear, my simple example is NOT how it literally works, I’ve just found it to be the basic way to explain it so it makes sense to people. Reality is much more complicated and the odds aren’t even as good as that implies.
But hopefully you get it.
Yes, you can just invest in businesses, and only 40% will fail. And you won’t get near a 20x possible return.
Too, by the way, you can bet in a casino, and even there, you can get to about a 51% rate of failing.
VC is worse, as a percentage of wins. It invests in ventures: startups, because it’s seeking the greater than normal returns, in order to overcome the losses.
“Why do venture capitalists invest in startups if many of them are losing money?” If you think Venture Capital is for operating businesses and profitable companies, you’ve been misled; seek a business investors for your work. If you’re taking great risk to invent an industry anew, if you don’t have customers but you have the very real potential to disrupt an industry and create wealth and jobs, the venture capitalist is your friend, and they’re doing precisely what they’re supposed to be doing.
“Destroying value” is a horrible misunderstood perspective on this.
None of that destroys value, it creates more value than just about anything.
Failed startups create value. They weed out the things that won’t work so others don’t try it. They train entrepreneurs to find success in the future. They develop IP that though startup might fail, a company or investor might use it again. They create acquisitions.
In failure we learn, more than in success.
The entire sector of our economy, comprised of Angels, entrepreneurs, and VCs, likely creates more value for the world than anything else humans do.