Investing in startups is a risky business. The failure rate of venture capital companies is between 20% and 90%. However, the risks associated with venture capital firms are often off-set by the successful few investments that drive profits. In this article, we explore these ideas.
How Venture Capital Works
VC firms function as liaisons between investors and capital-hungry entrepreneurs. Venture capitalists solicit funds from investors and funnel that money into promising new ventures. However, the failure rate of venture capital companies is always a consideration. If a venture stumbles and falls, the VC firm loses everything. VCs thus seek to diversify their portfolio by investing in many ventures in several different fields. The small percentage of startups that really take off generate big money for venture capitalists: a company that goes public can yield huge returns on investment. For most venture capitalists, a venture must yield at least five times the initial investment to be considered successful. For more of the basics of venture capital firms, see A Newbie's Guide to Venture Capital and learn about how VC firms invest through funds.
There are risks associated with venture capital firms, and different venture capital firms have different appetites for that risk. Some more conservative firms may hold a very diverse investment portfolio to limit the impact of failing ventures and poor business climates. Aggressive venture capitalists, like those who fueled the dot-com boom in the 1990s, poured their resources into the untested fields of Internet technology and e-commerce. Their overly keen appetite for risk famously ended in the dot-com bust that laid waste to the industry. Most VCs fall somewhere between the two extremes. Fred Wilson, a well-known venture capitalist, argues that VCs should expect a third of their ventures to fail, a third to underperform, and the remaining third to generate between a fivefold and tenfold return.
Kleiner Perkins Caufield & Byers: One of the Most Failure-Prone VC Firms also Produced These Successes
Failure Rates: A Misnomer?
A 90% failure rate raises eyebrows among the risk-averse. But is the failure rate of venture capital companies really such a deciding factor? Blogger Keith Cowing argues that the VC failure rate is "meaningless" unless considered as part of a much larger picture. As a liaison between investors and entrepreneurs, a venture capital company promises funding and a support network to startup founders and an acceptable return on investment (ROI) to the people writing the checks. Whether with a 20% failure rate or 90%, the one that delivers that best ROI with the least risks associated with venture capital firms is going to attract the most investors.
Failure and Entrepreneurship
The high failure rate of venture capital companies parallels the high failure rate for new businesses themselves. Thousands of books, articles and blog posts have been written about successful investments and startups that made millions overnight. Entrepreneurs and investors are far less willing to talk about their failures. But being comfortable with the knowledge that a venture could go up in smoke is crucial to entrepreneurs. It's important to take a more sanguine approach: every botched decision teaches a lesson, and by learning enough of those lessons, entrepreneurs and venture capitalists alike can learn what it takes to be successful.
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