Entrepreneurs - Beware Of The Twilight Zone Of VC-Funded Startups

The MIT Technology Review just published an article titled Why Startups Are Struggling where it looks for answers to the question:

Even amid the venture capital boom of the past few years, entrepreneurs are finding it harder to build big, enduring companies. What does this mean for the future of innovation?

The entire game in the VC-funded startup business is to find high growth, large-TAM companies. These types of firms also tend to have significant impact on the job-growth and economic prosperity of regional economies. The number of startups with such aspirations has grown dramatically in the last decade, and many have been seed funded. However, as this article points out, the aspirations are not really translating into reality.

These high-growth firms, then, are the kinds of companies that matter most if we’re trying to understand the impact that startups are having on the economy and on innovation. And according to a May  report from the Kauffman Foundation, such startups are being launched at a brisker rate than in recent years. Even more telling,  new work by the MIT economists Scott Stern and Jorge Guzman shows that in 15 U.S. states between 1988 and 2014 there was no long-term decline in the formation of what they call “high-quality” startups. Stern and Guzman have figured out the characteristics of startups that are trying to become high-growth firms, which include being chartered in Delaware, registering for patents, and not being named after the company’s founder. What they find is that the rate at which these kinds of startups are being formed has not dropped—in fact, 2014 saw the “second-highest level of entrepreneurial growth potential” ever. In places like the San Francisco Bay Area, unsurprisingly, the rate of high-quality startup creation is at an all-time high.

But there is a catch. While Stern and Guzman show that high-growth firms are being formed as actively as ever, they also find that these companies are not succeeding as often as such companies once did. As the researchers put it, “Even as the number of new ideas and potential for innovation is increasing, there seems to be a reduction in the ability of companies to scale in a meaningful and systematic way.” As many seeds as ever are being planted. But fewer trees are growing to the sky.

The article offers some explanation on why this is happening:

Stern and Guzman are agnostic about why this is happening. But one obvious answer suggests itself: the increased power of established incumbents. We may think that we have been living in a business world in which incumbents are always on the verge of being toppled and competitive advantage is more fragile than ever. And clearly there are industries in which that has been the case—think of how Amazon transformed book retailing, or how digital downloads and streaming disrupted the music business. But as Hathaway and Litan document, American industry has grown more concentrated over the last 30 years, and incumbents have become more powerful in almost every business sector. As they put it, “it has become increasingly advantageous to be an incumbent, and less advantageous to be a new entrant.” Even in tech, the contrast is striking between the ferment of the late 1990s, when many sectors had myriad players struggling for share, and the seeming stability of today’s Google/Amazon/Facebook-dominated world.

The point that worries me about this trend has to do with the fact that many VC-funded startups that have germinated in the last decade are actually able to build good, solid businesses. What they cannot build are these rockets like Facebook, Amazon, or Google all that often.

However, once you have raised venture capital, unless you become a rocket or get acquired, even if you build a $10 million or $20 million, even $50 million business, you are considered a failure. The VC structure relies on exits, and there just aren’t enough acquirers in the market to acquire so many companies. And if your growth has slowed, you can’t continue to raise money.

This state – a slow-growth venture-funded company – even with substantial customers, revenues, and profits, is considered to be in the Twilight Zone. Other than salary, entrepreneurs and employees make no money off these businesses. VCs write them off.

Instead, if you are able to achieve even a smaller degree of revenue without outside funding, you have more options. A bootstrapped $5 million, $10 million, $50 million company is considered a success, not a failure. If you have smaller-scale shareholders – founders, friends and family, local angels – they can be compensated with dividends. You can continue to grow, slowly and steadily, without constantly feeling that you’ve essentially failed to meet the expectations of a bunch of investors who won’t fail to remind you of that shortcoming.

Entrepreneurs, I know that you are obsessed with raising venture capital. But please consider what you are signing up for.

You can end up spending 10 years of your lives, and create no personal wealth whatsoever. 

The Twilight Zone is actually quite a dark place.

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 Photo credit:  marcusrg/Flickr.com.