Co-Founder Taliferro
Introduction
With years of scrutinizing startup investments, I have witnessed numerous failures. It is undoubtedly disheartening to witness not only the loss of capital but also the disappointment of friends and acquaintances who were once filled with excitement about their ventures. One might assume that such experiences would drive investors to diversify their portfolios and refrain from investing in familiar circles. Surprisingly, this is not the case, as the majority of venture capitalists (VCs) still concentrate their attention on deals involving individuals they already know.
If you find yourself contemplating startup investments or wondering why other investors are not making more informed decisions, the question arises: why do so many VCs persist in investing solely in individuals who bear a resemblance to themselves? This article aims to shed light on this phenomenon and elucidate the reasons behind the continued preference for investing within one's network.
The Statistics
For those involved in startup investments, the statistics have likely become familiar. It is frequently cited that 90% of startups fail, and only 1 in 10 VC-backed companies will ever be acquired or go public. While these figures may appear discouraging at first glance, a deeper examination of their implications provides valuable insights for approaching early-stage ventures.
When we say that 90% of startups fail, it is essential to consider the underlying reasons behind these failures. Startups can falter due to various factors, such as inadequate funding, business model pivots, acquisitions by larger corporations, or closure resulting from unmet sales goals. However, the ultimate determinant of a Startup's fate lies in its ability to attract customers. Regardless of other factors, if a Startup fails to gain a customer base, its demise becomes inevitable.
The statistics regarding the failure of startups that secure investments from VCs or angels are even more alarming. In both cases, approximately 90% of these ventures will cease operations within five years of securing investment (excluding companies that go bankrupt without ever raising venture capital).
As we ascend the revenue scale, the odds become increasingly unfavorable for investors. Merely one out of every ten VC-backed companies will ever achieve acquisition or public listing status. Similarly, only 1% of all seed-stage startups will reach the coveted "unicorn" status of billion-dollar valuation. The probabilities continue to dwindle as we explore companies with more than $5 million in revenue, where less than 1% will attract outside investments exceeding $1 million. The harsh reality remains that the vast majority of companies at all stages will not yield substantial returns for investors.
The 1 Million Threshold
It is crucial to discern that revenue does not equate to profit, nor does it necessarily signify positive cash flow. It is a fallacy to assume that reaching the milestone of $1 million in revenue translates to profitability. In fact, statistics reveal that nine out of ten companies with $1 million to $5 million in revenue are not profitable, and many may never achieve profitability.
Challenges at the Top End of Startups
The realm of companies with revenues surpassing $50 million is relatively small, and only a fraction of them manage to generate profits. Consequently, the majority of investments in such companies do not yield returns and result in the complete loss of the invested capital.
In essence, out of every ten companies with revenues exceeding $50 million, only one will deliver a meaningful exit for its shareholders.
The Bias Factor
Despite the availability of historical data and information, investors persist in adhering to their existing approach, investing predominantly in individuals within their network. The primary driver behind this behavior is the inclination towards complacency. Trusting friends or colleagues is deemed easier, rendering investments in familiar circles as a default choice. Investing in individuals outside one's network necessitates extensive due diligence and further scrutiny. It is worth noting that numerous instances exist wherein companies with fraudulent intentions have successfully deceived investors, even when those investors were personally acquainted with the deceivers.
The Counterintuitive Nature
When investors allocate funds to startups, they do so with the expectation of reaping significant returns from one or two successful investments in their portfolio. For instance, consider a scenario where an investor allocates capital to 50 startup companies, and only one of them achieves substantial success, compensating for the losses incurred by the remaining 49 failures. Such an outcome would be deemed a successful investment strategy. Alternatively, one could spread the same investment amount over five years, allocating $200K annually to each growing company, thereby mitigating the risk of losing the entire investment at once. Venture capitalists, in particular, derive profits from one or two major investments, amplifying the significance of these successful ventures.
Furthermore, it is not solely the VCs who stand to gain from these investments, but also the founders themselves. While the average returns on startup investments remain modest, the top 20% of companies with the highest valuations contribute 80% or more to the total returns of investment funds. Therefore, entrepreneurs seeking venture capital funding aim to secure a place within this top 20% bracket, hoping for a significant exit through acquisition or an initial public offering.
Investors in startups must ponder the level of risk they are willing to undertake to maximize their chances of substantial returns. If the appetite for risk is relatively low, conducting due diligence and considering opportunities beyond one's network is a prudent choice.
The Upside of Investing Outside One's Network
Investing in individuals outside one's immediate network presents the possibility of participating in groundbreaking technologies and reaping substantial financial rewards if the respective companies achieve success. Nevertheless, such investments inherently bear the risk of losing the entire investment. Although a gamble, the potential for substantial gains makes it an attractive opportunity for those seeking accelerated wealth generation, albeit at the cost of potential losses.
Investing in Startups: A Risky Endeavor
Investments in startups inherently entail risk. However, it is essential to recognize that the risks extend beyond the startups themselves. The considerable influx of funds into startups and the comparatively limited output emphasize the precarious nature of investments in this domain. Given these circumstances, it begs the question: why do investors persist in investing exclusively within their networks? Shouldn't they consider venturing into uncharted territory?
Conclusion
Undoubtedly, investing in startups is a risky proposition, as the statistics and realities of the startup landscape demonstrate. It appears that regardless of whether one invests within or outside their network, risks persist. The vast sums of money flowing into startups contrasted with the relatively modest returns for investors highlight the precariousness of the entire ecosystem. Consequently, it is crucial to question the rationale behind persisting with the status quo of network-focused investments. By contemplating alternatives and venturing beyond familiar circles, investors may discover untapped opportunities that could lead to significant breakthroughs and lucrative returns.
Tyrone Showers