Friday Sep 28, 2012 by Sean Marsh - Co-Founder and General Partner, Point Judith Capital
This recent article from the Wall Street Journal suggests that there is a “Venture Capital Secret: 3 out of 4 start-ups fail”. Failure, however, is defined as not returning the invested capital from the venture capitalists (as opposed to building innovative products, hiring a lot of employees, achieving an IPO, etc.). While I am a venture capitalist and I certainly don’t like investments where we don’t at least get our money back, this test does not reflect true failure of a startup (ie: goes out of business), but more a failure of the financing strategy (too much capital or shares priced too high). What the headline should read is “The Venture Capital Secret: 3 out of 4 Investments Fail”, in many cases the actual startup might succeed on other important measures but the venture capitalist may not make a profit. From an industry standpoint, especially given the time frame of the data set, this does not surprise me.
Our own portfolio data (which spans more than a decade but is, admittedly, a smaller sample set than the one from the article), shows that we only lose all of our investment in 25% of our companies. However, this is a measure driven by the number of companies, not the actual capital lost. If we look at our portfolios in terms of the amount of capital lost as compared to the amount of total investment, our loss ratio is 13% (meaning we have lost 13% of the actual money which is much more of a manageable amount to offset with our larger and profitable successes). This dynamic is primarily driven by the fact that venture capitalists invest in companies over time and try to stop investing in companies that are not scaling and invest more in those that appear to be headed in the right direction.
More importantly, however, I would suggest that a venture backed startup may succeed in extraordinary ways (hundreds or thousands of employees, massive product scale and distribution, even achieving an IPO) but it may not return all of the venture capitalists capital. This happens in cases where a company may do a recapitalization or substantial down-round (essentially hitting the reset button on past paid in capital and starting anew) or when a company sells to another company for less than invested capital but the company continues on as a subsidiary or becomes integrated into the company. In these cases, the successes of the venture backed startup include the continuity and often growth of the employee base coupled with the continuity and often increasing scale of the innovation and ultimate product or service delivery to the market. There are a number of companies that have recently gone public (Facebook, Zynga, Groupon) that sold shares to private investors, including some venture capitalists, at prices much higher than where the IPO share price occurred and where the stock price is now. So, in those cases, those investors did not have their capital returned (but those companies are not failures). The legend in venture capital circles that typifies this is Fedex. The first and second venture capital rounds of Fedex were priced per share much higher than the ultimate IPO price (meaning those shares lost a lot of money when the company went public), but the third round was priced at $0.63 per share and the IPO went out at $6.00, the investors who gave up and stopped investing early got diluted and lost money but but the third round investors did great and Fedex is certainly not a failure.