Why Early Stage Venture Investments Fail

A good article for startup founders, managers and investors.

From East Coast VC Firm, Union Square Ventures. I bolded some of the key points for all you skim readers out there.

November 29, 2007
Why Early Stage Venture Investments Fail

[S]o why do venture investments fail? Well if I look at the ones I’ve been involved in there are two primary reasons:

1) It was a dumb idea and we realized it early on and killed the investment.

2) It was a decent idea but directionally incorrect, it was hugely overfunded, the burn rate was taken to levels way beyond reason, and it became impossible to adapt the business in a financially viable manner.

Four of the five failures I’ve been involved in fit into this second category. I don’t blame the entrepreneurs and managers entirely for these failures. The investors and the boards of these companies are responsible for failures like this. Entrepreneurs may not have the experience to know the folly of taking burn rates to levels which make “figuring it out” impossible. But we as investors know how high burn rates kill companies and we have a responsibility to fight them at every turn.

This is a lesson that is etched into my brain and into my back with the scars of $20mm losses, bankruptcy filings, and mass layoffs. It’s ugly, painful, and totally and completely avoidable.

My friend Dick Costolo, co-founder of FeedBurner, describes a startup as the process of going down lots of dark alleys only to find that they are dead ends. Dick describes the art of a successful deal as figuring out they are dead ends quickly and trying another and another until you find the one paved with gold.

I like that analogy a lot. Of the 26 companies that I consider realized or effectively realized in my personal track record, 17 of them made complete transformations or partial transformations of their businesses between the time we invested and the time we sold. That means there is a 2/3 chance you’ll have to significantly reinvent your business between the time you take a venture capital investment and when you exit your business.

Here’s an interesting breakdown of the “transformers” versus the “stick to our plan” investments in my personal track record.

Greater than 5x – 11 total investments – 7 transformed, 4 did not
1x to 5x – 10 total investments – 6 transformed, 4 did not
Failures – 5 total investments, 1 transformed, 4 did not
Unrealized Union Square investments – 6 total, 3 transformed, 3 have not

You might think that the home runs had their plan figured out right out of the box and the deals that were less successful were mostly transformers. That’s not the case with the investments I’ve been personally been involved in. It’s about the same ratio for both categories.

But where you really see the value of being nimble is in the failures. All but one failed to transform their business and all but one were unable to do that because of the large unsustainable burn rates they had built up. Even the one business that did transform itself, it went from a low cost business model to a high cost business model and they put themselves in a pickle when the transformation didn’t pan out.

To go back to Dick’s analogy, you can go down lots of blind alleys if the cost of doing so is low. But if you are spending a million dollars on each blind alley, you’ll be out of business in no time.

So it’s pretty clear to me that most venture backed investments don’t fail because the business plan was flawed. In my experience at least 2/3 of all business plans we back are flawed.

Most venture backed investments fail because the venture capital is used to scale the business before the correct business plan is discovered.

I should also say that for businesses that don’t have the benefit of venture capital backing, the reverse is probably true. Almost certainly non-venture backed businesses will not have the ability to get too big too fast. They will mostly fail because they have the wrong business plan and they don’t have the wherewithal to survive for the period of time it takes to figure out the correct one.

Regardless of whether you have taken venture capital or not, capital efficiency and bootstrapping are critical values. You must keep your burn rate low until you can show without a shadow of a doubt that you have a business model that works, can be operated profitably and is ready to be scaled. Then and only then should you step on the gas.

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One Response to “Why Early Stage Venture Investments Fail”

  1. I found your site on google blog search and read a few of your other posts. Keep up the good work. Just added your RSS feed to my feed reader. Look forward to reading more from you.

    – Jason.

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