November 29, 2019 by Fred Haney
Why Do Venture Capitalists Invest in Such a Small Percentage of Startups?
The other day I mentioned to a friend—who happens to be an entrepreneur professor—my concern that so few startups satisfy the hurdles required to attract venture capital. His response was, “Well, the VCS only invest in .052% of startups so they are pretty much irrelevant.”
Let’s think about this a little and see if we can put it in perspective.
First, it’s true that VCs invest in about .052% of startups. This could mean that VCs are not terribly active or that they are missing a lot of opportunity or that there aren’t enough of them. But it could also mean that professional investors—people who invest for a living—think only .52% of deals pencil out as good investments. Or something in between.
Personally, having managed a very successful venture capital fund and falling into the traditional pattern of investing in only about 1% of the companies I saw, I’m inclined to believe the latter—that a very small percentage of startups meet the criteria for venture capital investment.
Looking for Answers
“Facts sometimes have a strange and bizarre power that makes their inherent truth seem unbelievable”—Werner Herzog
Can we find some statistics to help us understand what’s going on here?
According to a Quora article referencing the National Venture Capital Association, from 1995 through 2019 a total of 28,536 companies received venture capital funding. Of these, 2010 executed in IPO and 7515 were acquired for a total of 33% of all companies achieving an exit.
This data suggests that the .052% of startups funded by venture capitalists are producing about one-third of all exits. That is extremely disproportional. It seems to say that the VCs are in fact making good investments and that they are not missing many opportunities.
A recent Stastica report shows that from 2004 to 2018, venture-backed IPOs have comprised an average of approximately 24% of total IPOs. This implies that venture capitalists are turning ,052% of startups into about 24% of all IPOs. (“Number of IPOs in the United States from 1999 to 2018,” Stastica. Again, this is highly disproportional compared to .052% of startups.
A 2018 report by J. Ritter, offers some insight as to the makeup of the non-venture-backed IPOs.
From 1980 through 2016 and there was a total of 8252 IPOs. Of these, 2703 (33%) were venture-capital back companies, three hundred eighty-seven were “growth capital” backed companies. One thousand ninety-six were “buy out” backed companies. The number of IPOs without a financial sponsor (presumably including all angel-backed IPOs) was 4066. So. what would the message be if venture capitalists invest in .052% of deals but produce 33% of the IPOs? It certainly suggests that the .052% of startups that the VCs are investing are the “cream of the crop.” (“Initial Public Offerings: Updated Statistics on Long-run Performance.” Jay R. Ritter, Cordell Professor of Finance, University of Florida. June 13, 2018)
Another way to look at venture capital participation is to look at the list of investors participating in “Unicorn” deals. Pitch Books’ 2017 Annual Unicorn Report lists the primary investors in unicorns at that time. All of the significant participants are venture-capital firms, with the exception of the SV Angel group (Silicon Valley angels) which are a unique angel group because of their location in Silicon Valley. If the VCs were missing the boat, wouldn’t we be seeing some unicorns backed by angels but not VCs?
Supply and Demand
“Supply Creates its Own Demand.”—Jean-Baptiste Say
Presumably the market for venture capital is a free market and laws of supply and demand should prevail. This prompts us to ask the following questions:
- If there are viable deals available, why wouldn’t a VC firm do them?
- If there is an over-supply of fundable deals (more than .052% of startups) then wouldn’t new venture capital firm be formed to fund them?
- If more than .052% of the deals are truly fundable wouldn’t other alternative methods arise to fund them?
VCs are in the business of seeking out the best investment opportunities that fit their strategy and doing deals within their risk and reward parameters. There is no reason that a venture capital firm would decline to make an investment that is truly attractive within its guidelines. Venture capital firms do have limited capacity, as it’s difficult for each partner to make more than 2-3 investments per year. But within that capacity, there is no reason for them to not make an investment that fits their criteria. This brings us to our second question.
Why wouldn’t new venture capital form firms be formed to absorb the supply if there are attractive startups not getting funded? Granted, it is not easy to create a venture capital firm. Institutional investors keep funding the traditional successful venture capital firms, but many unicorns and highly successful exits have created new billionaires, whom in turn, have created new venture capital firms. Since 2008, the number of venture capital firms in the CrunchBase database has increased from slightly over 100 to slightly over 560. So, there has been over a five-fold increase in the number of firms but still the percentage of startups getting funded is small. (“There are More VC Funds than Ever, but Capital Concentrates at the Top.” Jason D. Rowley, CrunchBase. March 7, 2019. http://bit.ly/323HGdW Accessed August 25, 2019.)
Some might argue that the angel groups, crowdfunding, and Initial Coin Offerings have filled the void. But are these vehicles doing the same deals that the VCs would do? Are their hurdles the same? I have my doubts. If they were, wouldn’t we be seeing a significant percentage of IPOs and unicorns backed solely by these alternative investment vehicles? So far, the data doesn’t show that. It is difficult, for example, for most of the angel groups to make the kind of very high-tech, capital intensive investments that the Silicon Valley VCs make.
Having been on the firing line as both a venture capitalist and an angel investor, it is my opinion that the .052% number is representative of the number of the percentage of truly “fundable” startups. It seems to me that a very high percentage of startups do not satisfy the venture-capital firms’ criteria for both “fundable ideas “and “fundable management teams.”
In my opinion, the small percentage of startups getting funded by VCs does not represent a failure of the venture-capital community as much as it represents shortcomings in the approach most startups take to getting funded.
About the Author
Dr. Fred Haney is the founder and President of the Venture Management Co., a firm that provides assistance to high tech companies. He is the author of “The Fundable Startup: How Disruptive Companies Attract Capital,” published on February 6, 2018, by Select Books of New York. Download the first chapter for free below: