By: Julio Cacho, PhD & Juan Carlos Herrera
Most innovation and technological advances, which are fundamental parts of economic progress, are developed in startup companies. Although investing in these new companies that are “sure to succeed” sounds enticing, BE CAREFUL because most startup companies fail over time.
Let’s say you’re an entrepreneur with a dream to start a company. You’ve used up all of your money and now need more to keep the company going. What do you do? You may turn to a venture capital firm for funding. Venture capital, often known as “VC”, is financing given to startup companies that want to grow, but are so new that it’s difficult for them to get traditional bank loans or access to capital markets. When choosing investments, many might assume that entrepreneurs with a clever technology startup are currently sitting on gold mines. However, this is likely to result in fool’s gold.
Recent evidence reveals that venture-backed startups fail much more often than the industry rate that is usually cited. Shikhar Ghosh, a senior lecturer at Harvard Business School, looked at more than 2,000 companies from 2004 – 2010 that received venture capital funding, and found that 75% of VC-backed startups in the United States don’t return investors’ capital. That’s right…three out of every four startups fail!
Ghosh defines failure as any company that cannot return at least $1 for every $1 invested by the VC firm. For instance, if a VC firm invested $100 but the startup could only return them $75, then that is deemed a failing company. Ghosh’s report is vastly different from those of the National Venture Capital Association. They estimate that only 25%-30% of VC backed businesses fail; However, that estimate is usually based solely on the companies that declare bankruptcy or close business.
What are reasons for this discrepancy? The main reason is the lack of in-depth research done on the failing companies. It was discovered that many VC funded startups sell the company at a loss, while others get out of business but remain as entities. Despite their failures, these startups do a great job at silencing their defeat by emphasizing any success and completely ignoring their loss. For example, a startup that loses all of its money, but sells off its computers and office furniture could claim that an “acquisition” occurred, when in reality the company went broke.
Venture capitalists make risky investments with the knowledge that some of them will fail. While some startup companies can use VC funding to springboard into mega success, most often fail after four years of existence when the investors stop adding more capital to the company. So, as tempting as investing in these new innovative startups may sound, it’s important to be aware that the odds of succeeding are steep.
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