Countless major American corporations have accepted venture capital financing at some point during their histories, including such goliaths as eBay, Google, and Genentech. But that doesn't mean that every company that gets venture capital is destined to become a business titan. In fact, when you take VC funding, you might actually increase the odds that your venture will go belly-up.
That's the central finding of a study that compared Belgian venture capital-backed companies to other companies that did not receive venture capital. It's counter-intuitive, the authors note. "This longitudinal study, which reports findings from ongoing research, shows that VC-backed companies have a lower survival rate and a significantly higher probability of going bankrupt than non VC-backed companies, contrary to common wisdom and contrary to previous studies," they write.
What's the explanation? The research authors suspect that it may be due to something called "adverse selection." That means that the best companies avoid VC investment and instead pursue less costly and risky financing. It could also be due to the fact that VCs, unlike individual entrepreneurs, are concerned with the results of a portfolio of investment companies rather than the fate of any single venture. In practice, that means that if your company's results are dragging down the portfolio, the VCs may shut you down, even though the company could otherwise survive and, ultimately, prosper.
Another likely explanation is that companies guided by venture capitalists are not generally able to take long-term routes to success. VC investors seek to exit within a few years, either by selling shares to the public or by selling the company to an acquirer. With that in mind, they will readily bet the company's future on a risky gamble that might pay off more rapidly, even if it's more likely to fail than a longer-term strategy. As the study authors put it, venture capitalists "may well be willing to take the risk of bankruptcy of some portfolio companies, as long as the whole portfolio produces above average returns, thanks to some star investments. Bankruptcies may be viewed as an inherent part of the investment process."
Whatever the explanation, growth-minded entrepreneurs need to realize that taking venture capital may increase their risk of failure. That's because venture capital is an expensive financing source. Entrepreneurs who accept venture money pay for it by trading their independence. Swapping part ownership of the company for an investment is just the beginning. Venture investors may demand the right to put their people on the board and in key management jobs, including even the president and CEO positions.
Wielding that influence, they will steer the company in the direction that most effectively meets their goals of a huge financial payoff within their preset time frame, whether or not that objective coincides with the founder's. For instance, venture-backed companies are likely to be directed into mergers or acquisitions by larger firms. It's not uncommon for a founder to be forced to leave the company after venture investors determine that he or she is not running the business as desired.
None of this is to say that VC money is always toxic. It is to say that when negotiating with VC investors, the survival of your company ought to be one of the chips on the table. Because whether you realize it or not, accepting their investment may not be the pathway to success that you thought.
Image courtesy of flickr user onnola, CC2.0