VC Money some myths

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VC money has always put a question mark before entrepreneurs, is it good? is it bad? is it risky? is it safe?

We have published various articles to study the topic.

According to Kauffman director of Private Equity Diane Mulcahy debunks common myths about venture capital to empower founders when negotiating with VCs, published by Kauffman Foundation NewsRoom.

Venture capital is the exception, not the norm, as a funding source for startups. More VC-backed new companies fail than succeed, and since 1999 VC funds have barely broken even.

Those are just some of the myth-busting facts revealed by Diane Mulcahy, director of private equity at the Kauffman Foundation and a former VC herself, in the May issue of the Harvard Business Review that focuses on entrepreneurship.

“For someone who’s starting (or thinking of starting) a company, the myths surrounding venture capital can be powerful,” Mulcahy writes. “In this article I will challenge some common ones in order to help company founders develop a more realistic sense of the industry and what it offers.”

Mulcahy’s six VC myths are highlighted below:

Myth 1: Venture Capital is the Primary Source of Startup Funding
VC financing is the exception, not the norm, for startups. Historically, less than 1 percent of U.S. companies have raised capital from VCs, and the VC industry is contracting. But less venture capital does not mean less startup capital since non-VC sources of funding, such as angel capital, are growing.

Myth 2: VCs Take a Big Risk When They Invest in Your Company
VCs take risks with investors’ money, not their own. The typical VC commits only 1 percent of partner capital to a fund while investors commit the remaining 99 percent. The VC revenue model that generates guaranteed and cumulative management fees regardless of investment performance insulates VC partner personal compensation from the risk of poor returns.

Myth 3: Most VCs Offer Valuable Advice and Mentoring
VCs differ in how much effort they put into these nonmonetary resources, and the quality of advice and mentoring from VCs can vary widely, so founders who want more than capital from their investors should conduct a thorough due diligence on a VC firm they are considering.

Myth 4: VCs Generate Spectacular Returns
Mulcahy cites the data and findings from the Kauffman Foundation report she and her colleagues published last year about the under-performing VC industry. The report provides data on historic VC industry returns, and the Kauffman Foundation’s experience as a long-term investor in VC funds.

Myth 5: In VC, Bigger is Better
The contrary is true for both the industry and individual funds. Industry and academic studies show that VC fund performance declines as fund size increases above $250 million.

Myth 6: VCs are Innovators
VCs may be well known for funding innovation, but the VC industry and business model have not seen significant innovation in two decades. The VC fund structure, fund life and economic terms have remained the same for more than 20 years. Note to GPs: Increasing the standard 2 and 20 compensation model to 2.5 and 25 is not innovation.

VCs will continue to play a significant, but smaller, role in channeling capital to startups, Mulcahy concludes. The contracting VC industry and new funding sources now available to founders are finally “shifting the historical balance of power that has too long tilted too far toward VCs.”

Recently, Kauffman Foundation did a research for this under the name of ““WE HAVE MET THE ENEMY… AND HE IS US”
Lessons from Twenty Years of the Kauffman Foundation’sInvestments in Venture Capital Funds and The Triumph of Hope over Experience”.

It’s report highlights the following points-

Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years.
The Kauffman Foundation investment team analyzed our twenty-year history of venture investing experience in nearly 100 VC funds with some of the most notable and exclusive partnership “brands” and concluded that the Limited Partner (LP) investment model is broken1. Limited Partners—foundations, endowments, and state pension fund—invest too much capital in underperforming venture capital funds on frequently mis-aligned terms. Our research suggests that investors like us succumb time and again to narrative fallacies, a well-studied behavioral finance bias. We found in our own portfolio that:

 Only twenty of 100 venture funds generated returns that beat a public-market equivalent by more than 3 percent annually, and half of those began investing prior to 1995.

 The majority of funds—sixty-two out of 100—failed to exceed returns available from the public markets, after fees and carry were paid.

 There is not consistent evidence of a J-curve in venture investing since 1997; the typical Kauffman Foundation venture fund reported peak internal rates of return (IRRs) and investment multiples early in a fund’s life (while still in the typical sixty-month investment period), followed by serial fundraising in month twenty-seven.

 Only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index.

 Of eighty-eight venture funds in our sample, sixty-six failed to deliver expected venture rates of return in the first twenty-seven months (prior to serial fundraises). The cumulative effect of fees, carry, and the uneven nature of venture investing ultimately left us with sixty-nine funds (78 percent) that did not achieve returns sufficient to reward us for patient, expensive, long-term investing.

The HBR article is available here.

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Mohit Bansal(23) is B.Tech in Electronics and Communication Engineering from Indian School of Mines, Dhanbad, India. He has interest in business and entrepreneurship and has published couple of research articles. He is also associated with various NGOs. He is with Techaloo when it was just in concept stage. The Techaloo site was not existing even then. Currently Mohit is working with Mu Sigma as a Business Analyst Profile.

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