The Lower-Risk Startup: How Venture Capitalists Increase the Odds of Startup Success DAV ID TETEN, ADHAM ABDELFATTAH, KOEN BREMER, AND GYORGY BUSLIG DAVID TETEN ur goal is to understand how ven- METHODOLOGY is a partner at ff Venture ture capitalists (VCs) can system- Capital and founder and atically help startups increase their Our study draws on a wide range of Chair of Harvard Business odds of success, beyond simply research: in-depth interviews with more than School Alumni Angels 50 venture capital investors, entrepreneurs, of Greater New York Oproviding more capital. The primary levers of in New York, NY. a VC to do this are team building, operational startup incubators, and advisory service pro- [email protected] improvement, perspective and strategic guid- viders; a proprietary database and survey of ance, skill building, customer development, VCs’ portfolio value creation practices; a wide ADHAM ABDELFATTAH analytics, and the VC firm network. We will scan of academic and practitioner publications is the founder and CEO focused on the topics of entrepreneurship and of CircleVibe, a mobile discuss the range of philosophies we found startup in the crowd- among major VCs in their approaches. We venture investing; and the authors’ personal sourcing space and a find that certain operationally oriented VCs experience working in venture capital, ear- consultant on leave from are hiring unusually large teams of operators ly-stage technology companies, and strategy 1 McKinsey & Company and that the firms with this strategy typically consulting. in New York, NY. We should emphasize a key caveat. For [email protected] have top-quartile returns (above 20% IRR in the relevant time periods). We then def ine our study, we wanted to analyze whether the KOEN BREMER a blueprint for how investors can assess their Portfolio Operator strategy led to higher returns. is a consultant with strengths in order to meaningfully help port- Sadly, this is virtually impossible to do rigor- the Boston Consulting folio companies succeed. ously, for several reasons: Group in Amsterdam, We believe that developing and insti- The Netherlands. • This strategy is relatively new, so insuf- [email protected] tutionalizing management techniques that The Journal of Private Equity 2013.16.2:7-19. Downloaded from www.iijournals.com by Jeanne Miller on 04/03/13. enable better startup success rates will increase ficient data are available for the small GYORGY BUSLIG the availability of disruptive technology, while number of funds pursuing this strategy. is a consultant with also increasing investor returns and entrepre- • Returns data for VCs are difficult to It is illegal to make unauthorized copies of this article, forward an user or post electronically without Publisher permission. McKinsey & Co. in neur success rates. Given the mediocre median obtain and difficult to compare with one Budapest, Hungary. another across inconsistent fund sizes, [email protected] returns of the VC industry (4.41% end-to-end pooled for the 10 years ended March 31, 2012, check sizes, and strategies. according to the Cambridge Associates U.S. • VCs with higher returns naturally have Venture Capital Index) and the high failure more cash, feel more self-confident, and rate of the typical entrepreneur, techniques therefore are more likely to invest the to improve the odds of success are highly money needed for the expensive Portfolio needed. Operator strategy. SPRING 2013 THE JOURNAL OF PRIVATE EQUITY 7 JJPE-TETEN.inddPE-TETEN.indd 7 22/14/13/14/13 44:48:46:48:46 PMPM We can only say with reasonable confidence that • Team building: designing and recruiting for a start- most of the funds with well-developed portfolio operator up’s most important asset, its human capital base. strategies have returns in the top quartile (above 20% • Operations: enhancing administrative, accounting, IRR) for the time periods during which they have used legal, and technological capabilities. that strategy. We obtained data on returns from Preqin, • Perspective: strategy, competitive positioning, Fortune, and sources at funds of funds. Our thesis that defin ing the target market, and scoping the greater participation correlates with higher returns is con- product. sistent with two other formal studies: “Returns of Angel • Skill building: building the right skills, especially Investors in Groups” (2007), by Robert Wiltbank and for senior management. Warren Boeker, with funding and support from the Ewing • Customer development: identifying and gaining access Marion Kauffman Foundation, and “Prediction and Con- to the right customers. trol Under Uncertainty: Outcomes in Angel Investing” • Analysis: how entrepreneurs measure, understand, (2009), by Robert Wiltbank, Stuart Read, Nicholas and report the performance of their early-stage Dew, and Saras D. Sarasvathy. The studies were based on companies. entirely distinct datasets. Both found that higher levels of • Network: the cheapest and sometimes most value- angel participation in investments, as measured by number added service that an investor can provide is access of hours per week interacting with a portfolio company, to his/her network, particularly to potential inves- correlates with higher returns. tors and acquirers. WHO SHOULD BE INTERESTED A company’s need for the TOPSCAN services is IN THIS RESEARCH greatest in its earlier life. However, even among private equity funds that invest in late-stage, stable, established Venture capitalists. With the increasing competition companies, we see some such funds building portfolio in the startup funding space, providing distinctive sup- operations groups. These firms clearly believe that their port to portfolio companies can be a strong competi- portfolio companies benefit from a similar resource. tive advantage for VCs in deal sourcing as well as for Venture capitalists are financiers of a special nature. improving returns. They fund highly uncertain projects that usually operate Entrepreneurs. Our f indings help startups assess who within a very fast moving environment with constantly the most value-added investors are. Furthermore, this shifting technological paradigms. The teams they work study allows entrepreneurs to understand how they can with are entrepreneurs trying to engage in extensive extract more value from their current investors. product and customer development efforts for a product Large corporations. Almost every large company is or they don’t typically have a full vision of, for a customer it should be thinking about new, disruptive businesses it whose needs are opaque, and for a use case that is ambig- can incubate and/or buy. Our findings provide insight uous. This is a very different world from traditional on how to successfully gestate new businesses. corporate lending or investing. We believe that partially due to this unique con- The Journal of Private Equity 2013.16.2:7-19. Downloaded from www.iijournals.com by Jeanne Miller on 04/03/13. WHY AND HOW VCs SHOULD BE ACTIVELY text—quite distinct from that of other asset managers INVOLVED IN PORTFOLIO COMPANIES like private equity investors, hedge funds, and commer- cial banks—VCs can and should add tremendous value It is illegal to make unauthorized copies of this article, forward an user or post electronically without Publisher permission. The conventional school of thought is that inves- by supporting their portfolio companies more actively tors generally should create value by selecting the “right” beyond writing them checks. Almost all VCs say that companies, business plans, and teams in which to invest. they respond to portfolio CEO requests and make intro- This article argues that in addition to that selection func- ductions to people in their network when asked. We tion, venture investors have a wider role to play—the view that as the minimum level of appropriate support. value-creation function. Our research shows that many leading VCs have VCs can add more value to their portfolios through the invested significant resources in building out portfolio following seven elements, the “TOPSCAN” framework: operational support, based on a fundamental belief that their companies are typically incomplete in multiple 8 THE LOWER-RISK STARTUP: HOW VENTURE CAPITALISTS INCREASE THE ODDS OF STARTUP SUCCESS SPRING 2013 JJPE-TETEN.inddPE-TETEN.indd 8 22/14/13/14/13 44:48:46:48:46 PMPM ways and will benefit by systematic support. It is rela- • Industry network: One entrepreneur observed about tively easy for most VCs to do this, as VCs typically one of the most prominent VCs in America, “[X]’s enjoy a strong network and many have significant opera- default response to all problems is to e-mail intro- tional experience in their focus industries. duce you to 3–10 people in his network who can The Portfolio Operator strategy has potential to help.” See VC Profiles 1 (NextView Ventures) and boost returns, as discussed previously. In addition, VCs 3 for examples. (particularly those focused on internet investments) live • Funding network: Later-stage VCs pay careful atten- in a social-media-enabled world where almost every tion to who the earlier funders in a company are, investor has a very visible public resume on LinkedIn; using the reputations of the funders as a proxy for many have a public blog; and blogs and rating sites such as their own diligence. The next-best asset to a large TheFunded.com closely track their behavior. Social media pool of capital in-house is the ability to easily help footprints make it exceptionally easy for entrepreneurs to raise more capital in later rounds from past syn- assess precisely how much value a potential investor can dicate partners. See VC Profiles 7 (First Round add, and reach out to those investors specifically. Capital) and 9 (ff Venture Capital). • In-house expertise: VCs can provide consulting, ANALYSIS OF CURRENT PRACTICES accounting, or operational resources, both directly from their own staff and from preferred service We have identified three common categories of providers. See VC Profile 9 (ff Venture Capital).