March 1, 2012

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Measure Up

VCs are Getting Out of the Early Stage Funding Game

Tom Haraldsen

March 1, 2012

Here’s a business conundrum—is it easier in 2012 to start a new company needing $1 million in funding or $10 million? If you thought cheaper was easier, you’d be incorrect.

That’s the problem facing many entrepreneurs who want to launch a new business concept or product but who need help from investors and/or venture capitalists. Early stage funding is critical for most of those would-be business owners, but unfortunately, many have found that “stage” has already left town.

Until the economic meltdown nearly four years ago, there were plenty of VCs and angel fund investors to fill the void. As the venture capitalists began dropping off—by almost 80 percent from 2000 to 2010—more and more startups were turning to the angels. Today, Utah, like most other states, is faced with much more startup activity than its angels can fund on their own. And curiously, part of the problem is that those startups don’t need enough money to make investing worthwhile for venture capitalists.

“It takes a lot of work, so if you have low returns [on your investments], many VCs just don’t want to manage a bunch of $500,000 investments,” says John Richards, associate director for the BYU Center for Entrepreneurship and Technology, and managing partner of the UtahAngels Investing Group. “The whole landscape has changed. Costs are cheaper now—there are more open sources for software, lower costs for hardware and the ability to get offshore programming. The costs to get started in business aren’t as great as they once were.”

Richards says a company might need to raise less than $1 million to get started and may never need to raise more cash beyond that.

“This makes the deployment of a venture capital fund very difficult at the early stages,” he says. “This is why venture capitalists are migrating to later and later stages, which makes their deployment tranches of $5 to $20 million much easier.”

That reality led 31-year-old engineer Eric Ries to create something he called “The Lean Startup” movement in 2008. He advocates the creation of business prototypes to test market assumptions, uses feedback from customers to refine the development of products or services, and relies on what the movement calls “continuous deployment” of information.

“The lean startup movement says that where companies used to be product-focused, they now go with the business hypothesis before anything is made,” Richards explains. “Eventually, the company arrives at a business model, but first, the customer is brought way forward in the process and the product is moved back. This means it’s very inexpensive to produce a minimum viable product.”

Ries, who has a huge international following, states simply that startups need to “be more innovative and stop wasting people’s time.” His inspiration was the process that Japanese factories implemented decades ago—focusing on eliminating any work or investment that doesn’t produce customer value.

Some would think this change of philosophy would make VC money easier for startups to attract. The opposite seems to be true in the economy of 2012. Even though the initial investment from a VC might be lower (thus yielding a lower return and making it a less attractive investment), there are still the inevitable challenges and risks associated with new businesses.

“Venture capitalists look for reasons not to do deals,” says Brad Bertoch, president of the Wayne Brown Institute in Salt Lake City. “There are lots of common problems with new concepts. To begin with, 90 percent of all entrepreneurs are first-timers—rarely do we see someone who’s done it before. A VC-backed entrepreneur has a 30 percent chance of succeeding, while first-timers only have about an 18 percent chance, according to the Harvard School of Business. And among first-timers, 50 percent are out of business after four years.”

That makes many VCs leery of getting into the fray to begin with.

Bertoch says another problem is something known as feature creep: “There are entrepreneurs who always keep fooling around with what they’re doing and never get the product out the door,” he says. “That slows down the building of a team to sell the product, and might lend itself to members of the team not believing the product will sell.”

Add to that an underestimation of the sales cycle, pricing pressures, competition and the development of sales channels, and many new companies find themselves with what’s known as the two-by-four problem: it takes twice as long and costs four times as much as the entrepreneurs thought it would.

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