Why Not Invest in Startups?
There are two reasons. First, investing in startups is a different business – and it is not well suited to small investment funds. Here’s how we know.
The investment data platform CB Insights looked at a cohort of tech companies headquarters in the U.S. that raised the first round of seed funding in 2008, 2009, or 2010. They followed them through to February 28, 2017. Given the timeframe, these companies have had a substantial amount of time to obtain follow-on funding or to exit.
Of the 1,098 tech companies they tracked, less than half, or 46%, managed to raise a second round of funding. Every round saw fewer companies advance toward new infusions of capital. For example, only 14% of companies went on to raise a fourth round of funding, which typically corresponds to a Series C round.
This incredible fall-off rate means that startup investors (like 500 Startups) have to invest in hundreds of companies to achieve a rate of return. That requires capital we don’t have. Some of CBI’s other conclusions:
- Only 306 (28%) of companies that raised a seed round in 2008-2010 exited through an M&A or IPO within 7 rounds of funding with all that time and money, 2/3rds of the companies still failed.
- Less than 1% (10) companies from the CBI seed cohort ended up becoming unicorns, e.g., companies valued at $1B or more. Some of these companies are the most-hyped tech companies of the decade, including Uber, Airbnb and Slack. This compares to 7-10% of companies in Early Stage which would up as “winners” – albeit at a much lower return.
- About 70% of companies ended up either dead or became self-sustaining. “Self-sustaining” means cash flow breakeven, which may be great for the companies and their founders: It’s a great job! But this is not great for investors who need an exit to see a return. Perhaps worse, some companies often stumble on as Zombies for years before calling it quits. The death of the company? This generally happens without any official announcement.
Second, we don’t have the skills. To be a startup investor in technology, you have to understand technology in great depth – or at least enough to know if what you are seeing is really new and if it has a chance of success ten steps down the road. This means that successful startup investors typically have deep technology expertise and focus on one industry vertical where they know what they are looking at. We’re not smart enough in any area, so we invest in a wide range of verticals and we rely on customers to tell us whether the product is new, different or better.