Six Myths About Venture Capitalists

by Diane Mulcahy 

Steve Jobs, Mark Zuckerberg, Sergey Brin: We celebrate these entrepreneurs for their successes, and often equally extol the venture capitalists who backed their start-ups and share in their glory. Well-known VC firms such as Kleiner Perkins and Sequoia have cultivated a branded mystique around their ability to find and finance the most successful young companies. Forbes identifies the top individual VCs on its Midas List, implicitly crediting them with a mythical magic touch for investing. The story of venture capital appears to be a compelling narrative of bold investments and excess returns.

The reality looks very different. Behind the anecdotes about Apple, Facebook, and Google are numbers showing that many more venture-backed start-ups fail than succeed. And VCs themselves aren’t much better at generating returns. For more than a decade the stock markets have outperformed most of them, and since 1999 VC funds on average have barely broken even.

The VC industry wouldn’t exist without entrepreneurs, yet entrepreneurs often feel as if they’re in the backseat when it comes to dealing with VCs. For someone who’s starting (or thinking of starting) a company, the myths surrounding venture capital can be powerful. 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.

Myth 1: Venture Capital Is the Primary Source of Start-Up Funding
Venture capital financing is the exception, not the norm, among start-ups. Historically, only a tiny percentage (fewer than 1%) of U.S. companies have raised capital from VCs. And the industry is contracting: After peaking in the late 1990s, the number of active VC firms fell from 744 to 526 in the decade 2001–2011, and the amount of venture capital raised was just under $19 billion in 2011, down from $39 billion in 2001, according to the National Venture Capital Association (NVCA).

But less venture capital doesn’t mean less start-up capital. Non-VC sources of financing are growing rapidly and giving entrepreneurs many more choices than in the past. Angel investors—affluent individuals who invest smaller amounts of capital at an earlier stage than VCs do—fund more than 16 times as many companies as VCs do, and their share is growing. In 2011 angels invested more than $22 billion in approximately 65,000 companies, whereas venture capitalists invested about $28 billion in about 3,700 companies. AngelList, an online platform that connects start-ups with angel capital, is one example of the enormous growth in angel financing. Since it launched, in 2010, more than 2,000 companies have raised capital using the platform, and start-ups now raise more than $10 million a month there. (Disclosure: The Kauffman Foundation is an investor in AngelList.)

Another new source of start-up investment is crowdfunding, whereby entrepreneurs raise small amounts of capital from large numbers of people in exchange for nonequity rewards such as products from the newly funded company. Kickstarter reports that more than 18,000 projects raised nearly $320 million through its platform in 2012—triple the amount raised in 2011. Passage of the JOBS (Jumpstart Our Business Startups) Act last year promises to support even faster growth by allowing crowdfunders to invest in exchange for equity and by expanding the pool of investors who can participate. 

Myth 2: VCs Take a Big Risk When They Invest in Your Start-Up
VCs are often portrayed as risk takers who back bold new ideas. True, they take a lot of risk with their investors’ capital—but very little with their own. In most VC funds the partners’ own money accounts for just 1% of the total. The industry’s revenue model, long investment cycle, and lack of visible performance data make VCs less accountable for their performance than most other professional investors. If a VC firm invests in your start-up, it will be rooting for you to succeed. But it will probably do just fine financially even if you fail.

Why? Because the standard VC fund charges an annual fee of 2% on committed capital over the life of the fund—usually 10 years—plus a percentage of the profits when firms successfully exit, usually by being acquired or going public. So a firm that raised a $1 billion fund and charged a 2% fee would receive a fixed fee stream of $20 million a year to cover expenses and compensation. VC firms raise new funds about every three or four years, so let’s say that three years into the first fund, the firm raised a second $1 billion fund. That would generate an additional $20 million in fees, for a total of $40 million annually. These cumulative and guaranteed management fees insulate VC partners from poor returns because much of their compensation comes from fees. Many partners take home compensation in the seven figures regardless of the fund’s investment performance. Most entrepreneurs have no such safety net.

Other investment professionals often face far greater performance pressure. Consider mutual fund managers, whose fund performance is reported daily, whose investors can withdraw money at any time, and who are often replaced for under performance. VC performance is ultimately judged at the end of a fund’s 10-year life, so venture capitalists are free from the level of accountability that’s common in other investment realms. They take on less personal risk than angel investors or crowdfunders, who use their own capital. And all investors take fewer risks than most entrepreneurs, who put much of their net worth and all of their earning capacity into their start-ups. 

Myth 3: Most VCs Offer Great Advice and Mentoring

A common VC pitch to entrepreneurs is that the firm brings much more than money to the table: It offers experience, operational and industry expertise, a broad network of relevant contacts, a range of services for start-ups, and a strong track record of successful investing.

In some cases those nonmonetary resources really are valuable. But VCs vary tremendously—both as firms and as individuals—in how much effort they put into advising and assisting portfolio companies. Among those who do mentor their CEOs, ability and the quality of advice can differ widely. There are no solid data about the industry’s delivery on this mentoring promise. But if you asked the CEOs of 100 VC-funded companies how helpful their VCs are, some would say they’re fabulous, some would say they’re active but not a huge help, and some would say they do little beyond writing checks. This last group isn’t necessarily bad, of course: Some CEOs may be happy to skip the mentoring and just take the cash. But for founders who have bought into the idea that VCs provide lots of value-added help, it can be a source of great disappointment.

The best way to determine whether a VC firm or partner brings resources other than capital to the table is to conduct your own due diligence, just as you’d do a thorough reference check on a key hire. Talk with the CEOs of the firm’s other portfolio companies and ask if the partner is accessible, how much he or she adds to boardroom discussion, and whether the CEO has received constructive help in dealing with company problems. Ask about resources the firm offers—PR, recruiting, and so forth—and whether those have been useful.

Some questions you should ask the VC firm directly, such as: Whom does it intend to put on your board? Is the person a partner or an associate? Does the person have any experience (or any other portfolio companies) in your industry? On how many other boards does he or she serve? Asking such questions may seem like common sense, but it’s shocking how few company founders actually make the necessary calls before signing up for a long-term relationship with a VC. If part of what makes a firm attractive is that it offers expertise, mentoring, and services, the entrepreneur needs to confirm that both the firm and the partner have a track record of delivering them. 

Myth 4: VCs Generate Spectacular Returns
Last year my colleagues at the Kauffman Foundation and I published a widely read report, “We Have Met the Enemy...and He Is Us,” about the venture capital industry and its returns. We found that the overall performance of the industry is poor. VC funds haven’t significantly outperformed the public markets since the late 1990s, and since 1997 less cash has been returned to VC investors than they have invested. A tiny group of top-performing firms do generate great “venture rates of return”: at least twice the capital invested, net of fees. We don’t know definitively which firms are in that group, because performance data are not generally available and are not consistently reported. The average fund, however, breaks even or loses money.

We analyzed the Kauffman Foundation’s experience investing in nearly 100 VC funds over 20 years. We found that only 20 of our funds outperformed the markets by the 3% to 5% annually that we expect to compensate us for the fees and illiquidity we incur by investing in private rather than public equity. Even worse, 62 of our 100 funds failed to beat the returns available from a small-cap public index.

Venture capital investments are generally perceived as high-risk and high-reward. The data in our report reveal that although investors in VC take on high fees, illiquidity, and risk, they rarely reap the reward of high returns. Entrepreneurs who are distressed when VCs decline to fund their ventures need only review the performance data to see that VCs as a group have no Midas touch for investing.

Myth 5: In VC, Bigger Is Better

Venture capital in the United States began as a cottage industry, notable in the early years for investments in companies such as Intel, Microsoft, and Apple. In 1990, 100 VC firms were actively investing, with slightly less than $30 billion under management, according to the NVCA. During that era venture capital generated strong, above-market returns, and performance by any measure was good. What happened? During the peak of the internet boom, in 2000, the number of active firms grew to more than 1,000, and assets under management exceeded $220 billion. VC didn’t scale well. As in most asset classes, when the money flooded in, returns fell, and venture capital has not yet recovered. The number of firms and the amount of capital have declined since the boom, though they are both still far above the levels of the early and middle 1990s.

What’s true for the industry is also true for individual funds: Bigger isn’t better. Company founders often feel that signing a deal with a large VC firm lends cachet, just as MBA students may get special pleasure from being offered a job by a big, well-known employer. But industry and academic studies show that fund performance declines as fund size increases above $250 million. We found that the VC funds larger than $400 million in Kauffman’s portfolio generally failed to provide attractive returns: Just four out of 30 outperformed a publicly traded small-cap index fund. 

Myth 6: VCs Are Innovators
It’s ironic that VC firms position themselves as supporters, financers, and even instigators of innovation, yet the industry itself has been devoid of innovation for the past 20 years. Venture capital has seen plenty of changes over time—more funds, more money, bigger funds, declining returns—but funds are structured, capital is raised, and partners are paid just as they were two decades ago. Any innovation in financing start-ups, such as crowdfunding and platforms like AngelList and SecondMarket, has come from outside the VC industry. 

The story of venture capital is changing. Entrepreneurs have more choices for financing their companies, shifting the historical balance of power that has too long tilted too far toward VCs. Entrepreneurs will enjoy a different view as they move from the backseat into the driver’s seat in negotiating with VCs. An emerging group of “VC 2.0” firms are going back to raising small funds and focusing on generating great returns rather than large fees. And the industry’s persistent underperformance is finally causing institutional investors to think twice before investing in venture capital. As a result, VCs will continue to play a significant, but most likely smaller, role in channeling capital to disruptive start-ups.

Diane Mulcahy, a former venture capitalist, is the director of private equity for the Ewing Marion Kauffman Foundation, an adjunct lecturer in the entrepreneurship division at Babson College, and an Eisenhower Fellow.  

What This Female CEO Learned About Gender Bias After Pitching 200 VCs

BY Erika Trautman

There’s no denying that female CEOs are still a rarity. We account for only about seven percent of CEOs in the start-up world. Female VCs are equally scarce, which means a female CEO is usually pitching to a male investor who is used to hearing pitches from other men.

So if the guys create the benchmark for a successful venture pitch, which they do by shear volume alone, what does that mean for how women are perceived by venture capitalists? Does that affect the fundraising process?

Many of the male CEOs I know pitch their startups with a “Billion Dollars or Bust” story and the successful ones are masterful storytellers.

I remember being amazed at the ease with which one CEO painted a picture of the massive value that his company would create. He peppered his story with just enough metrics to pre-emptively neutralize any doubts that might arise. He made his vision seem inevitable.

But listening closely, trying to hook into the tangibles that would make his vision come true, I found that those tangibles weren’t really there. They couldn’t be. The reality is that startups must navigate so many unknowns. It’s impossible to map out the route from seed to IPO. That mapping has to happen on the road.

And yet, that storytelling ability is critical in raising capital.

I think there’s an inherent challenge for women telling the “Billion Dollars or Bust” story, or at least there was for me.

Don’t get me wrong. I want nothing less than to reinvent online video to make it richly interactive. And I want Rapt Media to lead that billion-dollar expedition.

But the process of building a company is iterative and I focus on the next set of milestones and the next risks to be mitigated. If the guys are great at describing the view from the top of the mountain, then I’m the one focused on putting one foot in front of the other to get to the next ridge.

This is not uncommon for female CEOs. Mauria Finley, CEO and founder of Citrus Lane, has written about lessons-learned in fundraising. She says that too often, women “pitch based on their skills and competence, and they undersell their vision.”

So should female CEOs adapt to a more masculine style of pitching? I don’t think so. There is still subtle gender bias when it comes to how women are perceived that might actually make the Billion-Dollar story ineffective.

I first understood this from one of Rapt Media’s investors, Adam Quinton, who is an active early-stage investor and a professor at Columbia’s Graduate School of International and Public Affairs.

“When it comes to leadership behaviors,” says Quinton, “there is plenty of evidence that women suffer the double-bind, a sort of damned-if-you-do, damned-if-you-don’t scenario.” Because typical male behaviors are more commonly associated with leadership, women are often perceived as great team players, but not leaders. And yet taking on male leadership traits is often actually counter-productive," says Quinton.

“Women who step outside of the recognized feminine behavior patterns are typically tagged by both men and women as unlikable,” he says. “You’re really only going to be successful if you are authentic. People need to see you for what you are. You can flex things at the margins, but you can’t make yourself into a macho bullshitting guy if you aren’t one!”

Rapt Media has raised $3 million and in that time, I’ve probably given more than 200 pitches. I’ve tried pitching big vision. I’ve tried pitching demonstrated progress over time.
Ultimately, building relationships with investors who I like and respect, and who understand me as a leader worked best. This relationship building is a slower method for closing capital, but over the long run, it’s better for the company and our investors.

The good news is that, according to PitchBook, the number of venture deals going to female-lead companies has more than tripled, from four percent to 13 percent since 2004. This may be driven, in part, by the growing body of research that has shown companies with gender-diverse executive teams outperform those that are homogenous.

I think this will become a virtuous cycle. The more women that found and lead good companies, the more open VCs will be to different leadership styles, and that benchmark for what a successful pitch should look like will shift to include approaches that may be less stereotypically male.

But until we have more female CEOs, just remember: Be authentic. But be sensitive to what your audience wants to hear. Know that women founders do get funded. And recognize that fundraising is hard no matter who you are because ultimately, shrewd tenacity may be even more important than selling the dream.

Erika Trautman

Erika Trautman founded Rapt Media, a Boulder, Colo.-based creative platform for interactive enterprise video. Before Rapt Media, she founded and ran an Emmy Award Winning Production company, Outlier Films, and worked as a documentary filmmaker.

The One Thing VCs Could Do Immediately to Increase Returns

If the person who can cure diabetes came to you for money, if you were a VC you’d likely turn that person away. And, an inventor who could reduce global dependency on oil by designing better batteries? That VC might not even take the meeting. By venture capitalists’ individual actions, they are limiting growth and innovation. By their collective choices, they are risking our very lives.

Now that might sound a little extreme. But bear with me.

Ted Schlein, general partner at Kleiner Perkins, was recently invited to discuss race and investment in technology. The conversation took place at an inaugural conference called Platform, created by Hank Williams after a provocative series that Soledad O’Brien did on CNN on black entrepreneurship. At Platform, luminaries like Quincy Jones and Governor Deval Patrick, as well as entrepreneurs like urban revitalizer Majora Carter, and Juliana Rotich of Ushahidi came together to discuss what specific changes could be made to have all aboard the innovation economy.

And so all ears were tuned in when well-known VC Ted Schlein of Kleiner Perkins started talking… but Ted denied there was a problem. Despite the story the numbers tell — women receive less than three percent of all venture capital funding, and blacks even less than that — Ted said that the venture capital community was “color-blind” and “operates fully on a meritocracy.” This continued argument disregards the astounding facts that essentially 100 percent of funded founders are white or Asian, and 89 percent of founding teams are all-male.

Since then, we’ve had the case of Paul Graham, who recently got into a brouhaha because he claimed a correlation “between founders having very strong foreign accents and their companies doing badly.” He continued to dig into his argument, believing people were simply misunderstanding him, but he doesn’t acknowledge the facts: immigrants with accents do found successful startups, but often without VC support. Kauffman Foundation research shows that more than half of Silicon Valley start-ups are founded by foreign-born entrepreneurs. Imagine if those with accents could get your support — what tougher problems could they solve?

And who can forget that only two years ago, Vinod Khosla said that only the young can innovate. “People under 35 are the people who make change happen,” said Khosla, who explained his belief that old entrepreneurs can’t innovate because they keep “falling back on old habits,” because “people over 45 basically die in terms of new ideas.”

So, basically, if you followed this limited logic… you’d hear that if you’re a woman, black, foreign, or old, you need not apply; you will not be seen. No matter how good your idea could be. No matter how many lives it could save, or new solutions you create, or how much revenue it could generate.

Listening to Ted Schlein, Paul Graham, Vinod Khosla, and countless other conversations among VCs reminds me of playing peek-a-boo with a baby. Amazed that the person is there, even though they can’t be seen, this mystery creates joy. In the vast majority of VCs case, they believe that the person isn’t there, because they can’t see them. And there’s no joy in that.

Venture capitalists are often “pattern matching”, thus actively looking for someone who looks like the successful founders of Google, FaceBook, Amazon, or Apple. In other words, you are actively looking for people who look like Larry Page, Mark Zuckerberg, Jeff Bezos, or Steve Jobs — white men. Forget differentiation. Forget newness. VCs primarily invest in sameness.

By not seeing (and funding) new-ness you are actually blind, not color-blind.

Now what each of you says when this topic of “blindness” comes up is this: “I am not a racist / sexist / whatever it is you are accusing me of.” And, let me assure you that you’re (likely) not. What you probably are is biased, which is to say your lens is altered by cultural norms and so see what you expect to see. If you’ve largely been surrounded by, say, women who don’t work outside the home, your lens when it comes to women may be warped. But, as I’ve already written in a prior HBR post, bias is fixable — though it takes work.

Others of you say that it’s okay to pass up any particular group since you’re not interested in what you believe is a limited category. The most common one I hear is “I’m not interested in investing in fashion which is why it’s fine with me that I don’t see a lot of women’s pitches.” What doesn’t seem to occur to you is that women are also interested in bio-tech (like Nina Tandon), policy (like Marci Harris), and electronics (like Ayah Bdeir). Even the consumer goods industry is affected. Kara Goldin of Hint is taking on goliaths in the consumer beverages space by redefining what “is” and “is not” water. Each is an innovator, and many more like them exist. If you want to create higher returns, see these “new” types of innovators and watch them deliver home runs. But, first, you have to first actively filter them in, not out.

Finally, I hear you say is that this is about market capitalism and the only measure of success is whether you have made money. You, of all people, know that if you only focus on the profits of your existing enterprise, even though the rules of the game are changing, you leave yourself open to disruption. You now face the innovator’s dilemma — and if you fail to adopt new approaches, you will eventually fall behind, fail, and die. You know this, but mostly you dismiss the opportunity to reinvent.

But my bigger concern is that you will take us collectively down with you. You have — by far — the most access to funds to invest in new ideas. You are the structural gateway of innovation.

You recognize capitalism as an economic system, while dismissing these issues of inclusion as “social”. But I would argue that, in practice, your collective acts in venture capital are fundamentally a new type of structural power, the effect of which is economic in nature. When your collective actions limit human capital, when they deny opportunity based on race, gender and age, then that must be viewed and evaluated as an economic system. Today, practically speaking, it is not the laws that are structurally limiting our economy; rather, it’s money — specifically the flow of money to new ideas.

Ignoring inclusion is something you do at your own peril — and at ours. For we are all at risk when your system excludes. We — society, that is — need you to reinvent how you do what you do.

Now I’m not an innocent. While I’d like to believe in a just world where all creative and hardworking people will be seen, I know better. I know enough of Jeffrey Pfeffer’s work to know that the world has pervasive power differentials and that groups in power, like yourselves, will often respond to outside pressure by digging in your heels because you’d rather feel good about yourselves than risk change.

But what I also know is that it takes some relatively small set of influencers (data says only 10-20% are needed) with an unshakable belief to convince the rest to adopt the same belief. And, of course, some of you are already there, trying to get the rest to join you. Challenging the venture community may seem like an attack, but actually this is a call from the future. Step into the leadership we so need from you.

Nilofer Merchant

Nilofer Merchant is a corporate director at a NASDAQ-traded firm and a lecturer at Stanford, and formerly the founder and CEO of Rubicon. Among other Fortune 500 firms, she’s worked at Apple and Autodesk. She’s the author of The New How and 11 Rules for Creating Value in the Social Era. 

Six Myths About Venture Capitalists

by Diane Mulcahy

 

Steve Jobs, Mark Zuckerberg, Sergey Brin: We celebrate these entrepreneurs for their successes, and often equally extol the venture capitalists who backed their start-ups and share in their glory. Well-known VC firms such as Kleiner Perkins and Sequoia have cultivated a branded mystique around their ability to find and finance the most successful young companies. Forbes identifies the top individual VCs on its Midas List, implicitly crediting them with a mythical magic touch for investing. The story of venture capital appears to be a compelling narrative of bold investments and excess returns.

The reality looks very different. Behind the anecdotes about Apple, Facebook, and Google are numbers showing that many more venture-backed start-ups fail than succeed. And VCs themselves aren’t much better at generating returns. For more than a decade the stock markets have outperformed most of them, and since 1999 VC funds on average have barely broken even.

The VC industry wouldn’t exist without entrepreneurs, yet entrepreneurs often feel as if they’re in the backseat when it comes to dealing with VCs. For someone who’s starting (or thinking of starting) a company, the myths surrounding venture capital can be powerful. 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.

 

Myth 1: Venture Capital Is the Primary Source of Start-Up Funding
Venture capital financing is the exception, not the norm, among start-ups. Historically, only a tiny percentage (fewer than 1%) of U.S. companies have raised capital from VCs. And the industry is contracting: After peaking in the late 1990s, the number of active VC firms fell from 744 to 526 in the decade 2001–2011, and the amount of venture capital raised was just under $19 billion in 2011, down from $39 billion in 2001, according to the National Venture Capital Association (NVCA).

But less venture capital doesn’t mean less start-up capital. Non-VC sources of financing are growing rapidly and giving entrepreneurs many more choices than in the past. Angel investors—affluent individuals who invest smaller amounts of capital at an earlier stage than VCs do—fund more than 16 times as many companies as VCs do, and their share is growing. In 2011 angels invested more than $22 billion in approximately 65,000 companies, whereas venture capitalists invested about $28 billion in about 3,700 companies. AngelList, an online platform that connects start-ups with angel capital, is one example of the enormous growth in angel financing. Since it launched, in 2010, more than 2,000 companies have raised capital using the platform, and start-ups now raise more than $10 million a month there. (Disclosure: The Kauffman Foundation is an investor in AngelList.)

Another new source of start-up investment is crowdfunding, whereby entrepreneurs raise small amounts of capital from large numbers of people in exchange for nonequity rewards such as products from the newly funded company. Kickstarter reports that more than 18,000 projects raised nearly $320 million through its platform in 2012—triple the amount raised in 2011. Passage of the JOBS (Jumpstart Our Business Startups) Act last year promises to support even faster growth by allowing crowdfunders to invest in exchange for equity and by expanding the pool of investors who can participate.

 

Myth 2: VCs Take a Big Risk When They Invest in Your Start-Up
VCs are often portrayed as risk takers who back bold new ideas. True, they take a lot of risk with their investors’ capital—but very little with their own. In most VC funds the partners’ own money accounts for just 1% of the total. The industry’s revenue model, long investment cycle, and lack of visible performance data make VCs less accountable for their performance than most other professional investors. If a VC firm invests in your start-up, it will be rooting for you to succeed. But it will probably do just fine financially even if you fail.

Why? Because the standard VC fund charges an annual fee of 2% on committed capital over the life of the fund—usually 10 years—plus a percentage of the profits when firms successfully exit, usually by being acquired or going public. So a firm that raised a $1 billion fund and charged a 2% fee would receive a fixed fee stream of $20 million a year to cover expenses and compensation. VC firms raise new funds about every three or four years, so let’s say that three years into the first fund, the firm raised a second $1 billion fund. That would generate an additional $20 million in fees, for a total of $40 million annually. These cumulative and guaranteed management fees insulate VC partners from poor returns because much of their compensation comes from fees. Many partners take home compensation in the seven figures regardless of the fund’s investment performance. Most entrepreneurs have no such safety net.

Other investment professionals often face far greater performance pressure. Consider mutual fund managers, whose fund performance is reported daily, whose investors can withdraw money at any time, and who are often replaced for under performance. VC performance is ultimately judged at the end of a fund’s 10-year life, so venture capitalists are free from the level of accountability that’s common in other investment realms. They take on less personal risk than angel investors or crowdfunders, who use their own capital. And all investors take fewer risks than most entrepreneurs, who put much of their net worth and all of their earning capacity into their start-ups.

 

Myth 3: Most VCs Offer Great Advice and Mentoring

A common VC pitch to entrepreneurs is that the firm brings much more than money to the table: It offers experience, operational and industry expertise, a broad network of relevant contacts, a range of services for start-ups, and a strong track record of successful investing.

In some cases those nonmonetary resources really are valuable. But VCs vary tremendously—both as firms and as individuals—in how much effort they put into advising and assisting portfolio companies. Among those who do mentor their CEOs, ability and the quality of advice can differ widely. There are no solid data about the industry’s delivery on this mentoring promise. But if you asked the CEOs of 100 VC-funded companies how helpful their VCs are, some would say they’re fabulous, some would say they’re active but not a huge help, and some would say they do little beyond writing checks. This last group isn’t necessarily bad, of course: Some CEOs may be happy to skip the mentoring and just take the cash. But for founders who have bought into the idea that VCs provide lots of value-added help, it can be a source of great disappointment.

The best way to determine whether a VC firm or partner brings resources other than capital to the table is to conduct your own due diligence, just as you’d do a thorough reference check on a key hire. Talk with the CEOs of the firm’s other portfolio companies and ask if the partner is accessible, how much he or she adds to boardroom discussion, and whether the CEO has received constructive help in dealing with company problems. Ask about resources the firm offers—PR, recruiting, and so forth—and whether those have been useful.

Some questions you should ask the VC firm directly, such as: Whom does it intend to put on your board? Is the person a partner or an associate? Does the person have any experience (or any other portfolio companies) in your industry? On how many other boards does he or she serve? Asking such questions may seem like common sense, but it’s shocking how few company founders actually make the necessary calls before signing up for a long-term relationship with a VC. If part of what makes a firm attractive is that it offers expertise, mentoring, and services, the entrepreneur needs to confirm that both the firm and the partner have a track record of delivering them.

 

Myth 4: VCs Generate Spectacular Returns
Last year my colleagues at the Kauffman Foundation and I published a widely read report, “We Have Met the Enemy...and He Is Us,” about the venture capital industry and its returns. We found that the overall performance of the industry is poor. VC funds haven’t significantly outperformed the public markets since the late 1990s, and since 1997 less cash has been returned to VC investors than they have invested. A tiny group of top-performing firms do generate great “venture rates of return”: at least twice the capital invested, net of fees. We don’t know definitively which firms are in that group, because performance data are not generally available and are not consistently reported. The average fund, however, breaks even or loses money.

We analyzed the Kauffman Foundation’s experience investing in nearly 100 VC funds over 20 years. We found that only 20 of our funds outperformed the markets by the 3% to 5% annually that we expect to compensate us for the fees and illiquidity we incur by investing in private rather than public equity. Even worse, 62 of our 100 funds failed to beat the returns available from a small-cap public index.

Venture capital investments are generally perceived as high-risk and high-reward. The data in our report reveal that although investors in VC take on high fees, illiquidity, and risk, they rarely reap the reward of high returns. Entrepreneurs who are distressed when VCs decline to fund their ventures need only review the performance data to see that VCs as a group have no Midas touch for investing.

Myth 5: In VC, Bigger Is Better

Venture capital in the United States began as a cottage industry, notable in the early years for investments in companies such as Intel, Microsoft, and Apple. In 1990, 100 VC firms were actively investing, with slightly less than $30 billion under management, according to the NVCA. During that era venture capital generated strong, above-market returns, and performance by any measure was good. What happened? During the peak of the internet boom, in 2000, the number of active firms grew to more than 1,000, and assets under management exceeded $220 billion. VC didn’t scale well. As in most asset classes, when the money flooded in, returns fell, and venture capital has not yet recovered. The number of firms and the amount of capital have declined since the boom, though they are both still far above the levels of the early and middle 1990s.

What’s true for the industry is also true for individual funds: Bigger isn’t better. Company founders often feel that signing a deal with a large VC firm lends cachet, just as MBA students may get special pleasure from being offered a job by a big, well-known employer. But industry and academic studies show that fund performance declines as fund size increases above $250 million. We found that the VC funds larger than $400 million in Kauffman’s portfolio generally failed to provide attractive returns: Just four out of 30 outperformed a publicly traded small-cap index fund.

 

Myth 6: VCs Are Innovators
It’s ironic that VC firms position themselves as supporters, financers, and even instigators of innovation, yet the industry itself has been devoid of innovation for the past 20 years. Venture capital has seen plenty of changes over time—more funds, more money, bigger funds, declining returns—but funds are structured, capital is raised, and partners are paid just as they were two decades ago. Any innovation in financing start-ups, such as crowdfunding and platforms like AngelList and SecondMarket, has come from outside the VC industry. 

The story of venture capital is changing. Entrepreneurs have more choices for financing their companies, shifting the historical balance of power that has too long tilted too far toward VCs. Entrepreneurs will enjoy a different view as they move from the backseat into the driver’s seat in negotiating with VCs. An emerging group of “VC 2.0” firms are going back to raising small funds and focusing on generating great returns rather than large fees. And the industry’s persistent underperformance is finally causing institutional investors to think twice before investing in venture capital. As a result, VCs will continue to play a significant, but most likely smaller, role in channeling capital to disruptive start-ups.

Diane Mulcahy, a former venture capitalist, is the director of private equity for the Ewing Marion Kauffman Foundation, an adjunct lecturer in the entrepreneurship division at Babson College, and an Eisenhower Fellow.