GigaOM » Kauffman Foundation

The VC industry is broken. So now what?

Stacey Higginbotham — Tue, 08 May 2012 15:23:26 +0000

OMG! These returns!!

The investment team at the Kauffman Foundation believes the venture capital industry is broken and they — or rather investors in VC funds — are partially to blame. The report condemns venture firms for being too big, not delivering returns, and not adjusting to the times. But then it blames the situation on a misalignment of incentives: Namely, limited partners that invest in venture firms have done so in a way that encouraged VCs to raise huge funds at a time when huge funds weren’t really warranted. And now, for the Kauffman Foundation at least, the chickens have come home to roost. From the report:

The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will — generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.

A smaller VC industry is needed

The solutions to the problem — changing the compensation structure, investing in smaller funds where the partners have also committed at least 5 percent of their own capital, investing directly in startups or alongside funds at later stages, and taking more money out of the over-saturated VC market — are already happening. Look at the widespread trend of angels or smaller funds created by a few investors. Or look at the rise of hedge funds or Digital Sky Technologies’ investing directly in hot companies like Twitter or Facebook at crazy valuations.

It’s unclear if other LPs will take the advice issued in this report, but the trends around VC investment these days are fairly clear. There are plenty of firms willing to put small amounts in at an early stage, so they have the option to keep playing if the deal gets hot. And they are just as likely to drop firms quickly around the second (Series B) fundraiser if they aren’t shaping up into a Pinterest or a Spotify. This hit-driven style of investment is a symptom of too much money chasing a new type of startup, and it’s likely that venture investors will compete until much of the return is squeezed out of a hot deal. And that’s no good for limited partners either.

The Kauffman report lists the ways it has decided to solve the mismatch between LPs and venture firms, and it goes into a lot of depth on how to improve the industry overall. But if one agrees with the assessment and solutions offered in the report, it also will result in some serious questions about the startup economy. The venture industry invested $28.4 billion into 3,673 deals in 2011, according to the NVCA and the PWC MoneyTree report. About 50 percent of their total investments were in seed and early-stage companies.

Does less venture money mean fewer startups?

Following the Kauffman Foundation’s suggestions means the pool will shrink. In many ways this is a good thing, as there will be less money chasing the few standout deals, but it also opens the door to thinking about building companies in a connected era. Angels are already picking up some of the VC slack and will likely continue to do so. Once Facebook goes public, I expect we will see a host of newly minted millionaires playing at being an angel or perhaps taking their riches and using it to build something new.

For those without soon-to-be-liquid options, Kickstarter and the gold rush promised by the JOBS Act are also likely to fill the gap. So it’s entirely possible the pool of venture capital will shrink while the pool of startups will remain about the same. In such a scenario, VCs, angels and then the rest of us play the role of investor. It’s a role millions already undertake, with Kickstarter’s seeing $200 million pledged and 22,000 projects funded since its founding.

And the passage of the JOBS Act means startups can now beg for money among the ranks of friends and family who aren’t accredited investors. I for one am leery of this development, believing it ripe for scams. The law also has the side effect of cloaking information about companies until right before they hit the public markets, which I think is the exact opposite of what a bill that encourages consumer investment ought to do. But still, there will be legitimate companies that will be able to start businesses thanks to the bill.

And as lawyers and entrepreneurs get comfortable with the law, new funding platforms should arise. So perhaps the Kauffman Foundation will find itself on the cusp of a trend, from the old-school style of fundraising where an entrepreneur has few choices and has to play by the VC industry’s rules to a crowdsourced and connected era of raising capital that mimics how the Web is changing a variety of businesses. Maybe the VC industry is like Motown. And it’s going to have to adjust to the new reality.

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Some data on the democratization of entrepreneurship

Stacey Higginbotham — Wed, 07 Mar 2012 22:52:49 +0000

Go ahead, cook up an idea for a new startup!

Entrepreneurs who build a product for their own use are also likely to build a successful company around it, according to a study out from the Kauffman Foundation. Maybe the idea is for an app to help avoid speeding tickets or litmus-style test strips for nursing moms to see if they can feed their baby without getting them drunk, but the Kauffman survey found that what it calls “user entrepreneurs” have created more than 46 percent of innovative startups that have lasted five years or more, even though this group has founded only 10.7 percent of U.S. startups overall.

Many of these startups might be lifestyle businesses and bootstrapped, but the survey did find that almost 6 percent of end-user entrepreneurs across all industries reported receiving venture capital in their first six years of operations. And in general these firms seem to be a viable and attractive path for women and minority entrepreneurs. From the release announcing the report:

“User entrepreneurs are different from other entrepreneurs,” said E.J. Reedy, Kauffman Foundation research and policy fellow and co-author of the report. “It is clear that these entrepreneurs are coming into their businesses with more tangible ideas, innovations or customers to build a successful firm. This was a first pass at analysis, and we will be going back to look at them in more depth.”

The report divides user entrepreneurs into professional users (people using business products) and end users (consumers), and it notes that 48 percent of the end-user entrepreneurs are women, while about a fifth of the professional-user founders are women. So it’s likely women have a greater willingness or opportunity to start consumer-facing businesses based on their experience. There is a similar jump in end-user entrepreneurs from the African American community starting businesses, with 16.9 percent of consumer-facing firms founded by user entrepreneurs started by blacks. African Americans also started 5 percent of the business-facing user-inspired startups.

The data here is encouraging for those of us who have a vision for a product. Plus, breakthroughs in 3-D printing and platforms such as Quirky or Kickstarter make it that much easier for anyone to think up a product and try to start a business selling it.

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Startup Open 2011 Kicks Off Search for Most Promising New Companies

Colleen Taylor — Fri, 27 May 2011 17:00:26 +0000

Attention startups: Now’s a good time to be on your best behavior. The entrepreneurship-focused Kauffman Foundation nonprofit is officially on the hunt for the 50 most promising startups from around the world for its second annual “Startup Open” competition.

The Startup Open is a part of the Global Entrepreneurship Week (GEW), a Kauffman Foundation initiative aimed at fostering new business innovation through events in more than 100 countries. Applicants have from now until Sept. 15, 2011 to submit their startups for consideration for this year’s GEW, which will kick off on Nov. 15, 2011.

Any entrepreneur worldwide who has had a “startup moment”– defined by the Kauffman Foundation as any action related to launching a new business — since the last GEW on Nov. 22, 2010 is eligible to apply for Startup Open 2011. The top 50 startups will be chosen based on their concept, growth projections, and demonstrated industry knowledge.

The 2010 Startup Open’s first place winner was Olivier Ceberio, founder of Boston-based startup Resolute Marine Energy, which is developing technologies to produce clean energy from ocean waves. Ceberio received a trip to visit Richard Branson’s Necker Island for a day-long networking pow-wow with Branson and other entrepreneurs. “The day flew like a dream: a race in hobby cat with Sir Branson as personal pilot; a trip around the island in the Necker Belle, a catamaran that looks more like a floating resort than a sailboat; a casino night; and several networking sessions where I could mingle with some of the brightest people I ever met,” Ceberio wrote in a blog post.

This year’s grand prizes haven’t been announced yet, but if you have a brand-new startup, it could pay off to throw your hat into the ring.

Image courtesy of Flickr user Simon Peckham

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Are Crappy Startups Wall Street’s Fault?

Stacey Higginbotham — Thu, 24 Mar 2011 15:00:37 +0000

Is Wall Street blocking the next Google from even getting off the ground? Yes, according to a new report from the Kauffman Foundation, which says high-paying jobs in the financial sector have bled the prospective pool of startup founders and employees until it’s pretty shallow. In a report called Financialization and its Entrepreneurial Consequences, the authors (Paul Kedrosky and Dane Stangler) explain that because jobs in the finance sector pay so well, they take talent away from startups and may even be responsible for the “potentially weaker” startups being funded. From the report:

As the data on MIT graduates and the sectoral share of science and engineering employment suggest, it is conceivable that some degree of talent allocation between entrepreneurship and employment was affected by the rise of finance. Recall Figure 3 [shown below]: If we presuppose that some fraction of those scientists and engineers working in the financial sector would otherwise have started companies, we can imagine perhaps a slight effect of financialization on potential entrepreneurship. This also points to a question of the quality of companies being started, which we discuss below. It is difficult, again, to make firm statements as to causation, but the historical data seem to suggest that a two-way feedback effect exists.

Financialization could have a suppressive effect on potential entrepreneurship by draining away human capital. Conversely, an underlying decrease (or, at least, not an increase) in entrepreneurship creates a shortage of new financing opportunities for the financial sector, meaning the sector must find other outlets in which to be innovative and make money from money—causing the sector to expand.

The report acknowledges its drawbacks; for example, it draws causation from a variety of factors hugely affected by outside variables, from the overall economy to generational shifts in views about entrepreneurship. It also relies heavily on data from 2006 or earlier, which omits the impact of the latest bursting of the financial bubble as some of that innovation in finance resulted in the mortgage crisis. The study also looks at the rate that science, engineering and math (STEM) graduates have moved into the financial sector as opposed to starting companies.

The report’s primary argument is that Wall Street pay is so monumental startups don’t really have a chance to recruit the best and brightest of the so-called STEM graduates. This can make it difficult for startups to find more employees, which affects the overall quality of the startups.

Here’s where I think the survey breaks down a bit: It equates STEM graduates with the pool of founders. Many startups today are created not only by those in the so-called STEM fields but also by liberal arts, business and other graduates . I’ve written before how simple it can be to create a “startup” with little code and access to someone’s cloud platform. I don’t think these startups are out to create a business necessarily, so I don’t think they are the audience that the Kauffman report is talking about, but it’s also true that some of those startups will become a business.

Plus, even for those that start out in a STEM degree program, history is littered with college dropouts who go on to build huge companies. Yes, the debate between dropping out to start a business or stay and graduate continues to rage, but I think the survey misses a crucial point about entrepreneurs: For most, starting a business isn’t a career choice; it’s a calling. Thanks to an idea, a passion, a strong desire to never work for anyone else, most people start companies because they can’t do anything else. Typically, those founders create the strongest companies. If they fail, they’re still likely to go back and try again.

So while I can buy into the argument that there are a missing generation of scientists, mathematicians and entrepreneurs ready to join startups because they were lured by Wall Street’s high-pay, I can’t buy that there are many entrepreneurs among that crowd that have forsworn building their own business for the sake of a gilded paycheck. So yes, Wall Street may be taking away prospective employees, but perhaps a wider base of engineering and science talent would help solve the problem? Maybe our immigration programs should be revamped, or perhaps a greater emphasis on science and math will pay out in more children choosing to go through those degree programs.

The report concludes by imagining what would happen as the financial sector becomes a smaller proportion of the gross domestic product. Its authors conclude that not only could entrepreneurship rise, but the quality of companies will improve and then through the growth of those new companies, financial services will be available to meet their needs as opposed to creating bizarre financial instruments that seem to be the equivalent of shell games. It’s likely that we’ll soon be able to test that conclusion.

Picture courtesy of Flickr user epicharmus.

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When It Comes to Job Creation Startups Are More Fertile

Stacey Higginbotham — Thu, 05 Nov 2009 18:43:23 +0000

[qi:_foundread] Startups may have a high failure rate, but they also are a leading driver of job creation in the U.S., according to a report put out by The Kauffman Foundation this morning. As part of a deeper look at what small business means for the U.S. economy, the study found that 1- to 5-year-old companies create the highest average number of jobs, at roughly four jobs per year. From the report:

The dynamics of firm age, moreover, point us away from a discussion on the existing distribution of employment and toward a focus on the annual changes in jobs. Let’s ask not where people work, but where each additional increment in net job creation occurs. This approach immediately forces one to recognize that companies in a given size class are not necessarily homogenous: a company with fifteen employees that is twenty-five years old will behave differently than one that is only two years old (differences that will multiply if we classify firms according to economic sector).

First the report points out that, while companies with more than 500 people make up about half of the nation’s employment and payroll, a business’s size is not a good indicator of where new jobs come from. Dane Stangler and Robert E. Litan, who wrote the report, offer up this graph to show that without startups overall job creation in the U.S. would have been negative in most of the years since 1977.

There’s also discussion, but no data, about how M&A at large companies — through which they typically acquire smaller, younger firms — accounts for the job growth at larger companies. The report offers a ton of data about economic sectors, and acknowledges that relying on startups for job creation is both messy and hard to track. It’s all very well to say at a macro level that young companies create jobs even though they have a high likelihood of failure, but at the individual level, relying on an uncertain startup for employment can create enormous personal risk.

The report recommends that to foster job creation, young companies need help. The authors think credit should be made more accessible to businesses as well as banks, and note efforts happening in these area today. They also suggest a payroll tax holiday for new and young businesses, while noting that such a move could add to the deficit.

I would suggest rather, that the government consider some level of universal health care that would reduce costs for a young company, as well as offset the difficulties faced by employees who have to navigate the turbulent nature of working at a startup. Overall, it’s an interesting report, although I’m not sure big business should be written off so easily. They may not be engines of job growth, but in many cases they are engines for startup growth as they buy services, equipment or even ads from them.

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Credit Cards Increase Risk of Failure for Startups

Stacey Higginbotham — Fri, 07 Aug 2009 00:00:25 +0000

Is your startup carrying a balance on its Visa? If so, you’d be well-advised to get it paid off. Credit card debt reduces the likelihood that a new business will survive its first three years of operation, according to a study released today by the Kauffman Foundation; it found that every $1,000 increase in credit card debt increases the probability a firm will close by 2.2 percent. However, to be clear: No relationship was found between using credit card debt to start a business and that business’s survival or closure.

The key appears to be how startups handle their debt, in particular when they’re able to pay it off. Of course, the ability to repay debt has always been tied to the overall health of a business, but the report makes clear that a higher balance is linked to outright failure. And it comes just as venture firms are putting less money into startups and banks are shying away from small business loans — forcing entrepreneurs to turn to credit cards. About 58 percent of the firms in the survey sample used credit cards in their first year of operations.

A June report published by the U.S. Small Business Administration Office of Advocacy notes that small business lending has decreased for loans between $100,000 and $1 million in value. Between 2007 and 2008 (the time frame measured in the most recent report) the number of loans fell by 23.3 percent, to 2.2 million from 2.9 million. When it comes to those under $100,000, the number of loans actually rose, by 15.7 percent, but the group believes such an increase can be attributed to continued efforts to promote small business credit cards. Which makes this research even more relevant.

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