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Beware the VC Fad Factor

An annual ranking of top start-ups suggests VC funding and success go hand in hand. That's one huge mistake you don't want to make.
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Trying to identify the next big entrepreneurial thing? The Wall Street Journal has some implicit suggestions in its ranking of the top 50 start-ups. According to the Journal's third annual account, these are the top venture capital-backed young companies. One of the big takeaways this year is that business-to-business concepts are ahead of online consumer companies.

If you're focused on consumers, that means it's time to shift strategies and look at how to sell to other businesses, right? Not quite--because there are some mighty big assumptions and contradictions in this start-up compilation, and you don't want to send your horse to the corral on someone else's say-so.

Venture capital partners are subject to whim and fad

It's fine to talk about which companies are getting the most venture money. As in any other part of human existence, there are fads and fancies. Right now, venture firms are looking more at B2B. There are some good reasons they might. For a long time, B2B companies often found themselves passed over for the flashier Internet consumer offerings: Facebook, Twitter, Foursquare, and so on.

Companies that sell to businesses typically are using proven business models with a twist, so it is easier to predict outcomes. A larger portion of businesses than consumers are willing to pay for what they need and get, because the lack of the right service or tool can make the difference between profit and loss.

But remember that not too long ago--as recently as earlier this year, in fact--VCs were all over consumer Internet companies. They literally poured money into the space. According to start-up database Crunchbase, Facebook pulled in $2.24 billion in investment. Twitter has received $1.16 billion. Foursquare, which looks like it's in the low-rent district, by comparison, has $71.4 million. Zynga had $860 million and LivingSocial got $808 million. And let's not forget Groupon at $1.14 billion.

VC-backed doesn't mean successful

Notice that a lot of these companies have either had stock trouble since their IPOs because of concerns over revenue (read that as business success) or have raised questions about their ability to increase income--or even make income. It's a clear demonstration that the whims of VCs don't necessarily map to ultimate business success. In fact, according to new Harvard Business School research reported by the Journal, three out of four venture-backed start-ups fail. Compare that to the 30% failure rate that most VCs say they see.

VCs don't necessarily depend on operational success

Although some venture capitalists seem to truly believe in the companies they back--Fred Wilson at Union Square Ventures comes to mind (and even he holds to the 30% will fail, 30% will under-perform, and 30% will meet expectations model)--a good many look to build up a business only to eventually exit, which is the polite way of saying buy low, sell high.

They create demand for a product and then unload it to someone else. Too often the VCs depend on the greater fool market theory: that you buy something and wait for a bigger fool to come along and pay more for the same item.

It's a fact of venture money that the Journal did not mention in its ranking. Of course, the ranking also takes into account valuations. But remember what Facebook's valuation was right before its IPO in May 2012? Right--much higher than now.

Forget the rankings and the implications of what will work in the real world. If anyone had such a lock on the truth, that person would be able to print money. And yet, that's not happening. So, consider your idea, think of the best market for it, look at data, think long and hard, and work longer and harder. It's a much more certain formula to success than watching for trends in lists of well-funded companies.

Last updated: Sep 27, 2012

ERIK SHERMAN | Columnist

Erik Sherman's work has appeared in such publications as The Wall Street Journal, The New York Times Magazine, and Fortune. He also blogs for CBS MoneyWatch.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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