Venture capitalists: Everyman as entrepreneur

By:
Helen Avery
Published on:

Some six million businesses were created in the US in 2012. The country is experiencing a start-up boom. What impact is the wave of entrepreneurs having, and how are the angel investor and venture capital industry adapting?

The word ‘entrepreneur’ used to enjoy a certain cachet. The impresario was predominantly male, charismatic for sure, with a devil-may-care attitude. To be entitled to the label you probably worked 20-hour days for a few years, travelled extensively, made and lost a few million dollars, dated an heiress to a corporate empire and at some point owned a failing sports team or airline. But you fundamentally changed the industry in which you were operating, be it fashion, transport, technology, retail, art or entertainment, and that entitled you (after you had made your first billion dollars) to write a book outlining the keys to your success.

These days in the US, however, it seems everyone is an entrepreneur. Since the financial crisis, the number of businesses being started has rocketed. In 2012, 514,000 businesses a month were created, according to the annual index of entrepreneurial activity from the Kauffman Foundation.

"If everyone used to walk around with a script under their arm, now it’s a business plan," says the head of a New York City incubator. ‘Entrepreneur’, ‘innovation’ and derivatives thereof have saturated the global vocabulary. According to Amazon.com, 642 books pertaining to ‘innovation’ have been published since February alone. Entrepreneurship is the most popular focus among university students when selecting courses – more than 2,000 courses in the US reportedly have an entrepreneurship bent.

It would be easy to regard the current hype around entrepreneurship and start-ups with scepticism. The younger wave of entrepreneurs has little or no recollection of the dotcom boom and bust. Back then there was a similar gusto. Everyone with an idea set up a domain name; many were certain that was enough to become an internet millionaire. There are elements of the ridiculous this time around too. Are you thinking about building an app? You’re an entrepreneur. Renting out your second bedroom on Airbnb.com? Congratulations! You’re an entrepreneur.

But this cycle is also different. Technology is driving start-ups and aiding their innovation, but the industries the start-ups are in reach far beyond pure tech. And the new businesses are not only disrupting the markets in which they are playing, they are also disrupting the venture capital and angel industry. The world of start-up finance is having to evolve.

Jeff Fagnan, a partner in venture capital firm Atlas Venture
Jeff Fagnan, a partner in venture capital firm Atlas Venture
"It’s always been ‘cool’ to be an entrepreneur; now, however, it is accessible," says Jeff Fagnan, a partner in venture capital firm Atlas Venture. One difference between the current burst in start-ups and those in the dotcom boom is that it is far more capital-efficient to start a company today than it was 10 years ago. "With open-source software, the cloud and on-demand, it is five to 10 times cheaper to get a product to market now," says Fagnan. Companies can build hundreds of customers or thousands of unique site visitors or users in a very short time thanks to the internet and the ease of connecting with targeted interest groups. Social media have also made it possible for interesting ideas to garner broader public attention.

"It used to cost $2 million in infrastructure to set up a firm. Now you can get off the ground with just a few hundred dollars," says Akhil Nigam, co-founder and president of Boston-based accelerator MassChallenge.

That’s a little misleading. But if at least one of your co-founders is a techie who can work for free initially, you can certainly set up enough of a company to see if your ideas/products are worth pursuing further.

If it’s so easy to run with a new business idea, why wouldn’t you? Nigam says: "There aren’t a lot of employment opportunities for young people and graduates. There is very little hiring going on in the government sector worldwide given that governments are close to bankruptcy. Corporations are also not employing at rates that they once were. Add to this that people hear more about their peers attempting to start their own apps, come up with new ideas, start new projects, and the result is an increase in the amount of young people launching new companies."

It is not just graduates. Waves of layoffs during the financial crisis left many unemployed with little option other than to take the plunge and start their own businesses. In 2009 and 2010 more businesses were created in the US than in any year before, except perhaps immediately after the Second World War. The figures for 2012 are still far higher than pre-crisis figures.

Ask angel and seed investors and they will also tell you that there seem to be more new business ideas than ever before. It’s impossible to quantify. It could be that individuals are simply more vociferous about their ideas today and that ease of communication means ideas are shared more widely now. But it is certainly arguable that the economic collapse forced people to come up with new ideas to make money, or to come up with ways to improve efficiency. Technology has also opened up new industries – such as the applications industry – allowing for hundreds of thousands of new ideas to emerge.

Two sectors in particular seem to be driving the increased rate of innovation. The first is technology. In its purest form this is companies that provide tech-based solutions and products – many of which have been enabled by cloud computing and smartphone technology that did not exist before 2000. Other industries have also sprung out of technology, such as the apps industry. The first iPhone launched in 2007; Apple now has around 800,000 apps in its store, Google has some 700,000, Amazon and Microsoft have about 200,000 between them. The global apps industry is expected to make $25 billion in revenue this year.

Yet tech isn’t confined to industries associated traditionally with technology. Technology has disrupted every industry, including retail and even traditional consumer industries such as food. It has enabled efficiencies to be brought into markets, often cutting out layers of middlemen. Michael Horn started his Brooklyn-based firm Craft Coffee three years ago. A former corporate lawyer and previous start-up owner, Horn identified a niche in the market for a premium roasted coffee delivery service. His firm ships coffee to thousands of customers in 25 different countries, but to Horn, Craft Coffee is a tech company.

"Technology is the core part of our business," he says. "Yes, the product we sell is not technology, it is coffee, but technology is integral in how we differentiate ourselves and win in an economy where consumers are constantly changing and using technology in a different way." Craft Coffee employs coders, and Horn says the firm is constantly "looking at how to make customer acquisition funnels smoother, analysing consumer data, adding features to make the web product more engaging".

 Scott Gerber, who runs the Young Entrepreneur Council in New York
Scott Gerber, Young Entrepreneur Council in New York
It’s a new age of entrepreneurs, says Scott Gerber, who runs the Young Entrepreneur Council in New York – an invite-only members’ club for business founders aged under 40. "The new companies setting up are hybrids. These are retail companies using tech to scale up faster. The founders see that if they add a tech component to their business they will have more opportunities."

It certainly enables business to rocket, but hybrids have their own challenges – namely talent. There is a dearth of coders and developers, even more so on the east coast of the US than out west in Silicon Valley. And when you can find them, they don’t come cheap. The average developer commands a triple-figure salary. Guillaume Gauthereau is the founder of Totsy, an online flash sales site specializing in children’s items with 5 million customers. It is a hybrid of retail and tech and one of the largest funded start-ups out of New York, raising close to $40 million. Gauthereau had a strong background in retail, but Totsy required tech expertise. "Six or seven years ago you could learn coding and build your website. There were few codes and it was simple. But now you cannot do it yourself without significant tech expertise. It is very involved and platforms have many elements to them. That’s a few million dollars for the platform and top-notch employees and then you have to work hard to keep them. Not a week goes by when my guys aren’t receiving other offers."

Guillaume Gauthereau is the founder of Totsy
Guillaume Gauthereau is the founder of Totsy
The second-largest driving force behind start-ups is the increased interest in positive social impact. Be it as a result of greater communication about disparity and social or economic problems, or a growing disillusionment with large corporations and governments, the younger generations in particular have an overwhelming desire to change the world not witnessed since the 1960s. And their desire to come up with solutions to age-old problems is spurring a wave of social impact start-ups.

MassChallenge is a Boston-based accelerator that each year accepts 125 start-ups to its platform across all industries and runs a four-month accelerator programme for all 125, surrounding them with resources to help accelerate their growth, such as free office space and access to funding, mentors and customers. At the end of four months, companies also compete for $1 million in prize money. Social impact is one of four main sectors it recruits from alongside hi-tech, life sciences and energy and clean tech. One of last year’s winners was Grit, a start-up that has designed a wheelchair that is usable on dirt roads such as those in rural communities in developing countries. Grit is pursuing sales in India. Tish Scolnik and Mario Bollini, who head Grit, say that the trend towards social impact is in part the result of a sentiment that businesses can both "do good and be successful".

Help in a crisis: Bounce Imaging’s camera ball
Help in a crisis: Bounce Imaging’s camera ball
David Young, chief commercial officer at Bounce Imaging, says much of the focus on social impact could be driven by the universities. Young is a student at MIT Sloan and his company is currently a finalist in the MIT Ideas Global Challenge – a competition for students to come up with solutions to a social need. Bounce Imaging has developed a camera-ball that can be thrown into burning buildings or into air pockets in rubble and captures 360-degree shots. It could help locate earthquake survivors, or aid firefighters or police in rescue missions. The venture has just closed a round of seed funding and plans to field test its product this summer.

For all the good ideas that are springing up, every entrepreneur will at some point hit a wall without funding. Start-ups have always been too risky for banks’ tastes so have suffered less from the drying-up of bank lending since the financial crisis than established businesses. If all goes well, the financing path for a start-up predominantly begins with friends and family, moving through angel investors and ending up with venture capital. That path, however, is undergoing a seismic shift.

Venture capital firms, on aggregate, have not had a good run. The latest data from Cambridge Associates shows 10-year returns for US VC funds to September 2012 were 6.1%, and one-year returns were 7.7% – far less than the US equity markets. According to Ernst & Young, US venture capital investment fell 15% in 2012 to $29.7 billion. Although that was higher than during the peak of the financial crisis, it was lower than the amount invested in the three years before the downturn.

John Landry is on the board of Common Angels, a group of angel investors. He also runs an incubator, has years of experience in large tech companies such as IBM and Lotus and has started many of his own firms. He says venture capital is a harder game than it used to be. "The number of start-ups used to be limited – particularly in tech. It was hard to build a business because there were not a lot of programmers around. There wasn’t the information available, and getting a competitive edge was very challenging." Landry recalls disguising himself with a fake moustache when going to an event to glean information.

"But if you did succeed in having a viable business idea, you also knew that it would be years before you would be obsolete or in danger of competition," he says. "Software companies were smaller and there were more of them. That meant there was a lot of demand for your company to be acquired – and that was good for the venture capital guys that were backing you."

Today, however, he says, there are fewer acquirers. The number of acquisitions of VC-backed companies fell in the US by 21% last year, to 433 deals. That’s the second-lowest total in seven years. "We seem to have huge corporations, and then a huge number of small companies all thinking they will get acquired – but there is no middle market to support acquisitions," says Landry. "Venture capital is not the attractive proposition it once was." Add to this a disappointing IPO market as a viable exit opportunity for firms, and end investors are not banging on the door to commit capital to venture funds.

But while venture capital firms might be struggling to make their propositions work, there is a large amount of capital that is willing to go into start-ups. It is in the seeding stage. Over the past three years, seed funding has taken off.

Food for thought: Freight Farm’s Brad McNamara
Food for thought: Freight Farm’s Brad McNamara
At the very earliest level of seeding, crowdfunding has provided start-up companies with a means to at least get a product to a prototype stage. Last year, $2.7 billion was raised globally on crowdfunding platforms. Jon Friedman, co-founder and CEO of Freight Farms, used crowdfunding to get his business off the ground. Together with Brad McNamara, Friedman developed the idea of converting shipping containers into automated hydroponics systems for commercial agriculture that can be kept in cities or warehoused. Growing kale, lettuces and herbs in a container can yield the same as one acre of farm, using less energy than a one-bedroom apartment and Freight Farms containers can be controlled remotely, cutting down on manual labour and smoothing out seasonal fluctuations.

Friedman says crowdfunding is now being used to boost what would have formerly been the "friends and family round of funding". If the idea is niche or has a social appeal, crowdfunding campaigns that are actively promoted through social networks can be highly successful. Freight Farms’ first round of funding was through Kickstarter, raising $31,000. Crowdfunding has also advantages beyond just financing. "We heard from people around the world during the campaign, and it allowed us to get proof that the concept was needed and wanted," says Friedman. Freight Farms has already sold some plug-in units and several are in operation for wholesale basil production or for local retail consumption. The firm is now with accelerator TechStars and in the process of talking to angel and VC investors.

Incubators and accelerators have also provided much needed seed and intellectual capital to start-up companies, and they are increasing in number.

Incubators tend to be non-profits and supplied by academic institutions and governmental bodies. Many good universities will have an incubator where alumni can use shared space and resources for a limited time and receive mentoring. Last year there were more than 1,250 incubator programmes in the US, compared with just 12 in 1980, according to the National Business Incubation Association.

Accelerators tend to be sponsored by companies that are looking to keep their finger on the pulse of innovation, or by investors. There are an estimated 50 to 120 accelerators in the US – most of which have sprung up in the past five years, such as TechStars, MassChallenge and Y Combinator, which select start-ups that can join their programmes.

Both incubators and accelerators mean that start-ups no longer need to raise money for infrastructure costs and space. They also provide networking, advice, education and introductions to angel and venture capital investors.

The increase at the very earliest seed stage of the crowd, the incubator and the accelerator has resulted in a surge in the number of angel investors. "Angel investing has now become popular to an extreme. Everyone wants to be an angel," says Landry. For one, there is now a generation of successful business owners that have several of their own start-ups on their résumés, and who want to be able to give the same support to those coming up behind them. Atlas Ventures’ Fagnan says: "Many of the successful entrepreneurs of the early internet days are far enough along in their careers to want to invest in start-ups. They also recognize the social impact of supporting emerging entrepreneurs in the way that they were supported."

Landry says that there is also more comfort for angel investors now. High-quality incubators and accelerators act as due diligence for angel investors. MassChallenge, for example, has some 1,230 applicants to join its programme that it whittles down to 125. TechStars’ acceptance rate for its New York programme this year was just 0.6%. Angel investors and venture capital firms are welcomed into accelerators and incubators to mentor the start-ups. Landry says: "That means you could be alongside the CEO for eight to 10 weeks, really learning about the company and guiding them – sometimes before you invest. It means the investment process is much smoother for angels now than before."

Bringing start-ups together in one space in an incubator or accelerator has also given angel investors access to a broad range of companies, reducing concentration risk, which used to be a common problem. AngelList, founded by Naval Ravikant, provides an online platform featuring hundreds of start-ups, giving angel investors access to the CEOs directly.

Some angel investors are now forming groups and acting as funds. Landry is part of Common Angels, which is not only a group of angel investors that share information, but also has a fund that is open to members and to outside money. "Some of these start-ups move so quickly you can miss an opportunity if you wait. Acting as a group if managed correctly can prevent that happening and means greater diversification and more shared knowledge," says Landry.

The growth in supply of angel investors has been met with an increase in demand for them. As companies need less money to get started than they used to, they don’t necessarily need to go straight to venture capital firms. A group of five angels can provide a much-needed $1 million. Angel investors are also perceived as being more in tune with start-ups’ philosophy. Freight Farm’s Friedman, for example, says he feels a closer alignment with angel investors who realize the vision behind the company and would be more supportive of time taken to explore the viability of providing crops to countries such as those in Africa, rather than rushing the firm to focus entirely on creating immediate profits. "Angel investors seem to get the bigger picture," he says.

The large middle level of start-up financing that the angel investors have created is causing some friction in the venture capital industry. The so-called ‘Series A crunch’ – where there has been a drying-up of this first venture capital round of funding after angel/seed money – is blamed on unsavvy angel investors valuing companies too highly and pricing venture capital funds out. Some angels say that it is actually the venture capital funds that are valuing companies too highly and so their shares become too diluted at the Series A round. And others argue that really there is no Series A crunch – just that the increase in seed money means that more companies are ready for Series A financing – so there is the appearance of a crunch.

Fagnan says the venture capital industry is having to evolve. "Venture capital firms are being forced to collaborate more with angel investors. That would not have happened before. But now we realize the benefits of having angels. They bring transparency, as does crowdfunding. There has been talk of alternative seed financing as being a threat to venture capital, but I don’t see it that way. It’s not competition because we are looking for the $500 million to $1 billion companies."

Ultimately, angel investors and venture capitalists have the same goal – to find companies that have a future. With so many more start-ups than ever before, that means more failures. Not everyone can win. There are only so many apps you can fit on your iPhone’s front page. And not everyone is cut out to be an entrepreneur. Craft Coffee’s Horn says that he works more hours now running his own business than he did as a corporate lawyer. "It’s not a lifestyle choice; it takes a lot of hard work to bring something new into the world. One of the problems with a boom in entrepreneurship is that some companies get founded that maybe shouldn’t. First-time founders often don’t realize the level of commitment required to build a great company."

MassChallenge’s Nigam is optimistic: "Not all of the ideas will funnel down into realities and successes, but even just an increase in failures will result in more second attempts." That’s the argument that many are giving for why the hotbed of start-ups is not a bubble – that there has been shift enough to create momentum so that the ideas that fail can be reworked more easily and cheaply than ever before.

And the entrepreneurship story in the US is one that nearly everyone wants to embrace. Not only does it fit the American dream, but business creation leads to much-needed jobs.

Landry leaves food for thought. "There’s talk that maybe there are just too many start-ups right now," he says. "Would it be better if all this talent went into a company of 100 people instead of 50 to 100 companies of one to two people? Perhaps the failures of companies will be the natural evolution – that people begin to join forces and start with bigger ideas and larger start-ups. It will be interesting to see how this evolves."