How Venture Capital Can End Up Hurting Startups

If you happen to be one of the millions of people who bought S&P tracker funds over the past decade, you're smarter than most venture capitalists. Since 2000, the average VC company has under-performed versus the S&P 500 . Welcome to the lie of the 1%, which says that everything is cozy at the top, and that you really need to be up there is you want to make any money. Turns out, you'd do better just betting on the market.

How venture capital is supposed to work
In an ideal world, I'm at a waterpark. In that same world, venture capitalists fund innovative businesses that need help in their early stages. Silicon Valley companies are a perfect example of the kind of business that VCs should be investing in.

Most start-ups aren't making money out of the gates -- Facebook (NASDAQ: FB  ) , for instance -- and they don't have a great idea of how to make money. What sets them apart, however, are their ideas and their executions. Facebook had a model that was executed in a way other companies couldn't match. VCs come into businesses like these, give them money they need to hire new people, buy equipment, and get the word out. They also offer advice, often acting as a board for the fledgling business.

In the real world, I'm mowing the lawn and VCs are sinking cash into anything that breathes. One of the biggest problems with the current model is that it's founded on a lottery mentality, with the idea that something has to hit big, so why not this thing? Venture capital is sinking cash into loss after loss, and yet we rarely hear about it.

The success brings the average back down
The myth is reinforced constantly by high-profile IPOs, like Twitter (NYSE: TWTR  ) and Facebook. Twitter insiders, including a few VCs, made bank on opening day, earnings hundreds of millions of dollars . But one early Twitter investor, Fred Wilson of Union Square Ventures, recently said that venture capitalism is itself a get-rich proposition, with a few firms doing exceptionally well while the rest wither on the vine .

Tim Worstall, a fellow at the Adam Smith Institute, thinks that there's a simple explanation behind the discrepancy. Things are only incredibly profitable until everyone sees that a thing is incredibly profitable. Once we all get wind of how much money is being made in gold, Bitcoins, venture capitalism, or the local lemonade stand, we pile in and drive overall profitability back down to the average level .

Venture capitalism had its heyday during the Internet bubble, when most of the world thought -- rightfully so, it turns out -- that investing in companies that didn't make any money was a bad idea. Once the bubble burst, the business model changed but the desire to get in on the ground floor didn't diminish. Now here we are, sinking cash into another moderately profitable business venture.

The dangers of taking VC money
From the outside, it looks like the insiders are winning. After all, we only hear about the big fish. Wilson made this point in his recent discussion, saying that once a firm is successful, it becomes the go-to firm . That means that the best businesses will seek out funding from the previous winners, putting all the firms that were already on their back feet even further behind. Thus, success in 2013 means that you're more likely to be successful in 2014, as well.

Beyond its failure as an investment vehicle, venture capital is also prone to all sorts of management problems. Jason Freid, co-founder of 37signals, has argued that taking other people's money too early in your company's life can lead you to focus on the wrong sorts of issues and developments. He says, "When you have all the resources in the world and all the people in the world, things slow down, they don't get faster. "

In addition to muddying the development and production cycle, VC money often creates new and unfortunate personal dynamics within a company. In his book, Hatching Twitter, Nick Bilton shed light on some of the problems that VC money caused at the start-up.

In their search for more, faster, different firms decided different people should be running Twitter. That led to surprise firings, a feeling of turmoil at the business, and a lack of trust among higher-ups. Twitter's success is impressive, but with a better environment, who knows what the company could have achieved.

While having a board of directors can be helpful for a growing business -- especially when the founder of the business is more innovator and less manager -- having heavily invested, impatient overseers can twist office relationships. Those sorts of problems are almost always ignored when media outlets cover successful IPOs. Who fell along the way and what could have been done better are shoved aside for headlines about the number of millionaires that Twitter now employs .

The bottom line is a repetition of the usual investor mantra -- you don't have to be rich to make money investing.

Investing for the future
LIke a hot IPO, the market stormed out to huge gains across 2013, leaving investors on the sidelines burned. But that doesn't mean it's too late to find huge winners. The Motley Fool's chief investment officer has just hand-picked one such opportunity, detailed in our new report: "The Motley Fool's Top Stock for 2014." To find out which company is going to own 2014, and get access to our free in-depth report, simply click here.


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