Embarking on the journey of an early-stage venture can be both exhilarating and daunting. Macmillan's comprehensive analysis of these ventures sheds light on the intricacies of achieving success. Whether you're an entrepreneur, a venture capitalist, or part of a startup team, understanding these findings can be pivotal.
Four Classes of Successful Ventures The study identifies four broad classes of successful ventures, each with unique attributes contributing to their success. Let's dive into these categories:
1. High-Tech Ventures with Strong Teams These ventures thrive on the backbone of a well-qualified team. Equipped with the skills and tenacity to face intense competition, these teams ensure the venture's sustainability and Growth. Their technical prowess and strategic insight are key drivers of success.
2. Ventures with Protected Products In this class, the venture team might need more extensive credentials, but the product boasts high protection. Whether through patents or trade secrets, this protection shields the product from competition, allowing it to flourish in the market.
3. Market Makers with Perseverance Market makers are ventures led by teams with exceptional perseverance. They carve out new markets by proving the demand for their product and securing protection for it once the market is established. Their relentless effort and market foresight are crucial to their success.
The above three classes of successes have a similar look-alike failure except for some things that could be improved in the venture team.
A final class of successful ventures is a small group of low-tech products in which distribution skills are critical. These ventures tend to focus on consumer goods generally.
On the flip side, Macmillan classifies unsuccessful ventures into three broad categories:
1. The venture team needs more experience or staying power; the product has no prototype or clear market demand. Despite these weaknesses, the ventures somehow slip through the screens and get funded.
2. Venture teams were noted to possess great credentials but needed more staying power and ran out of steam in the face of early competition.
3. A third class of ventures is where the team has exceptional staying power. The team, by perseverance, demonstrates that a market exists only to lose out to market competition because of a lack of protection for the product.
The Macmillan team developed another important finding and learning for venture capitalists and investors. The team identifies two major criteria that are predictors of venture success.
These are:
· The extent to which the venture is initially insulated from competition.
· The degree to which there is demonstrated market acceptance of the product.
Investors, therefore, should screen out management that may be well qualified but need more experience. Ventures where the basic viability of the project is in doubt should be weaned out. Then, ventures exposed to competitive attack and profit erosion must be weaned out before the investment can be recouped. Finally, criteria that avoid ventures that lock up the investment so that it cannot be cashed out for long periods. (MacMillan et al., 2002)
Living dead investments
Investments that do not meet expected yields or are loss-making are classified as 'living dead' investments. Such investments are usually caused by deficiencies in investee management, particularly in responding to market conditions.
In these cases, markets were too small or slow growing, some opportunities were missed, or the ventures faced unanticipated competition. In the initial stages, the venture meets sales targets, but its growth flags during the rollout stage, when it seeks to push for rapid Growth and gain market share. Achieving a successful exit in such cases is difficult.
A study shows that around twenty percent of investments are 'living dead' companies. Investors try to turn these companies around to achieve an exit. They sell or merge the company, replace the management, reposition the product, and revise the venture opportunity strategy. A successful turnaround or exit happened in around 60 percent of such situations. Success is achieved when the underlying causes of the living dead problems are successfully dealt with, and remedial actions are successful. (Ruhnka J C et al., 2022)
When alert, investment managers take turnaround actions and deploy the right team of experts to prevent their ventures from becoming dead investments.
Business plans
It has been fairly established that the entrepreneur's quality determines a funding decision. The question, then, is why startups emphasize the business plan.
A business plan generally needs to consider the entrepreneur's characteristics. Most business plans describe the product/service, the market, and the competition.
Many startups are looking to create business plans that focus more on the look and feel of the product, present dressed-up numbers of profits, and miss critical decision making elements. Such content is necessary but not sufficient.
The business plan should also clearly show that the entrepreneur has staying power, a track record, can react to risk well and is familiar with the target market. The entrepreneur's ability to lead the team needs to be clearly outlined.
Investor's critical list
Venture capitalists assess ventures in terms of the following categories of risk. These are:
1. Losing the entire investment
2. Lack of capability to bail out if necessary.
3. Failure to implement the venture idea
4. Competition risk
5. Management failure
6. Leadership failure
Therefore, venture capitalists are classified into those who carefully assess the competition and implementation risks, seek easy bailouts, and deliberately keep as many options open as possible. (Macmillan I C et al. 1985)
Entrepreneurs looking for investments should be ready with answers that address critical investment risks. Smart entrepreneurs should also gauge whether the investor is looking for easy bailouts or wants to keep many investment options open. The entrepreneur-investor relationship should be based on trust and mutual benefit.
Investors are tolerant of repeated business failures. They understand that several factors are responsible for the failure and are generally sympathetic to proposals from serial entrepreneurs. (Cope J et al., 2004)
Early-stage investing is inherently uncertain and carries a high risk of failure, with outcomes varying widely. The performance of venture capital portfolios is fundamentally different, with some suggesting that investment decisions are primarily subjective assessments heavily influenced by personal judgment.
Despite differences in investor experience, investment preferences, and risk tolerance, venture capital managers share a common understanding of the risks of investing in new ventures. These risks are spread across the venture-capital-funded development phase, fostering a shared perception among managers.
VC managers share certain common perceptions and reactions to risk in investing and strategies for controlling risk. Kahneman and Tversky (1979) and Coombs and Huang (1970) mention that these investors adopt a 'portfolio approach' to risk.
Investment decisions in established companies fundamentally differ from those involving established companies. These are generally made under widely recognized financial models.
In the case of startups, decision-making is complicated by the general need for quantifiable financial and market data in early-stage ventures. Decisions are hostage to unanticipated competition, market shifts, and economic cycles.
However, these risks can also be associated with traditional investing. Substantial variation in the magnitude of returns for early-stage versus later-stage ventures is seen.
Risk distributions are seen over the stagewise development of new ventures. Differences in behavior from aggressive to conservative investors in screening investment prospects are noted. Strategies utilizing a lower level of risk to reduce the chances of achieving negative or sub-normal final portfolio returns are pointed out. (Ruhnka, J C et al., 1991)
Exits and distress prediction
A study on UK ventures notes that the median time of exits for successful investments was four years. Large investments, large deal sizes involving multiple co-investors, and management buyouts are most likely high-performing investments (Mason C M et al., 2002).
Studies have shown that the need for a structured business development strategy is the cause of most startup failures. Only a small cadre of high-tech startups was noted to drive innovation and economic Growth. (Cantamessa M et al., 2018)
Financial distress can be predicted by examining operating cash flows. Profitability and financial leverage analysis has an 83% probability of predicting failure one year before its occurrence. The analysis can assist investors, creditors, managers, auditors, and regulators. These results were an outcome of a UK study. (Charitou, A. et al., 2004)
It has also been noted that replacing the CEO with an outsider is more than twice as likely to lead to a firm's bankruptcy. Larger levels of insider ownership are positively associated with the likelihood of a firm's survival. (Parker S et al., 2002)
References:
Parker, S., Peters, G. F., & Turetsky, H. F. (2002). Corporate governance and corporate failure: a survival analysis.
Corporate Governance: The international journal of business in society, 2(2), 4-12. Charitou, A., Neophytou, E., & Charalambous, C. (2004).
Predicting corporate failure: empirical evidence for the UK. European Accounting Review, 13(3), 465-497. Cantamessa, M., Gatteschi, V., Perboli, G., & Rosano, M. (2018).
Startups' roads to failure. Sustainability, 10(7), 2346. Mason, C. M., & Harrison, R. T. (2002).
Is it worth it? The rates of return from informal venture capital investments. Journal of Business Venturing, 17(3), 211-236. Cope, J., Cave, F., & Eccles, S. (2004).
Attitudes of venture capital investors towards entrepreneurs with previous business failure. Venture Capital, 6(2-3), 147-172. Ruhnka, J. C., & Young, J. E. (1991).
Some hypotheses about risk in venture capital investing. Journal of Business Venturing, 6(2), 115-133. MacMillan, I. C., Zemann, L., & Subbanarasimha, P. N. (2022).
Criteria distinguishing successful from unsuccessful ventures in the venture screening process. In Venture Capital (pp. 119-133). Routledge. MacMillan, I. C., Siegel, R., & Narasimha, P. S. (1985).
Criteria used by venture capitalists to evaluate new venture proposals. Journal of Business Venturing, 1(1), 119-128. Ruhnka, J. C., Feldman, H. D., & Dean, T. J. (2022).
The "living dead" phenomenon in venture capital investments. In Venture Capital (pp. 349-367). Routledge.