Startups are hogging the limelight of mainstream media. You read about startups in financial, technology, and even unrelated genre of lifestyle publications. Uber alone has over 100K references on CNN website! Startups have caught the attention of normal people with the extensive media coverage and the rags to riches stories of successful entrepreneurs.
For example, the media coverage on the Airbnb vs Hilton comparison. Hilton is almost 100 years old and worth $25 billion, with 500+ hotel properties, while Airbnb is 10 years old, owns no properties, but is worth $38 billion! It was started by two youngsters as they could not afford the rent and had to let out their living room!
Stories like these have sparked interest in people from all walks of life. But really, how large is the startup ecosystem? Does it truly deserve all the attention? When it comes to numbers, startup ecosystem is both huge and tiny, but what is more important: it is absolutely unique, with its own rules of the game.
70 K US Startups Received $109 Bln. investment from Angels and Ventures in 2017
There are two major categories of investors into startups, individual investors or “angel investors”, and organizations or “venture funds”. Angel investors usually invest their own money, while venture funds generally invest using money given to them by other bodies to manage. Angel investors normally invest at the very beginning of a company life cycle, while venture funds usually invest midway or on the later stages. In 2017, 288 K angel investors provided $ 24 Bln. in funding to 62 K US companies. On top of that, 1.7 K venture funds poured $ 85 Bln. dollars into 8 K companies.
Bigger Than GDP of 75% Countries on the Planet…
$ 109 Bln. — is it a large number or a small number? To emphasize the huge value that the US investors poured into startups in the US, let’s take a macroeconomic perspective. There were 149 nations with a GDP lower than 109 billion in 2017.
It means that in those 149 countries, the entire economy of a nation state generated less money than the US invested into startups during a year. There is a gradual increase in money invested in startups year over year, though for the last few decades it was always above $ 40 Bln. One can say that US startup ecosystem is a whole “country” in itself.
…But Smaller Than Revenues of 50 World’s Largest Companies
There is, however, a different way to look at this. $ 109 billion is almost as much as Alphabet (which means Google) generated in sales in 2017. And 51 companies from the Fortune Global 500 list had even higher revenues. Each of these companies generated more money in sales, than the entire US economy invested into startups. From this perspective, we can understand that the US venture ecosystem is not very large.
The main goal of an angel or venture investor is not to get dividends from a startup’s operational activities. An investor wants to get stake in the company, and then to sell it in a few years. The objective is to get an exponential figure of the original amount, assuming the company’s valuation has grown that much. The point of time when the company is sold so that investors can sell their shares is called an “exit”. In other words, the exit is a way of “cashing out” an investment. Examples include an initial public offering (IPO) or being bought out by a larger player in the industry. In 2017, around 800 venture-backed companies in the US had exits. It’s not a lot.
A Lot of Money, Not So Many Players
Only 50% of the 62K companies which received investments from angel investors got first-round angel deals. This means that these 31K companies received investment for the first time in their company life cycle, they entered the ecosystem in 2017. The other half was not “fresh recruits”, they already got their first angel money before 2017. The ratio is even more dramatic in venture funding, where only 2.4K out of the 8K companies got first round deals. This means that 70% of the startups which got VC investment, were already “in the game” and not newcomers. They used VC funds to further develop their business. In terms of dollars, the numbers seem very large. But in terms startups, the numbers are quite modest.
Though there were 1,700 active venture funds in 2017 in the US, they all were controlled by about 900 managing companies. Most of managing companies had a few venture funds each and the investment decisions were made by employees of the managing company. Regardless of the number of venture funds, there was only 900 decision-making bodies. Similarly, though there are almost 300K angel investors, vast majority of them invested infrequently and are under radar. The more active angel investors are usually part of the approximate 250 angel groups in the US. Again, in terms of invested money, the US startup venture ecosystem looks large, but in terms of players, it is small.
Venture Ecosystem is Less Than 1% of Overall US Business Ecosystem
Venture funds are only one of many categories of investment funds. Most of the money goes to other fields catered to by investment companies. The overall size of this economy, including all assets under management in investment firms in the United States in 2017, was $ 37.4 trillion. At the same time, venture firms managed assets worth only $ 359 billion, less than 1% of the overall US AUM (Assets Under Management).
Let’s consider one more point of view. There were 7,758K companies with employees in 2016 in the US. In 2017, only 70K companies received angel or venture funding — again, less than 1%.
Hence, one can argue that the venture/startup economy is tiny and almost insignificant for a vast majority of players. This is because venture model does not work for every business, it is only applicable to a narrow group of potentially groundbreaking companies. Most of such companies die, but a few survive; they become huge and make the history.
It is clear that depending on the perspective, we can say that the US venture ecosystem as very large, or very small, but essentially, that is not important. What really matters, is what is happening there, and how it differs from other industries. The venture economy is unique and works differently from other economies. The “startup country” is governed by its own laws and rules.
Long-Term Equity Investments into High-Risk / High-Reward Opportunities
Investments in venture world have the following distinct features:
- High-risks / high-reward opportunities
Venture startups usually promise to develop breakthrough products/technologies. Hence, if they are successful, they will generate outstanding returns to the investors.
- Investing into large number of companies to find just a few “big wins”
Most of the venture startups, unfortunately, die. Investments into these startups become investors’ losses. To compensate for these losses, at least one of the portfolio companies most become a super win that generates 100-X return.
- Equity financing (as opposite to debt)
When angels or VC-s invest into a startup, the company issues new shares and sells them to the investors.The company does not “owe” investors the money. They become partners fully vested into the company’s future success. When(if) a few years later the company becomes huge, the price of each share grows exponentially and investors make a profit by selling the shares at the exit point.
- Long-term increase in company’s value (as opposite to short-term profitability)
Startups’ stock market is a private market, it’s very hard (almost impossible) for investors to sell the shares before the exit point. Hence, making short-term profit is very rare here.
- Helping companies to grow by leveraging investor’s expertise and network (as opposite to proving just money)
Investors generally can’t sell the shares they own before the exit point, but they can contribute to how fast the exit happens and how much the company grows by that point.
Case Study: ARD and DEC
To better understand how the venture industry works, we need to study its history. A very good overview of the industry origins is provided in an iconic paper “The Rise and Fall of Venture Capital” written by Paul A. Gompers over 2 decades ago. In particular, it discusses American Research and Development, the company which is believed to be the very first institutional venture investment firm in the US. Here are a few quotes from this paper:
- “…The first modern venture capital firm was formed in 1946, when MIT president Karl Compton, Massachusetts Investors Trust chairman Merrill Griswold, Federal Reserve Bank of Boston president Ralph Flanders, and Harvard Business School professor General Georges F. Doriot started American Research and Development (ARD). The goal of the company was to finance commercial applications of technologies that were developed during World War II…”
- “…Doriot was the heart and soul of ARD and is justifiably called the “father of venture capital.” Doriot’s focus was on adding value to companies, not just supplying money…”
- “…ARD created the standard venture capital paradigm with its highly successful investment in Digital Equipment Company (DEC) in 1957. ARD invested $70,000 for a 77% stake in DEC. Doriot’s disdain for quick profits was displayed in the displeasure he expressed with Kenneth Olsen, DEC’s founder and president, the first time DEC reported a profit. Doriot was concerned that not enough money was being reinvested in research and development and that the company might suffer in the long run. Over the ensuing fourteen years, the investment in DEC increased in value to $355 million. Almost half of all the money earned by ARD during its 26 year existence was earned by its investment in DEC…”
How the Industry Evolved: Change in “Prudent Man” Rule and Dot Com Crash
After a few initial successes, venture industry went through two formative events. The first was in 1978, when US government explicitly allowed pension funds to invest up to 10% of their capital into venture funds (the famous change in “Prudent Man” rule). Before that point, the size of the industry was measured in hundreds of millions of dollars. Since 1979, billions of dollars started to influx into venture funds every year. The “gold rush” period started, when the industry was exploding, and venture firms generated outstanding returns, frequently exceeding 25% per year.
But the super growth led to a collapse of dot-com bubble in 2000, which pushed away opportunistic investors and forced industry to revisit its practices; the remaining players developed more elaborated and mature strategies.
This evolution resulted in establishment of very sophisticated rules and mechanisms, aimed to protect investors’ interests while keeping them aligned with overall company’s growth strategy. The complexity of these mechanisms manifests itself in hundreds of pages of legal documents, which all involved parties have to sign when a startup receives an investment. Not only these rules are complicated, but also often they seem counter intuitive and contradictory to “conventional wisdom” of traditional business.
Conclusion: It’s a Large But Peculiar Industry, with Unique and Rapidly Developing Rules
Depending on the perspective, one can say that venture ecosystem is:
- Huge: $109 billion was invested in US startups in 2017. 75% of world’s countries had GDP which was smaller than that.
- Tiny. Less than 1% of US companies receive angel/venture investments, and venture assets constitute less than 1% of all US AUM. Venture model (high risk / high reward investments) does not work for majority of businesses.
Regardless of the perspective, it is:
- Unique and Evolving. It has unusual rules and non-conventional practices, which are developing rapidly.
- “The Rise and Fall of Venture Capital” Paul A. Gompers (1994)
- “The Angel Market” The UNH Centre for Venture Research (2005 — 2018)
- “NVCA Yearbook 2018” National Venture Capital Association (2018)
- “NVCA Yearbook 2015” National Venture Capital Association (2015)
- Fortune Global 500 list (2018)
- US Census Bureau online database (2018)
- International Monetary Fund online database (2018)