Why Equity Financing Eludes Startups

Despite the hype surrounding equity capital, very few startups raise money from outside investors. The Census Bureau's most recent Survey of Business Owners shows that only 2.7 percent of U.S. companies obtained startup financing from a venture capital firm, strategic investor, friend, or family member. Even raising external equity after the startup stage is uncommon. Data from Angelsoft, a provider of angel investment tracking software, reveal that only 2.8 percent of those seeking money from angel groups receive it. The share of successful requests for venture capital is even lower. A primer on venture capital produced by the Small Business Administration estimates that only 0.1 percent to 0.2 percent of funding requests made to VC firms result in an investment.

So why do so few succeed at getting others to invest in their businesses?

The Poor Track Record

To start, most outside investors won't put money into a startup unless there's a way for them to cash out of the investment. But most startups aren't designed to be sold or to go public, precluding the investors' ability to sell their shares.

In addition, most startups don't plan to grow enough for external investors to consider putting money into them. Estimates by several sources show that startups need to expect to generate at least $10 million in sales within six years of starting for most external investors to consider investing. A recent analysis by Paul Reynolds of the Panel Study of Entrepreneurial Dynamics, which tracks founders of new businesses, showed that only 4 percent of entrepreneurs expect to achieve that level of sales in that time period.

Most important, the bulk of new businesses aren't attractive to external investors because they won't ever return enough money. Studies, including this 2003 working paper from the Small Business Administration, show that only 2 percent to 5 percent of the companies that seek equity financing have the characteristics necessary to attract such an investment.

Outside investors try to invest in companies with the potential to make a lot of money because their successful investments need to make up for a large number of unsuccessful ones. Consider this scenario: As an investor, your target rate of return is the 8 percent per year that the stock market has tended to earn over long periods of time. Yet you're aware that 80 percent of your investments will return nothing. That means you need to put your money into companies that will return 40 percent annually. Otherwise, you can't make up for the losers you invested in.

Very few new businesses have the potential for generating a 40 percent per year return. In my book Fool's Gold: The Truth Behind Angel Investing in America, I cite several different estimates, which show that less than 2 percent of startups will do so.

Why Do So Many Entrepreneurs Look for External Equity?

If so few entrepreneurs have a chance of raising external equity, why do so many look for it? After all, the time spent looking for external capital by entrepreneurs who won't raise it is a wasted resource.

Part of the answer is that most entrepreneurs aren't wasting a lot of time or effort. Once an entrepreneur has written a business plan, the marginal cost of sending it to a potential investor is pretty low. And because most investors reject the vast majority on the basis of a quick evaluation—Angelsoft's data show that less than 14 percent of companies that apply for angel group funding pass the first screen—most entrepreneurs incur little more than the cost of e-mailing a business plan to a potential investor.

But some entrepreneurs tailor their business plans to potential investors as a way to pass through the initial screen. Those that do then incur substantial costs of meeting with, presenting to, and otherwise trying to persuade investors to finance their businesses.

Some do it because they are overoptimistic about the prospects of their ventures. Founders almost always think that their companies have greater potential than they actually do. For example, thousands of companies that seek financing from organized angel groups every year project having at least $100 million in sales within six years of starting—a feat achieved by only 400 of the more than half a million new employer businesses founded annually.

Ignorance Is Not Bliss

Although I'm now in the realm of speculation rather than data, I think that a sizable number of entrepreneurs with very little chance of raising external equity put a lot of time and effort into trying to get it by going to networking events, entering into competitions, and paying to present their business opportunities to angel groups and at venture fairs. Many, if not most of them, are wasting their time and money.

Rather than searching for capital they are very unlikely to get, many entrepreneurs would be better off redesigning their business models so they can pursue their opportunities without seeking external equity. For example, they might substitute variable costs for fixed costs—finding someone to manufacture a product in their plant rather than building one's own or paying people on commission instead of on salary. Alternatively, they might eliminate costs by borrowing facilities and equipment instead of renting them.

Entrepreneurs' most precious resource is their time—time they need to build a product, go after customers, hire employees, or any of the myriad other things necessary to building their companies. They can save a lot of it by understanding whether their business fits into what external investors want—before pursuing them.

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