Thursday, June 05, 2003

Fixing entrepreneurs

Joel has a nice post on why venture capitalists are dumb: they prefer taking risky longshots with big payoffs over sure things with lower payoffs even though entrepreneurs would prefer the latter. Since entrepreneurship is the lifeblood of economic progress, this mismatch in financing is bad.

I have no quarrel with this statement. Certainly during the bubble, lots of new people entered the VC arena and lavishly funded bad deals. Everyone was sure they could get rich quick (it was a bubble after all) and people took risks which, in hindsight, look crazy.

But because VC's are interested in the performance of their portfolio as a whole, they are willing to take greater risks with individual companies because they are diversified in a way individual management teams are not. I wrote about this a while ago. While this may be bad for the entrepreneur, it's good for the VC and probably good for the economy as a whole too. The larger economy is highly diversified so does best when everyone is taking risks because it can (at a macro level) aggregate those risks and therefore reduce them. This is no fun for people taking the risks themselves and failing, but good for the rest of us.

I will also add that those "sure things" that Joel mentions exist more often in the mind of the entrepreneur than in reality. They (the Small Business Bureau, I think) did a survey of 2995 entrepreneurs who recently started new businesses, 46% in retail, 19% in service, and 7% in construction, and asked them what they thought the odds were of their business succeeding vs. any other startup in their category succeeding.

Odds, your business succeeding, any business like yours succeeding
0 0 0
0.1 1 3
0.2 1 6
0.3 1 7
0.4 1 6
0.5 10 30
0.6 4 9
0.7 9 11
0.8 19 12
0.9 20 5
1.0 33 11

Poorer 5%
The same 27%
Better 68%

Forgive my lousy typesetting. But basically everyone thought that they were above average (surprise surprise) and we know at least half of them are wrong for sure. I'm not sure how many new businesses fail within the first two years, maybe 80%, but I'm sure every one of them thought they were a stable, conservative 80% sure shot success. VCs are probably closer to the truth when they assume most of their portfolio companies will fail.


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