If somebody is not paying you to build the product, you are betting that your product is something people might buy. Then, you are in the gambling business,” Professor Saras Sarasvathy
BEAM14 Feb, 2017
This article originally titled "Startups are nailing their own coffins with VC hammers. Here’s a way to escape that fate" was first published on Tech In Asia
The supersmart, know-it-all entrepreneur. I run into a handful of them every day. They say they know what the market wants. They know what the market is. They know who is the customer, what she wants, and how much she will pay for it. All this, when they haven’t yet got one paying customer for their product. And many a time, the product is nonexistent.
They think the products they are building are worth an X amount of money and there is a market of millions or even billions of dollars out there. They make these projections – or predictions, to be more honest – based on many hypotheses. Most of it is just fantasy.
In predicting the future, these bright, young entrepreneurs are nailing the first, fat nail into their startups’ coffins. Professor Saras Sarasvathy is sitting on enough data to tell me this.
“In Bangalore, they are doing more of it because they think predicting the future is the way to get venture capital funding. They are not even predicting the future to get the customer; they are predicting the future to get VC money!” Prof. Saras says.
“They have spent no time talking to the customer or actually building a product that a real customer wants. That’s my worry,” she tells me.
The professor has been studying expert entrepreneurs for over two decades and is clear about where the cracks begin.
She is one of the top scholars in the world on the cognitive basis for high-performance entrepreneurship. Her thesis on expert entrepreneurs was supervised by Herbert Simon, 1978 Nobel Laureate in Economics. She is a professor at the University of Virginia’s Darden School of Business, and also teaches doctoral programs in entrepreneurship and business strategy across Europe, Asia, Latin America, and Africa.
We’re sitting in a dining hall inside the Management Development Centre (MDC) of Bangalore’s prestigious Indian Institute of Management (IIM). There are entrepreneurs, educators, wannabe entrepreneurs, startup enthusiasts, and management aspirants flowing in and out of the hall as we talk. A perfect setting to discuss what’s going wrong in India’s startup landscape. Before we proceed, let me admit it. I am guilty as well.
The professor begins our chat by throwing a few irrefutable numbers at me.
In India last year, between 285 and 416 startups – depending on your source of information – raised venture capital funding. Let’s say two-thirds of them raised first rounds of funding. The success rate for VC-funded startups is less than 10 percent. If nine of 10 fail, there will be around 30 startups left standing.
“Those are the only ones that will actually do anything wonderful with VC money – in the entire country,” she says. I squirm.
Then she throws the killer punch.
“The probability of you getting the VC money is low. The probability of you succeeding after getting the VC money is low. And – the biggest nail in the coffin – suppose you get the VC money and you succeed, the probability that you will still be CEO of the company is 50 percent of that.” Why? “Because the moment you sign a term sheet with a VC, there is a 50 percent chance that you will not be CEO the next year.”
These are not numbers that the professor pulled out from thin air. They are actual numbers from the National Venture Capital Association in the US.
This is the exercise that the professor makes entrepreneurs do. First calculate the probability that you will get VC money. Then calculate the probability that you will succeed. Then the chances that you will actually be running that successful company. “That probability is actually worse than winning the lottery,” she points out.
Then why the hoopla around venture capital funding, she asks.
Mea culpa. As a journalist covering startups, I let out a cheer every time I hear news of a startup raising VC funding. So I am a key cog in the machinery that has produced the nonsensical hype around venture capital.
Even in the US, which has the strongest venture capital market in the world, only about 1,000 of the 500,000 employer firms – companies that actually employ people and not just file taxes as an entity on paper – get any venture capital funding. The rate of failure among them is also 9 out of 10.
“But if you look at the average company – not just the VC-funded ones – the failure rate drops to 50 percent. So I don’t understand why people chase venture capital funding,” the professor exclaims.
She points out that of all the companies that trade publicly, about two-thirds don’t take any venture capital money. “They are getting their money from somewhere else. So the question you ask is how are they building their company,” she says.
It turns out that these successful companies get their money from customers. Or suppliers. Or both. Microsoft is a big example, the professor points out. “Who funded Microsoft? IBM. IBM paid Microsoft for their software because they wanted that. That is how Microsoft was built. When the customer actually pays for what you are building, you have built something that the customer actually wants. Then you can turn around and sell that software to others too,” she says.
This is the kind of stakeholder partnership that the professor is championing as a viable alternative to venture capital funding, which she finds akin to gambling as it’s based on predictions.
She explains the ideal scenario to me: a supplier gives you credit to source material, a customer gives you an advance, and you build. Then you have proof that your product is valuable. If a customer is already paying, you know that what you are building is relevant. You are no longer placing a bet.
“If somebody is not paying you to build the product, you are betting that your product is something people might buy. Then, you are in the gambling business,” she says.
“VCs are willing to place that bet. And that’s okay,” she adds. Her gripe is not with investors or even the venture capital model. But with “the impression that the only way to build a successful startup is through VC money.” That’s the perception she wants to fight.
“I have nothing against the VC-funded startups. There are a certain kind of companies for which venture capital is perfect and the firms also do very well.” Uber, Airbnb, and so on. But the deafening noise around those few biggies are turning out to be the death knell of countless startups whose primary activity is chasing VC money, she feels.
A lot of the time, entrepreneurs are not thinking hard enough about what they need the funding for. “They think they are going to use the money for X,Y, and Z. But in reality, because they have money, they end up building software that’s not really customer-relevant,” the professor tells me.
“In Bangalore, most entrepreneurs don’t think that bank funding is even an option. Bank money would be very cheap money and patient money compared to VC money,” she points out.
Back in 1997, she travelled across the US, interviewing 30 entrepreneurs who founded companies with multi-million-dollar valuations. She studied each of them, quizzed them on decision-making, and drew out patterns. From this, she came up with a theory of entrepreneurial success called effectuation.
In a nutshell, the effectuation theory revolves around a few principles successful entrepreneurs practice:
1) Bird in hand: This encompasses all your means – the resources you have, skills you possess, connections you can use. Expert entrepreneurs start with this. They assess their means first and then imagine the possibilities that could come out of it.
2) Crazy quilt: Expert entrepreneurs partner with stakeholders like customers and suppliers to build the venture. They get pre-commitments right in the beginning. So the uncertainties are minimal. Together with stakeholders, they co-create.
3) Affordable loss: At every step, expert entrepreneurs have a clear understanding of what they can afford to lose. They are not chasing huge all-or-nothing opportunities. Instead, they take actions where even if they don’t get what they aim for, they can afford to lose what they have spent in time, money, and effort.
4) Lemonade: When the unexpected happens – as it always does – expert entrepreneurs interpret it as clues to create new markets instead of looking at it as bad news.
5) Pilot in the plane: Expert entrepreneurs just focus on activities they can control.
These five principles were at the core of successful ventures, the professor found. She has been studying entrepreneurship for the last 20 years and sharing her findings with the world.
Two years ago, entrepreneurs Manjula Sridhar, Prasanna Krishnamoorthy, and Thiyagarajan M attended a workshop by the professor on effectuation. They were stunned to encounter a framework that explained the patterns of decision-making that influenced the success or failure of ventures so succinctly. “If only someone had taught us this before we started our first companies,” they thought.
All three of them were volunteers with think tank iSPIRT, and they went up to Sharad Sharma, iSPIRT’s benign founder. Together, they along with Professor Saras created a program to help first-time entrepreneurs manoeuvre entrepreneurship. They named it iKen.
The program begins with a six-week boot camp, with mandatory assignments for participants aimed to bring clarity on ideas and develop action plans. Each task is designed with effectuation principles in mind. Every Sunday, the cohort meets, discusses progress, and does a course correction wherever required. You graduate if you complete all tasks. Even after the six weeks, you are encouraged to attend meetings and help others and yourself succeed.
“It’s a gym, not a school,” Prasanna tells me when I go to attend the first lesson of cohort 8. “We will tell you what skill is needed. It is up to you to do it. We’re only going to be like the trainers at gyms who will stand by and tell you techniques to lift weights. You have to lift the weight yourself,” Manjula adds.
The iKen program started in Bangalore in May 2015, and now has chapters in Pune as well as Atlanta in the US. Like all iSPIRT initiatives, this too is run entirely by volunteers. Manjula and Prasanna lead it along with a growing bunch of anchors, who were part of the earlier cohorts, found it transformative, and stayed on to help others and learn themselves.
I enrolled for the camp in November last year and have been learning to rewire my brain. Brutal feedback from the founders and anchors definitely speeds up the process, I swear.
The success of iKen is measured with a whole new scale. Unlike incubator or accelerator programs where raising funding is the usual yardstick, iKen aims for three outcomes:
1) You realize that entrepreneurship is not your cup of tea and drop it to go back to a regular job.
2) You realize what’s wrong with your idea of startup and pivot.
3) You co-create your startup with key stakeholders such as customers and suppliers.
“Any of these three is a success for iKen,” Manjula explains. The program already has examples for all three.
There are many more such examples from iKen. “Quite a few simply drop out of the program as well,” Manjula says. “Not many can handle it well when someone calls out their bullshit,” Rohan quips.
Can the growing popularity of the effectuation framework of entrepreneurship kill the venture capital model, I ask the professor. She laughs before saying: “I want VCs to survive. I think we need multiple models of funding for startups. While I think the effectuation model catching on won’t affect the VC model in any way, I hope it will affect the hype around the VC money.”
Many entrepreneurs who could be building strong, sustainable businesses are not doing it currently because they are just spending all their time chasing VC money. “Getting VC money is like winning the lottery. Chasing that is an enormous waste of an entrepreneur’s energy,” she says.
Think logically, she urges me. VCs aim to fund startups which they think are shooting for the moon. “Very few companies will become a billion-dollar or multi-billion-dollar business. What is wrong with aiming to build a company that would pay everybody’s bills, last for some 20 years, and may be get sold for US$20 million?” she asks.
What is wrong with that as a dream for a startup? We could do with more of those, instead of only chasing after unicorns.