Ninety percent of new entrepreneurial businesses that don't attract venture capital fail within three years.
A software engineer at the government contractor EG&G, Don Brooks had been working on computer systems for the Idaho National Engineering and Environment Laboratory, a Department of Energy facility, when he suddenly had a brainstorm that he knew would help him as well as others solve an all-too-common problem. 1 Using the "gopher" technology that had long made the exchange of files and programs across mainframe devices possible, in 1991 Brooks developed a way for one computer to access data stored on another and to interact with that information. As he publicized his innovation among his fellow employees and across the computing community, people admired the quality of his work. In fact, in head-to-head comparisons, his software program garnered ratings far superior to those of Mosaic, a similar tool then under development at the University of Illinois. Reviewers of Brooks's prototype raved about its ease of use and reliability. The engineer felt certain that, with EG&G's backing, his idea would soon be a major success in the marketplace.
But his hopes were not realized. Four years later, another company working on the same technology went public to great acclaim and fanfare. The firm? Netscape Communications, under the leadership of Marc Andreessen and Jim Clark. 2 Because its new product was based on the Mosaic technology developed at the University of Illinois, Netscape became embroiled in a messy intellectual-property dispute. Despite these challenges, on its first day of trading, Netscape soared to a market capitalization of $2.1 billion.
Why did Andreessen and Clark succeed where Brooks failed? Part of the answer lies in the role of Netscape's initial financiers, the venture capital firm Kleiner Perkins Caufield & Byers. While Brooks struggled to interest EG&G in backing his concept (EG&G considered Brooks's idea outside its core business), Kleiner Perkins moved decisively to fund the fledging Netscape, realizing that market timing was critical to the success of the new venture. In addition to providing financing and advice on product development, marketing, and finance, Kleiner introduced Netscape to key Silicon Valley players, as well as the investment banking teams at Morgan Stanley and Hambrecht & Quist. Even more telling is that Jim Clark, cofounder of Netscape, had been a highly successful entrepreneur at Silicon Graphics and could have easily financed the firm himself. Instead, he understood the value that Kleiner Perkins could bring to Netscape. Lacking such assistance, Brooks soon fell far behind his rivals.
Like Brooks, most high-technology entrepreneurs are convinced that their ideas hold immense promise. Often, their excitement is well founded. An innovative product or new service concept may have enormous market potential and may far outperform competitors' alternatives. Moreover, the intellectual talents of the founding team may be stellar.
However, many of these entrepreneurs discover they need to attract money to fully commercialize their concepts. Thus they must find investors—such as their own employer (if the idea was created while on staff), a bank, an "angel" financier, a public stock offering, or some other source. But potential investors often greet entrepreneurs' business plans with skepticism, or worse, turn them down entirely. Alternatively, some investors demand a large equity stake in the project and tight control rights in exchange for a modest sum of money.
Before the emergence of the venture capital market, the vast majority of entrepreneurs seeking financing from traditional sources failed to realize value from their ideas. Indeed, many product or service innovators privately (and sometimes publicly) referred to investment professionals as "vulture capitalists." These entrepreneurs' frustrations are understandable: Most financiers do not understand the fragile growth process that start-ups experience.
But entrepreneurs themselves have also contributed to their own financing problems. Many of them simply don't have a clear picture of the risks inherent in their business models—risks that pose some serious concerns for potential investors—or they lack a thorough understanding of the four basic problems that can limit financiers' willingness to invest capital, which we outlined in the introduction to this section:
- Uncertainty about the future
- Information gaps
- "Soft" assets
- Volatility of current market conditions
All companies must grapple with these difficulties, but young, emerging enterprises are particularly vulnerable to them, as these problems limit their ability to receive value from their ideas and innovations. This chapter will help both entrepreneurs and potential investors understand these financing hurdles and the various mechanisms that can be used to reduce potential conflicts that arise due to these four factors.
There's no getting around it: Innovation is risky business.
— Gompers & Lerner
Uncertainty About The Future
There's no getting around it: Innovation is risky business. All entrepreneurial individuals and companies face uncertainty about the future—not only in terms of their own development possibilities, but also in terms of market and industry trends. 3 But a word of caution: Many people who are interested in the investment world confuse uncertainty with that which is unknown or unknowable. In the case of something that is unknowable, no amount of research or analysis will lift the fog. However, for young, entrepreneurial firms, uncertainty doesn't have to mean unknowability. Rather, uncertainty can be viewed as a measure of the distribution of possible outcomes for a company or project. The greater the uncertainty, the wider the distribution of potential outcomes.
This distinction between uncertainty and unknowability is critical. A careful analysis of a particular entrepreneurial project can identify key phases of uncertainty, yield a list of potential outcomes of each phase, and provide an assessment of the likelihood of those various outcomes. This kind of thoughtful review constitutes the first step in determining a project's financing alternatives.