What Have VCs Really Done for Innovation?

SandHillRoadThis is a guest post by Vivek Wadhwa, an entrepreneur turned academic. He is a Visiting Scholar at UC-Berkeley, Senior Research Associate at Harvard Law School and Executive in Residence at Duke University. Follow him on Twitter at @vwadhwa.

Back in 1986, when Bill Gates was still making sales calls, he pitched my group at First Boston on why we should bet the farm on Windows. Despite the risk involved, we gave his fledgling startup the deal. This wasn’t because of his financial backers (he didn’t even drop any names), but because we believed in his vision and nerdiness. In the same way, Google became a huge success long before the deep pocketed VC’s arrived to ride Larry and Sergey’s coattails. They simply had a great technology and winning strategy.

So I’m miffed by the National Venture Capital Association’s (NVCA) claim that companies like Microsoft and Google “…would not exist today without the funding and guidance provided during their early stages by venture capitalists.” And I’m amused that the NVCA claims credit for creating 12 million jobs and generating $3 trillion in revenue (that’s only 21 percent of U.S. GDP). In the software industry (which includes Internet/Web 2.0), they stake claim to 81% of the all jobs created. Yes, 81%. Can they please give the entrepreneurs who risk their life savings, max out their credit cards and put their families in the back seat a little more credit? We’re not talking about divvying up the company’s stock here, just a pat on the back.

How’d they come up with these numbers? They added up all the revenue generated in 2008 by any company a venture capitalist ever invested a dime in. So if John Doerr bought Bill a lunch in 1985, they’d count Microsoft as part of their empire. Maybe I’m exaggerating a bit. But seriously, the NVCA numbers aren’t even remotely credible. How can VCs claim credit for the revenue of a company which they cashed out of twenty or thirty years ago? And even then, claiming credit for 81% of tech jobs and 21% of GDP? More to the point, would those jobs never have been created if the VCs had never appeared on the scene? How can the NVCA prove causality?

The answer is, the NVCA can prove nothing and a growing pool of data suggests that VCs at best have little to no impact on these companies and at worst have a negative impact. I just completed a research project in which we interviewed the founders of 549 successful companies in several high-growth industries – the ones VC’s are most likely to fund. We selected companies that had made it out of the garage and were generating real revenue. Guess what? Hardly ten percent of the serial entrepreneurs took venture money in their first startups. In their subsequent launches, the proportion who took venture money went up to a quarter. In other words, three-quarters of even the most experienced entrepreneurs didn’t rely on venture capital (new report to be released in October).

NVCA claims that VCs created entire industries like biotech and turned the software development and semiconductor industries “…into prime drivers of the U.S. economy.” I am a big fan of Vinod Khosla’s and believe he is a real pioneer. But he is the exception rather than the rule. The fact is that VC’s follow innovation, they don’t lead. They go where they smell blood.

The correlation between venture capital investments and productivity growth was researched by Masako Ueda, a professor at University of Wisconsin-Madison. She analyzed total factor productivity (or TFP, which is a measure of innovation) in several industries. She found that VC investment actually lagged behind TFP growth by two years and later rounds of VC investments actually caused a decline in TFP. In other words, venture capital slowed down the innovation process. What’s more she found that delayed TFP growth is correlated with first round VC investment. In simple English, this means that money goes where the innovation is, not the other way around.

The NVCA report also touts all sorts of statistics about how their investments outperformed the overall economy. But this isn’t what Kauffman Foundation’s Paul Kedrosky found when he researched the Inc. 500 list of the fastest-growing private companies. His study determined that from 1997-2007 venture industry lagged the small-cap Russell 2000 Index by 10 percent (this includes returns from the dot-com hey-days). What’s more the study found that only 16 percent of these 900 companies had venture capital backing. And less than 1 percent of the 600,000 new employer businesses created in the United States every year obtain venture capital financing.

What’s behind the NVCA’s voodoo economics? Even though they vehemently deny it, VCs are looking for bailout money and tax-breaks. After spending so much time, energy and breath in the past decade arguing that government subsidies distort markets, now the wealthy, bloated VC community wants its own handouts.

My VC friends complain over drinks about a new breed of VCs who are crowding out the really smart and experienced. These gold digger VCs bear MBAs and have no real operational experience but plenty of taste for IPOs. (Interestingly, if they don’t have an MBA, they have a law degree. Go figure.) With all this dumb VC money sloshing through the system, VCs end up funding hordes of “me-too” companies. This leads to declining returns and high startup failure rates. Everyone loses.

What we need to do is to apply the same rules to VC’s which they impose on their companies – force them to make tough choices and get their business models in order. And instead of giving the tax-breaks to the middlemen, let’s give these directly to the entrepreneurs who take the risks and create the innovation. It is the entrepreneurs who fuel the economy, not the venture capitalists or investment bankers.