Skill Versus Luck in Entrepreneurship and Venture Capital

December 4th, 2006 • Entrepreneurship + Startups, Venture Capital

I stumbled upon a paper published by the National Bureau of Economic Research titled “Skill vs. Luck in Entrepreneurship and Venture Capital: Evidence from Serial Entrepreneurs”. The title held promise for the paper and so I took a read. The paper is pretty long (42 pages total – 26 pages of text with the rest being tables and other miscellaneous stuff). If you are a current, past, or future entrepreneur, I’d highly recommend taking a read of this paper. Here are the parts that I found interesting.

Looking just at the entrepreneur’s success history alone, the authors found:

The predicted success rate of entrepreneurs with a track record of success is 30.6%, compared to only 22.1% for serial entrepreneurs who failed in their prior venture, and 20.9% for first-time entrepreneurs.

So a lot of entrepreneurs who weren’t successful in the past don’t learn all the lessons of why they failed so as to improve their performance in the future. You can also take this to mean that successful entrepreneurs have a non-learnable skill which allows them to succeed.

But maybe the experience of a VC can help an entrepreneur improve their performance.

First-time entrepreneurs have a 17.6% chance of succeeding when funded by more experienced venture capital firms and an 11.7% chance of succeeding when being funded by a less experienced venture capital firm.

Well, that is a big improvement. What about entrepreneurs who failed in the past?

Likewise, failed entrepreneurs who are funded by more experienced venture capital firms have a 22.1% chance of succeeding as compared to a 14.7% chance of succeeding when they are funded by less experienced venture capital firms.

That’s a even bigger increase. So what about those folks who have succeeded in the past?

… the predicted success rate for previously successful entrepreneurs is 28.1% when funded by more experienced venture capital firms (at the 75th percentile of VC EXPERIENCE) and 27.7% when funded by less experienced venture capital firms (at the 25th percentile of VC EXPERIENCE).

and then the kicker:

Essentially, venture capital firm experience has a minimal effect on the performance of entrepreneurs with good track records. Where venture capital firm experience does matter is in the performance of first-time entrepreneurs and serial entrepreneurs with histories of failure.

Wow. So really, those of us who are entrepreneurs should really go after top experienced VCs (as defined by the authors – see the paper for how they determined this) if we’re on our first company. But actually, the authors take this to mean:

These findings provide support for the view that venture capital firms actively screen and/or monitor their portfolio companies, and that there is some skill in doing so. When an entrepreneur has a proven track record of success–a publicly observable measure of quality–experienced venture capital firms are no better than others at determining whether he will succeed.

So, really this means that once you’ve succeeded as an entrepreneur no one has any secret way of figuring out if you’ll be able to do it again. Okay, so that wasn’t as good of a finding as I had hoped. Let’s keep looking.

Of more interest is the finding that venture capital firm experience is positively related to pre-money valuation. The effect, however, is modest.

Sounds promising depending on what the impact is.

… at the 75th percentile of VC EXPERIENCE, the forecasted valuation is $10.49 million, whereas at the 25th, it is $8.92 million.

But then they say:

The finding that new ventures funded by more experienced venture capital firms invest at higher pre-money valuations needs to be reconciled with Hsu’s (2004) finding that more experienced venture capital firms make offers at lower pre-money valuations.

And then they go on to say that they may be experiencing an effect mentioned in this earlier paper. So that doesn’t help us either.

This next statement is somewhat of a disappointment.

… we find no relationship between pre-money valuation and LATER VENTURE and PRIOR SUCCESS.

So even though the success rate of successful serial entrepreneurs goes up (regardless of the experience of the firm that funs the entrepreneur), the pre-money valuation doesn’t. How can that be?

Given the higher success rates of previously successful entrepreneurs, one would have thought that firms associated with these entrepreneurs would have had higher valuations. Apparently this is not the case, which suggests that venture capital firms are able to buy equity in firms started by previously successful entrepreneurs at a discount.

I would suggest that this is one of our problems (”our” being entrepreneurs). I’m not sure what we, as a group, can do about this but it does stink. As the authors mention, VCs are getting a discount on their investments and thereby reducing their risk exposure in an investment. As entrepreneurs, our risk exposure is always pretty constant – which is to say high until you achieve a “good” liquidity event (”good” being defined as getting either cash or publicly traded stock and not private stock in another company). But one thing makes this a little better.

Kaplan and Stromberg examine venture capital contractual terms and find that repeat entrepreneurs receive more favorable terms for vesting, board structure, liquidation rights, and the tranching of capital, but did not receive greater equity ownership percentages. It therefore appears that serial entrepreneurs may extract greater value from venture capitalists in the non-price terms of investment.

So in wrapping up, the authors point out what I think are two important conclusions:

Successful serial entrepreneurs are more likely to replicate the success of their past companies than either single venture entrepreneurs or serial entrepreneurs who failed in their prior venture.

and

When experienced and inexperienced venture capital firms invest in entrepreneurs with a track record of success, there is no performance differential. This evidence would seem to suggest that prior success is a signal of quality or that venture capital firms add little value to talented, successful entrepreneurs. If prior success were pure luck, we would not see this pattern.

So I suggest taking a look at the full paper and its findings. The results are interesting and they should help you make better decisions about who to take as an investment partner in your venture.

Tags: entrepreneurship, fundraising, startups, Venture Capital

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