May 4, 2016

4 Factors That Predict Startup Success, and 1 that Doesn’t



What makes a venture capital investment successful? Some of the most interesting data on this question comes from an analysis published last year by the venture capital firm First Round Capital. The firm’s unique data set comprises information on over 300 companies and nearly 600 founders, including founder characteristics such as age, gender, education, firm location, and prior work and startup experience. The study found several correlates with success — some reassuring, some surprising.

First, it found that high-performing investments tend to have at least one female founder. This isn’t surprising, given other research about the performance of diverse teams; it’s a timely reminder of the importance of increasing female entrepreneurship and of the opportunity that VCs may be missing by continuing to disproportionately fund white men. The data also shows that younger founders and founders with prestigious educational backgrounds or prior experience in large technology companies tend to be more successful. There’s evidence that startup success is somewhat geographically diverse, not limited to Silicon Valley. Good investments are increasingly coming from burgeoning technology centers in Texas and North Carolina.

Of course, some caveats are in order. Correlation isn’t causation: The fact that successful investments have something in common could be a sign of a causal relationship, or it could reflect the importance of some hidden variable. Venture capital is largely an exercise in intuition and pattern matching. This sort of data doesn’t substitute for judgment, but to the extent that it can help investors identify things that track with success, data can inform those judgments. I talked to First Round about its research, combining those insights with my experience as a researcher of technology and entrepreneurship to consider what the findings could mean for entrepreneurship.

Female-founded startups outperformed all-male teams
Gender in entrepreneurship has recently garnered more and well-deserved attention. Globally, twice as many men become entrepreneurs, but the number of women becoming entrepreneurs is increasing rapidly. Although female-founded companies represent a greater percentage of First Round’s investments than the national average — startups with at least one female cofounder account for approximately 18% of new VC-backed new ventures in the U.S. — they were still the minority of investments.

However, in First Round’s data, investments in companies with at least one female founder meaningfully outperformed investments in all-male teams. In fact, companies with a female founder performed 63% better than investments with all-male founding teams. (For this analysis, performance refers to the change in market valuation between the initial First Round investment and the end of 2014.) Three of First Round’s top 10 investments of all time, based on value created for investors, had at least one female founder, far higher than the percentage of female tech founders in the data set. Simply stated, women are great technology entrepreneurs, and more of them need to be funded.

Younger founding teams outperformed older ones
The research also looked at founder age, education, and experience. The average age of an entrepreneur is approximately 40, and there is reason to think that entrepreneurs improve with age. But what about Facebook, Apple, Google, and Microsoft? The average founder age for those companies was approximately 23. A good argument can be made that technology favors the young. First Round’s investment portfolio gives credence to this argument. Founding teams with an average age of under 25 (when First Round invested) performed nearly 30% above the average investment. And while the average age of all First Round–backed founders is 34.5, the average age for the top 10 investments was 31.9. In the realm of technology, younger entrepreneurs do seem to be a key factor for success.

Founders from top schools performed better
Some prominent entrepreneurs and investors, such as Peter Thiel, question of the value of higher education in the realm of entrepreneurship. Moreover, many notable founders, including Bill Gates and Mark Zuckerberg, dropped out of college. First Round looked at the impact of alma mater on company performance. Teams with at least one founder who went to an elite school (defined by First Round as Ivy League, Stanford, or MIT) tended to perform better.

In First Round’s portfolio, 38% of the companies had one founder that went to one of those schools; the study found that those companies performed about 220% better than other teams. While costly and difficult to enter, a top education can be an ingredient for startup success. The challenge is convincing all those talented individuals seeking finance and consulting positions to take the leap into starting a new venture.

Experience at top tech companies predicts success as a founder
Before jumping into the startup fray, newly minted graduates should consider a stint at a marquee technology company. First Round found that teams with at least one founder coming out of Amazon, Apple, Facebook, Google, Microsoft, or Twitter performed 160% better than other companies. Founding teams with experience at any of those tech companies also landed pre-money valuations nearly 50% larger than their peers. That’s a signal that investors consider these individuals to have already been “pre-screened,” as it’s very difficult to get a job at those companies. (Interestingly, while going to an elite school correlated with higher financial returns, it did not correlate with a higher pre-money valuation, perhaps suggesting that investors do not view education as quite so effective a pre-screening measure.)

The Amazons of the world expect quite a lot of their employees, from technical ability to time spent at the office. Employees there learn hard skills, such as project management, but also softer skills, such as politics and networking. Once honed, these skills can be vital to effectively navigating the chaotic roller-coaster ride of early-stage startups.

Not all top startups come from Silicon Valley
Where do the best new ventures form? Founding location did not seem to make a dramatic difference in performance in our data set. First Round companies started outside New York City and the San Francisco Bay Area performed just as well as those founded in traditional new-venture hubs. Twenty-five percent of the investments in the data set were outside these cities and, on average, performed slightly better than the rest. This is good news for all the younger technology startup hubs propagating across the U.S., from Austin, Texas, to Raleigh, North Carolina.

It also coincides with the fact that finding good investments is becoming easier. Angels and VCs have historically been referred to potential investments through their own networks, but this is changing. First Round has been alerted to high-potential investments from a wide variety of sources, including Twitter and in-person pitch gatherings such as ”Demo Days.” These nontraditional sources yielded companies that outperformed referred companies by 58.4%. And founders that came directly to First Round with their ideas did about 23% better.

Seed investing has come of age, and it’s a leading source of funding for the next generation of disruptive technologies and services. In over 300 investments, we have observed some patterns: The importance of female entrepreneurs in a traditionally male-dominated industry and the benefits of a good education and pre-startup experience are clear. The leveling of the geographic playing field gives credence to the development of startup-friendly areas in cities nationwide. And while fit, gut feel, and due diligence will always be critical, this study points to the value of data in making equity capital decisions. Successful companies and their portfolios would be well served to understand their investments more deeply through longitudinal data collection and analysis. Smart companies will use this to create competitive advantage for themselves and for the startups they invest in.

Source Credits: HBR| Tucker J. Marion| First Round Capital

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