Do start-ups increase in proportion to the availability of venture capital? Nope.  Kaufman Foundation researchers Dane Stangler and Paul Kedrosky dispel that myth as well.  The authors note that the doubling of start-ups from the period 1960-1978 to the decades since may indeed have been due to the advent of the personal computer and the expansion of the venture capital sector.  (One wonders if the baby-boomers coming of age may not have contributed to this step-change as well.) However, the constancy of recent start-up data belies the influence of venture funding.  Start-up activity fluctuated by only 3% to 6% each year between 1977 and 2005; but the data shows that venture investment varied by as much as 500% during the same period.

Do tax or bankruptcy law changes, technological advances or entrepreneurship education affect the number of new ventures? No again!  The report, Exploring Firm Formation: Why is the Number of New Firms Constant? also finds no correlation between start-up activity and tax policy or any of these other factors; so much for the theories of our most vocal politicians.  Instead it documents the same steady half-million start-ups per year, give or take a 3 to6 percent.  The authors discuss a few possible explanations for the unexpected constancy, some rather arcane, but they do not seem to buy into any of them.

Common sense suggests that certain of the factors discussed in the Kaufman report must have at least some influence on the number of start-ups, even if they do not affect substantially the total for a given year.  For example, limited amounts of available venture investment must surely delay some particular start-up decisions.  I have been involved in a few such decisions.  Similarly, high interest rates and tight credit must also have an effect on many decisions, especially those involving sole proprietorships and mom-and-pop operations.  So perhaps a study with greater granularity would reveal that while the total number remains relatively constant, the mix of start-up types changes, maybe even substantially.  Perhaps in recessions when venture funding declines, a fall in interest rates turns entrepreneurs toward credit sources.  It could also be that more innovation-based entrepreneurs test their business innovations when the economy is booming, and that more laid-off workers start enterprises when unemployment is high during recessions.  I suspect that the “mix” of different kinds of start-ups changes a great deal even though the total number may not change much.

The Stangler and Kedrosky study does not encompass the current Great Recession, of course, it is too soon.  Yet surely this anomalous economic epoch will surely add some telling figures.  The investment portfolios of the wealthy individuals and institutions that comprise the limited partners of venture firms declined substantially since 2007 and venture investment has fallen by 40% or so since then.  At the same time, credit tightened historically and unemployment soared into double figures.  Will start-up totals for this period continue the constancy that Kaufman reports?  And if not, how will it vary?  Will the limitations on available capital drive start-up numbers down, or will necessity and cheap assets power them up?  Or will past constancy persist despite alterations in the mix?  Only a study based on more granular data could reveal that.  I doubt that such data is available or could be economically derived, though that information could prove useful to an economy so reliant on small businesses to create jobs.

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… lose the “Chinese math.” Chinese math is the argument that goes like this: If just 1% of the people in China bought a Macintosh, Apple would be the largest computer company in the world. Many plans cite a study that “proves” that a market will be $20 billion by 2003 and state that all the company needs to do to be profitable is to get 1% of the market.

There are problems with Chinese math: 1) there’s never been a consulting study that didn’t predict a multibillion-dollar market size. (Do you think consulting firms can sell studies that predict small or down markets?) 2) Getting 1% of a market is easier said than done. 3) If you say that you need to get only1%, does this mean you’re conceding the 99% to others? 4) You label yourself a bozo because only bozos would try this line of reasoning on sophisticated investors.

Kawasaki’s reason #1 continues to ring true, especially in emerging markets. Still, let’s focus on reasons #2 and #4.  They are closely related.  Reason #4 warns that if your presentation or business plan relies on Chinese math, sophisticated readers will think you are a bozo.  Why? Because of #2!  Naively taking for granted a 1% (or worse yet a 5%, 10% or more) market share simply sweeps the real world difficulties of marketing and sales under a flimsy statistical rug.  Let’s assume that a reasonable case can be made that your market comprises a million individual buyers. Capturing a mere 1% of that market means selling 10,000 customers.  If you enjoy a typical closing rate around 25%, then closing 10,000 sales requires making 40,000 sales presentations to qualified prospects, i.e., people who need what you sell, have the means to buy it and will give you a reasonable opportunity to sell it to them.  To find 40,000 qualified prospects, you may need to start with 100,000+ leads; that is people who express some kind of interest, such as visitors to your web site. 

These numbers put a little flesh on the bare bones of a 1% market share.  How will you attract all those visitors?  Does your business plan have an adequate marketing budget and strategy to reach them?  Does it describe an efficient means to qualify prospects out of the 100,000 leads?  Who in your company will make the 40,000 sales presentations? If it takes 12 minutes to fill out a sales slip and run a credit card, then the 10,000 sales will require 120,000 minutes or 2000 hours … just to cash out all those customers, to say nothing of selling them!  Investors want to know how you plan to do all these things. They will dismiss  an empty market share forecast that fails to comprehend such challenges.  To run your business, you will need to know the answers.  Consequently if your plan forecasts some small share of a large market, discuss that in terms of the actual numbers and how you will capture and service them.

Neophyte entrepreneurs continue to write business plans containing Chinese math.  They submit them to investors and to potential strategic partners and use them to recruit seasoned managers, executives, board members and advisors.  Many entrepreneurs have no idea what role Chinese math has played in the failure of these important initiatives.

By the time entrepreneurs go looking for venture capital funding, they have already invested a great deal. They have spent years developing and refining the business concept, researching technologies, markets, customers, products, competitors and alternative business models. Inevitably, they have invested some of their own money and maybe asked family and friends to take some risks too. Moreover, they have spent months drafting, vetting and editing a business plan that proves – right there in black and write – that this business is a winner with enormous financial upside. When they finally gets an audience with a VC, they are in no mood to hear a “no thanks.”

On the other side of the table, the VC knows exactly how the entrepreneur feels; he has been here many times. Any investor with an ounce of empathy would find it had to say no thanks to someone who has worked so hard to hear a “yes.” As if empathy were not enough, there are plenty of other reasons for VCs to avoid saying “no;” some good, some bad, some true and some false.

Now most VCs are honest, fairminded business people who behave ethically.  Still, VCs often fail to voice their sound business reasons for saying ”no thanks.” For example, if the entrepreneur has failed to make a convincing case that the target market size is attractive, that the product or service is compelling enough to sustain competitive differentiation, that the business model will work or that the management team has relevant experience, then a “no thanks” makes sense. Still, it feels bad to say “no” and VCs know that entrepreneurs don’t like it. Many presenters become defensive, some will think the VC is stupid and/or out of touch. The entrepreneur might even tell her friends and networking colleagues that this particular VC is a jerk.

If a VC does say “no thanks” and the entrepreneur reacts calmly and rationally, she is still rather unlikely to simply take one “no” as a final answer: The VC may well be in for a long discussion of the merits of the business plan, whether they want to listen or not. Yet VCs are professional investors disciplined to think ahead, to keep their options open and to avoid alienating rare resources such as smart entrepreneurs, so they often perceive that their interest lies in simply saying little or nothing; at least not saying “no” directly.

For VCs, there is always the nagging possibility that this idea might turn out to be the next Google, Genzyme or Facebook. If they say “no thanks” now, they may fear that the entrepreneur will shut them out of later investment rounds. Even if the VC is convinced that this venture is a loser, he may worry that the entrepreneur may not come back when she does have a great idea. It may be selfish to avoid saying “no” directly and not telling the candid truth about why not, but then entrepreneurs are unlikely to ever find out that the reason the VC gave them for not investing was only an excuse. 

VCs may avoid saying “no” in some quite ambiguous ways that are tough for an entrepreneur to see through. For example, they may tell the entrepreneur that the firm has too many portfolio companies that need attention just now; “Try me again in six months.” That could be true or it could be just the right “maybe” to get the entrepreneur out of the office without making them angry or inviting a debate. “I just could not sell the idea to my partners” is another hard answer to figure out. “This looks interesting, but it’s not in our space” might be true as well (but makes one wonder why the VC had you in for a presentation in the first place). A little advance homework should shed light on what kinds of deals a particular VC firm prefers and largely avoid this reason.

One egocentric, insensitive and potentially dangerous way that some VCs may avoid saying “no” is to send the entrepreneur on an impossible mission. “Get your sales up to $2 million before the next partners meeting and I’d say you have a shot” is one example. Another might be, “If you get Warren Buffet or Bill Gates to invest, we’ll come along” or “sign up a few high profile reference accounts like Boeing, Microsoft and Intel and we will reconsider.” These are extreme examples, of course, but you get the idea. By setting a high bar and/or a short timeframe, the VC can not only avoid saying “no” but also leave the entrepreneur believing that it was their own fault that they missed out on funding.  A thoughtless VC may may set a lower bar, or repeatedly send the entrepreneur off to put together just a little more information.  That behavior is sure to start a meaningless quest.

That is not to say that every suggestion that a VC might be more interested if the start-up achieved a certain milestone or had more information is either false or unreasonable. Yet sending start-ups on an endless quest leaves open the selfish possibility that if someone else funds them, the VC could still get in on the next round. Of course, if the entrepreneur does meet the challenge, the VC can always set up another impossible quest, or revert to “My partners are not crazy about it” or some other excuse. Again, most VCs strive to be fair and completely straightforward, but some do not.

So what’s the harm when VCs don’t say “no,” even when they mean “no?” Entrepreneurs are optimists by nature and they need to be. So the lack of a “no” sounds like “maybe” to them, or least an affirmation that there is nothing fundamentally wrong with their plan. Yet in fact, the mere lack of a “no” from a VC says nothing of the kind and it can create serious problems, especially for inexperienced entrepreneurs. Their idea may be a stinker, and plainly so to a professional investor: More commonly it may just be too risky to fund, or not have the potential for the $100 million to $500 million in fifth year revenues that attracts venture money. VCs reject many plans because the management team lacks relevant experience, but any one of a dozen other good reasons may apply.

So a discussion with a VC that ends in only a “not now” may actually teach an entrepreneur nothing of value, perhaps even mislead and encourage them to continue to seek funds and obfuscate that the management needs to make substantial changes in the business model, strategy and/or management. An entrepreneur may well leave the VC’s office, not only without a clue, but essentially lulled into believing that it was only his timing that was off or some other reason that seemed false but benign to the VC.

To avoid a long wasteful quest, entrepreneurs need to hold VCs to a higher standard. They must state clearly at the outset of their conversation that they welcome constructive criticism, that they want the whole truth, no matter how difficult, that they do not need coddling and won’t take a “no” personally and that they will not insist on a long debate. It may help to remind the VC that entrepreneurs hear “no” all the time. Point out that the VC’s experience and insights could really be helpful, but only if his assessment is frank and straightforward. No one wants to hear “no thanks” but the reasons underlying a decision not to invest are inherently valuable. Hearing only happy talk that avoids the actual issues can inadvertently fuel a fruitless quest that wastes the resources of entrepreneurs and investors alike.