Things Entrepreneurs Should Know (About Venture Capitalists)
If ever there was a prototypical "love-hate" relationship, there is a good chance it was between an entrepreneur and a venture capitalist. It's the perfect kind of relationship for the love-hate dynamic: lots of pressure; big egos; mutual dependence; and over-lapping but different and evolving relationship objectives and constraints. Unfortunate as it may be when things get ugly: surprising it isn't.
While ugly entrepreneur/VC relationships are inevitable, there are more of them than there should be. As both a VC and a VC-backed entrepreneur I've seen a lot of entrepreneur/VC relationships get ugly that shouldn't have; or at least shouldn't have as soon as they did. Many times, entrepreneur/VC relationships break down when one side - and it is more often the entrepreneur side - doesn't appreciate some of the realities that shape the attitudes and requirements of the other side.
And so this brief review of some of the realities of the world venture capitalists inhabit, and how those realities impact their relationships with entrepreneurs. Some are deeply ingrained in the nature of the venture investing business; some seemingly arbitrary rules of thumb. And yes, in almost every case subject to the occasional exception that most often proves the rule.
- Venture Capitalists are Fiduciaries. Venture capitalists manage money entrusted to them by their own investors (commonly referred to as "Limiteds"). That makes them fiduciaries, and that, in turn, means they are legally bound to act solely in the best interests of their Limiteds. Thus, as much as they may like and respect their portfolio entrepreneurs, their Limiteds have first call on their loyalty. A VC with any integrity at all (and you surely would not want to work with a VC lacking integrity, right?) will, when faced with a choice of doing the best thing for her Limiteds or doing the best thing for her portfolio company, pick the Limiteds every time.
The fiduciary character of the VC/Limited relationship manifests itself in all sorts of ways beyond the obvious "should I invest more capital to save this company that I want so much to succeed, or would that be a bad move for my Limiteds" sort of situation. For example, entrepreneurs are often bemused by the emphasis VCs put on dotting every "i" and crossing every "t" in the deal documents. Well, that's because while they personally might think a particular "t" does not need to be crossed, they have to think of their Limiteds - more specifically, what their Limiteds might think if not crossing that particular "t" turned out to be costly.
More generally, being a fiduciary makes VCs very sensitive to making and managing deals within the real if not always well-defined parameters of the then current market. So, for example, I once knew a very prominent VC who thought that the whole idea of anti-dilution price protection was silly (I actually agree with him on that). That said, he got it in every deal he did for his fund. Why? Because if he didn't his Limiteds would want to know why every other VC got it for their Limiteds, and he didn't get it for them.
The bottom line here is that entrepreneurs are well-advised to remember that as much as they may think of their VC as their VC, she is in fact first and foremost her Limiteds' VC. And if she is any good at all, as much as she may like and respect you, in terms of her priorities her Limiteds are at the top of the list.
- Venture Capitalists are … Entrepreneurs. You heard that right. VCs are entrepreneurs just (well mostly) like you. They put together a business plan and take it on the road to raise money from mostly very sophisticated institutions. If they deliver the goods, they will likely find it easier to raise capital for their next fund. If they don't they will probably find themselves in another line of work.
Beyond just generally helping you have some empathy for VCs, realizing how their life and yours have so much in common should tell you something about their nature. Look in the mirror. Do you have a big ego? Are you often wrong but never in doubt? Are you a tenacious bulldog when it comes to building your business? Do you have at least one serious personality … quirk?
Well, so does your VC. Which is to say, as difficult as you may find them to work with at times, you can be pretty sure they feel the same way about you.
- Venture Capital Funds Pivot, Too. If there ever was a startup that evolved exactly according to plan - from the first money in to the exit - you can be sure it was one of those exceptions that proves the rule. The same goes for venture funds. VCs leave funds unexpectedly. Markets evolve, and investment strategies evolve with them. Unexpected opportunities and challenges come up, and with them changes in resource (capital and people) allocation. Stuff happens and funds change, just like startups.
When stuff happens at a VC fund, portfolio companies can suffer. One of the saddest VC/entrepreneur stories I know involved a company where I was an angel investor and director. The entrepreneur was really good, and really wary of brining a VC into the business. He bootstrapped and invested most of what he had made in a prior deal. Finally, with a good product, cash-flow positive operations on $5 million revenue, and great press, he concluded (rightly, in my opinion) that to come out as a leader in the market and really scale the business he needed to bring in some capital.
So, he took $10 million from a very reputable venture fund at a good price, working with a partner who had followed the company and made noises about wanting to invest for several years. The first three months post-close were fantastic. And then .., the VC left the fund for greener pastures. The fund assigned a junior associate to the deal, and started looking at how to get out sooner rather than later. The company ultimately failed, largely, I believe, because what looked like such a sweet entrepreneur/VC pairing turned sour.
Ok, the general point is that your relationship with your VC and her fund will evolve. Sometimes for the better. Sometimes for the worse. It pays to stay attuned to what is going on in your VC's life, and her fund's life. Is her star - and the funds' – rising or falling? How much dry powder does the fund have? How much of that is for your deal? How is the rest of your VC's and her fund's portfolio doing? Knowing all of this, of course, doesn't mean you have a lot of influence on it. But it can give you some inkling about how your relationship with your investors is going to evolve, for better or worse.
- Venture Capitalists are Business Partners not just Investors. Entrepreneurs are all over the map on the notion that VCs bring more value than just cash to the table. In my view, good ones do. But that really is not the issue here. The issue is that whether or not you think your VC has anything to offer besides money, you can be sure your VC believes she does, and in any event she is going to have some serious things to say about how you manage your business. And it doesn't really matter how much of your company she owns: as folks who have run afoul of a bank loan covenant can attest, you don't need to have an ownership interest to have a controlling interest.
The point here is that you should be very careful, as you put together your deal with a VC, not to get so focused on the economics that you miss the management implications of the deal terms. Make sure you talk with your lawyer about control issues like class voting rights; Board seats and observer rights; fiduciary obligations (which can cut different ways in different circumstances); any voting agreements or side letters with investors; and most of all the extent and nature of the "Protective Provisions" in the deal documents. You'll almost certainly find that there will be things you will not like in these areas, some of which you will likely not be able to change. But you can often change some of them at the margins at least, and even when you can't it is better to know about the realities of control before your VC asserts them at a crucial moment.
- Venture Capitalists Don't Do NDAs. Having been a serial entrepreneur I get why entrepreneurs think VCs should sign Non-Disclosure Agreements. Having been a VC as well, I get why VCs don't do NDAs. And, well, the VCs are right. If they signed an NDA with every entrepreneur they took a business plan or pitch from, you can be sure they would spend most of their lives in court defending claims that they "borrowed" some entrepreneur's idea and used it in another deal. (And that does - very rarely, I think - happen).
Now, the VCs don't do NDAs shtick would be a really big problem if it did not have such an easy solution: don't tell a VC, until a term sheet is signed and final due diligence is in process (if then), anything that is really proprietary. If that seems impractical, consider this: You can sample my secret sauce without me sharing the recipe. For example, I can show you data demonstrating how my device detects metal fatigue, and likely even tell you some of the concepts about how it works, without telling you anything that would allow you to recreate my device.
Seriously, there is no reason to share real, valuable proprietary information in your business plan or pitch to VCs. You can have a "black box" at the heart of your value proposition if you have sufficient indications of credibility (team, data, etc.) surrounding it. How strong those indicators need to be depends on how extravagant your claims are for your black box. If you have a device for sampling someone's breath and diagnosing an infection, put a credible scientist beside it with some relevant literature and some early data and you've told me more than enough to get my due diligence going. If your telling me that your black box violates the second law of thermodynamics (I've seen plans like that a couple of times), you'll likely have to show me a lot more: perhaps, say, that Stephen Hawking is your CSO.
- The 20-50% and 10x Rules. Valuation is what most entrepreneurs focus on in negotiations with VCs (often to the detriment of equally important issues like control and exit provisions). Entrepreneurs, of course, want higher valuations (thus less dilution), and can be very creative coming up with fancy spreadsheet forecasts and financial analysis.
I must say I have seen some very slick spreadsheets supporting valuations for startups. Most of them, though, confuse precision with accuracy, and fail to deal with two fundamental realities of how VCs look at valuation. And in the process, provide a plethora of trivial details for folks to pick apart.
The first valuation reality, and probably the best known, is that a Series A investor's approach to valuation is very practical and simple: show me a model, from my investment to the exit, that I can believe in and that gets me at least $10 back for every $1 I invest. What they want to see is a list of likely buyers; the metrics for the likely sale; and some sense of how much additional dilution they will suffer to get there.
That is a "big picture" kind of analysis that just doesn't require a very detailed spreadsheet. It's an analysis that places a lot more importance on the accuracy of assumptions than their precision, and limits the number of cells in the sheet to debate about. So why not save the time and expense of the finely detailed and precise spreadsheet model that reaches a conclusion only loosely correlated with what the investor thinks is important?
The more overlooked valuation rule is the 20/50 rule. Most VC investors want to see an A round where the investors acquire at least 20% of the company, but no more than 50%. VCs want some minimum stake that reflects their centrality to the business. Most of them think that minimum is 20%. That may be arbitrary and capricious, but it is what it is.
On the other hand, most VCs don't want to see the founders and their team give up more than 50% of the equity in the A round because they want the founders and the team to have sufficient incentives to maximize the valuation of the company well past the A round. Again, 50% may be just a number, but it is pretty commonly "the" number in terms of maximum dilution at the A round.
The trick with the 20/50 rule is how it can impact valuation when the size of the VC Fund is mismatched with the size of the needed A round investment.
Most venture funds have a rule that limits how much of their capital can be deployed in any one company. That number is commonly 10%. So a $30 million fund is usually thinking that it can invest up to $3 million in any one company. Further, most VCs, given $X to invest in one portfolio company, will want to make sure some minimum fraction of X - let's say 1/3 for an example – is available for the round after they first get in the deal.
Ok, so let's assume our VC's Fund is $30 million. They want to put $2 million into you're a round, and they have another $1 million lined up from another investor that will follow them into the A round. So they have $3 million for the A round.
If you apply the 20/50 rule, you'll find that to get the minimum 20% ownership for the A round investors, the maximum pre-money valuation is $12 million. If you want a significantly higher pre-money than that, you are probably better off looking for another lead investor with a deeper pocket; perhaps the smaller fund will follow in the higher priced deal.
Now, as I noted at the outset, the various rules and such noted above are, like most rules not found in physics or mathematics books, subject to exceptions. Maybe your deal should be one of those exceptions. But even if your deal should be an exception, the chances it will be an exception will be maximized if you know the what and whys of the rules before you start trying to convince a VC to break them.