21 Sep Considering venture capital: Preliminary questions for entrepreneurs
Venture capitalists are generally not thought of with great affection by most entrepreneurs, which should be no surprise given that venture capitalists turn entrepreneurs away far more often than they let open their checkbooks for them, and have at best ambiguous relationships with most of the small minority of entrepreneurs they do invest in. The interesting questions are why so few entrepreneurs who seek venture capital are successful, and why so many of those who do get venture capital end up regretting it. Are venture capitalists just bad people? Or are there less sinister factors at work, factors that entrepreneurs should consider before they start looking for venture capital?
My own view – having been both an institutional venture capitalist and a serial venture capital-backed entrepreneur – is that much of the frustration so many entrepreneurs experience courting and working with venture capitalists is self-inflicted, or, at least, could be easily avoided if entrepreneurs asked themselves – and honestly answered – a few critical questions before they started talking to venture capitalists.
Question 1: Is Venture Capital Your Only Option? The first thing to understand about venture capital is that it is the most expensive financing option on the straight and narrow side of the law. Virtually any other legitimate form of financing will “cost” less than venture capital. So, consider venture capital only after either (i) you’ve exhausted all other capital sources or (ii) you conclude that the higher cost of venture capital is an acceptable price to pay for a more timely and/or more certain or substantial business success.
Question 2: Does Your Business Model Fit the Venture Capital Investment Model? If you get past the first question, you now have to ask whether your business opportunity is compatible with the venture capitalist’s investment criteria. This question is more nuanced then it might at first seem. To get right to the point, while you think of your deal as the deal, a venture investor thinks of your deal as a deal. In practice, this means that while you think of return expectations in terms of your deal, a prospective venture capital fund thinks of it in terms of the fund’s investment portfolio.
The standalone vs. portfolio perspective on deal returns is critical because entrepreneurs often mistake a venture capitalist’s portfolio return expectations (say a 40% IRR, a decent and common enough rough estimate) with the venture capitalist’s much higher expectations for each of the several deals that make up its portfolio of investments. A venture capital portfolio of10 deals, for example will likely include one or two “home runs” (generally 10x or greater returns, measured on a cash invested/cash harvested basis), a couple of doubles and triples, a couple of singles, and a couple of strikeouts.
If you think about that for a minute, the implication is clear: a venture fund’s success is driven almost entirely by how many home runs it hits. One home run covers the fund’s capital base; a second home run doubles that; and the doubles and triple provide most of the frosting on the cake. It is almost impossible for a fund to succeed without at least one and often two home runs, and industry-leading performance is almost always built on more home runs, not more doubles and triples. As a result, early stage venture investors generally only invest in deals that have home run potential. So, the question whether your deal suits the venture capital model really comes down to this: assuming your deal works, can the prospective early stage venture investor reasonably expect to get back at least $10 for each $1 invested. If the answer is no, don’t waste your time searching for venture capital.
Question 3: Are You Ready to Share Your Deal with a Stranger? If you think your deal fits the venture capital investment model, the next question is whether you, the entrepreneur, are really, deep down, ready to let a third party in on your dream, a third party with real power, real interests that don’t always mesh with yours, and, in most cases, an ego more or less as big as yours.
Venture capital investors have all kinds of personalities and styles (though, in my experience, there aren’t any VCs out there short on self-confidence). Hopefully, you can find one with a style and personality that is more or less compatible with your own. But even if you do, you still have to remember two things First, it’s the venture capital fund that matches the venture capitalist with the deal, and fund’s and their managers evolve in composition and focus over time, and either event will complicate, and can sour, your relationship with your venture investor. Second, your venture capital investor is a fiduciary charged with looking at your company solely in terms of maximizing the returns of his own investors. The vast majority of venture investors, even those considered the most “entrepreneur-friendly,” put their obligations to their own investors and fund ahead of the interests of the entrepreneurs they’ve invested with. Industry terms like “founder redeployment” may be funny, in a gallows humor sort of way, but they exist because, well, venture capitalists send founders to the gallows more often than most of them would like to admit. (One of the deans of the industry, Don Valentine, is widely cited for his statement “I have never fired a CEO to soon.”)
Now, lest I be accused of being one of those “they are all vulture capitalists” crackpots, let me say that I have worked with dozens of venture capital investors over the years, and can only think of a couple sociopaths. Most VCs are, if not charming, at least bright, adventurous, interesting and as benign as any other group of workaholics I can think of (including entrepreneurs). The “value added investor” pitch is more than a marketing slogan. Many VCs can and do make real contributions to the success of their portfolio companies beyond providing capital, and many of them genuinely care about the people and businesses they invest in. But never forget: when for whatever reason they need to make a choice between supporting an entrepreneur or protecting the best interests of their investors, they will always make the choice that best serves their investors. And they should. That’s their job.
Bottom line? Entrepreneurs with venture capital worthy deals should seriously consider seeking venture capital investment. But they should do so with their eyes wide open to the realities of bringing another powerful and interested party into their business. It may, at the closing of the courtship, feel like a deal made in heaven. But it’s still a Faustian bargain.
Other columns by Paul A. Jones
- Two sides of an often contentious issue
- Term-sheet etiquette and other rules of capital raising
- Technology transfer: Why private profit is good public policy
- Commercial Biopharma in Wisconsin: The next big step
- VC fund “flavors”