Four Things Entrepreneurs Should Know About How Venture Capital Firms Work
Not all venture firms are alike. Some are raising their 10th fund while others are investing out of their first fund. Some focus on early stage companies, while others focus on growth or later stage companies. However, they all do have one thing in common. They are using other people’ s money to take risk in an attempt to generate above market returns.
If you keep this in mind, you will appreciate these four common characteristics on how venture capital firms operate:
1. You are getting an individual, not a firm as a partner.
Venture capitalists are busy. They continually have to look for the next deal, they have to advise their current portfolio companies—many of which tend to be broken, they usually sit on multiple boards, and they constantly have to schmooze investors. Therefore, when you raise money from a venture fund, you get the individual, not the collective firm, as a partner. The partners just don’t have time to work on other partner’s companies.
Most venture capital firms are organized into silos, with partners working individually on the deals that they bring to the partnership. The only time an entrepreneur is likely to see the other partners at a venture firm is when the full partnership is reviewing the deal for final approval. Because of this, it’s more important to focus on the individual when evaluating a capital partner. Key criteria to consider when evaluating a VC partner:
- What is their individual track record, both in your sector and in general? Many venture capitalists at successful funds are still looking for their first big win. Be hesitant to take on a partner who hasn’t yet returned capital to their investors.
- What is the partner’s bandwidth – how many boards are they on? A partner who is on more than four boards won’t be able to give you much attention. You want your company to be a priority, and partners who are on too many boards may not do much more than attend board meetings – often only by phone.
- What is your chemistry with the partner? The inevitable ups and downs of growth companies make them difficult to manage. Differing incentives bring inevitable challenges with investors. Make sure your partner is someone who you feel you can work with when these differences arise.
- How does the partner’s skill set match what you are looking for? Try to find a partner who has a skill set that is complementary to that of you and your management team. Make sure to diligence how they have put that skill set to use with other portfolio companies or in their past careers.
- Where are they in their career trajectory? Partners early in their careers often don’t have enough experience and may be difficult to align with in terms of risk; partners who are too late may only want ‘home run’ outcomes, may be less hungry and less available to help, in part since they may have already made significant money. It should be noted that most firms are very hierarchical with the senior partners making the ultimate decisions on funding and follow-on investments.
2. Venture math can make it difficult to align interests.
Venture funds need to show success in order to raise their next fund. That usually means showing progress on investments that have not been realized. The venture fund may want to raise a round at higher valuation than is warranted and include terms that are unattractive to the entrepreneur. This way their current fund looks more attractive and helps them to raise their next fund.
It is well known that venture capital firms get the lion’s share of their returns from a small minority of their investments in each fund. Therefore, the ‘winners’ in each fund need to produce extraordinary returns over a fairly short period. With a portfolio of investments, VCs can afford to take the risks required to produce those returns. Conversely, as an entrepreneur, you don’t have portfolio economics, and may want to grow your company steadily over a longer period of time than the 3-5 years that venture investors often target for exits. Later stage ‘growth’ investors sometimes have longer hold periods and more diverse portfolios in terms of winners and losers, but they are directionally similar.
Consider alternate sources of financing that may better align your interests. Debt financing, equity from family offices, and money from individuals are all more available than they were even five years ago, and all have attractive attributes that are difficult for VC investors to match.
I learned about the conflict between entrepreneurs and investors concerning exits first-hand while working at a start-up in the 1990s. We had raised venture capital from a prominent Sand Hill Road firm and had an opportunity for an exit that would have been attractive to founders, employees, and customers. Our venture firm kept telling us to ‘swing for the fences’ because we would be a billion dollar company one day. Having a front row seat, the writing on the wall told us that we weren’t going to get there – but we couldn’t seem to persuade the investors.
Our investors saw themselves as the only stakeholder. Their portfolio economics pushed them towards getting a home run at all costs. Because of this, we missed the window on a deal that would have ultimately been better for everyone, including our investors.
It turns out that VCs will, at times, aggressively try to block a deal that doesn’t meet their criteria for a successful exit. An opportunity for a significant return to founders and employees might not be attractive enough for venture investors, and VCs are usually able to block exits through the terms of their preferred shares or by dominating the boards of the companies they invest in. It’s important to watch out for these ‘gotchas’ in investor term sheets.
3. Venture funds often don’t have as much flexibility as they advertise.
A VC fund’s agreement with their limited partners (largely pension funds and university endowments) will drive the behavior of the firm’s investment activities. The limited partners generally invest across a variety of funds, and they are counting on the investment fund to give them certain elements of diversification. Fund dynamics that limit their flexibility include the following:
- Fund life cycle – Funds tend to be structured for a 10-year life cycle, and have investment periods of 3-5 years. If you are being evaluated toward the end of their investment period, there is generally going to be more pressure for a quick exit. Find out where a fund is in its life cycle before spending too much time with them. Timing of the venture firm’s next fund raise is also important to consider. For example, firms generally need to show liquidity on their current fund while in the market for new capital, which can misalign interests.
- Dry powder – A related issue is how much ‘dry powder,’ or remaining capital a fund has to invest. This is relevant for two reasons: 1) If a fund has a lot of capital remaining to invest, they are often more likely to stretch in terms of valuation and other terms, and 2) It is important to know how much capital they reserve for follow-on investments – you want a fund you can go back to for additional capital if necessary.
- Hold period – As referred to above, entrepreneurs need to find out both a fund’s target and average hold period. Investors tend to give generic answers to questions about this, so it is important for entrepreneurs to ask for specific data and analytics (which all firms have). There is a category of funds called ‘evergreen funds’ which usually do not have specific hold periods and can be an attractive option if entrepreneurs are looking for a longer term exit. Family offices also tend to have more flexibility in terms of hold period.
- Size of fund – There has been a trend over the last 10 years for investors to raise larger funds, with partners being responsible for investing more money, and putting more dollars to work in each investment. While there are still plenty of firms that have maintained smaller funds, there are more total dollars to invest from larger funds, even for smaller check sizes. There are several implications for entrepreneurs:
- With more capital to invest, investors are more anxious than ever to put it to work. If investors don’t invest a certain percent of the fund every year, they often lose the management fee on that capital. Venture firms would often rather overpay than lose the management fees associated with that capital. We have found that investors who are ‘behind’ in putting capital to work will often stretch for investments.
- With the amount of capital each investor has to put to work increasing, investors have a tendency to overcapitalize companies. It takes as much time to manage a $10m investment as a $50m investment. This can be used to an entrepreneur’s advantage, but can also create misalignments if the transaction isn’t negotiated effectively.
- Raising only a modest amount of money from a large fund often pressures the entrepreneur to only shoot for a large exit. Small exits just don’t move the needle at a large fund.
4. The prestige of a venture fund has pros and cons.
On the one hand, prestigious funds can bring certain benefits to entrepreneurs such as large historical exits, potentially easier follow-on fundraising, brand name during recruiting, and introductions to valuable strategic partnerships.
Because of these benefits, there is a perception that entrepreneurs should always raise money from the “best” firm they can. Best is often narrowly defined as one of 15 Silicon Valley firms that have had extraordinary exits. This logic is worth questioning for several reasons:
- Top-tier firms often have a higher bar for exits. If Google or Facebook is in their portfolio, other companies are distant footnotes and do not end up mattering much to them financially. One of the investors in Google is said to have held a meeting with strategic acquirers to let them know that they wouldn’t be entertaining any offers for any of their portfolio companies for less than $500M. This may have made sense for the star portfolio companies, but not for the majority of their entrepreneurs.
- Prestigious venture funds generally don’t have to worry about raising their next fund. Therefore, they often take bigger risks to generate bigger rewards. This can work for or against an entrepreneur.
- Prestigious firms are often involved in the mega-exits – companies such as Google and Facebook. One reason for this is they get a disproportionate share of the high quality deal flow. This feeds on itself and the pattern replicates over a lengthy period of time, allowing such firms to give much less attention to their smaller portfolio companies.
- Companies with stratospheric exits often had unique technology that was likely to lead them to be wildly successful with or without the venture firms. In many cases, investors just jump on rocket ships that have already been launched. While highly publicized in the media, these mega-exits are the exceptions, and most entrepreneurs are much more likely to build successful companies carefully over time.
- Chasing unicorns is a good metaphor for how many of the top tier investors approach investment strategy. Many are gamblers more than company builders. Gamblers tend to place their bets and sit back and wait for the returns to materialize. Ask a CEO from a portfolio company of a top tier investor how much time they spend with their venture capitalist, and many will report their disappointment.
Investors continue to propagate the myth that there is a scarcity of capital. Since 2011, the amount of venture capital available to entrepreneurs has doubled. Since presumably today there aren’t twice as many quality companies for them to invest in, the negotiation leverage should be solidly on the side of entrepreneurs. It is important to be aware of the investor’s incentives and how their firms are organized and work. A good advisor can help manage the delicate process of selecting an investment partner and negotiating the favorable terms that entrepreneurs deserve.