An entrepreneurs guide to venture capital (1 of 3)

If you’re profitable, you can control your board.. We negotiate for the wrong thing because we don’t know what our goals are. “Who gives a shit what your valuation is? At the end of the day your valuation will be more impacted by a board made up by a bunch of old white men who show up once a month for half a day. It’s a lot easier if you just tell them what you’re going to do - Mark Pincus CEO of Zynga

For many an entrepreneur, raising venture capital (VC) money is an important – if not critical – milestone in the history of their business. In fact, raising VC money has become such an important part of the entrepreneurial experience, at least  for certain types of enterepreneurship (e.g. consumer Internet) that it’s hard to remember that raising VC is still a relatively new way to finance a new business – the VC industry having only really been established in the 60s with the likes of Arthur Rock (early investor in Apple and Intel) establishing funds that did nothing else. There are so many impressive stories about VC funded businesses (Google, Cisco, Hotmail, AdMob, Zynga, Etsy to name just a few) and so many “celebrity VCs” including Vinod Khosla, Don Valentine, Michael Mortiz, John Doerr and Fred Wilson that it’s easy to forget that the majority of small businesses in the US don’t ever raise VC money nor could they ever nor should they.

Given the brilliance of these VCs and the many stories that are written about the great success that VC funded companies have had, it’s hard to fault the entrepreneur who views raising VC money as a success onto itself. But the reality is that the likes of Cisco, YouTube and Google’s are massive exceptions to the rule. The VC industry as a whole has a negative ten year IRR. Obviously that did not happen because every company that raises VC is generating large returns. Billion dollar payouts are not the norm – they are the rare exception and most VC funded companies fail outright, many of them after raising a lot of capital.

Over the past 10 years I’ve raised approximately $25M in VC money from funds small and large – I’ve been both smart and dumb about it and lucky (raised capital in March 2008 before the world blew up) and unlucky (raised money in 2002). I’ve lost some money along the way but I’ve also had some moderate success and made some good money along the way. I’m still working on hitting a home run but my primary motivation is innovating – I love creating teams to create unique and valuable products that customers love.

With that in mind, here is a short primer on what every entrepreneur should understand about the VC industry. I’ll start with some high level context about how to think about the role of VC in your company, how raising VC impacts your destiny as an entrepreneur and how you actually make money.

Raising VC equity = selling a piece of your company that you can never get back. Ever. It’s marriage with no divorce. The capital you receive is a means to an end with lots of strings attached.

Be realistic – You’re an entrepreneur so you certainly have a tolerance for risk but you are likely a raging optimist as well. After all, you need a certain amount of ability to delude yourself if you are going to start a company; if you were completely honest with yourself about the risks, you’d probably never get started.  But while it’s great to be ambitious and set aggressive goals, you have to be very careful not to create a financial structure that only puts cash in your pocket (vs theoretical gains which are on paper) if you achieve very large outcomes at the end of a very long road. You may want to make $100M but if you currently have no net worth, making $10M makes you rich in a way that changes your life forever. Once you’ve made $10M, you can worry about making $100M, and you may well want to because it’s fun, but don’t lock yourself into a structure that only allows you to make money if you achieve a home run; entrepreneurship is about many things beyond just making money but the whole experience becomes dramatically more interesting and enjoyable if you are being rewarded with cash in your pocket. I’ll address this in a later post but contrary to what many VCs believe, entrepreneurs who make money along the way are actually better – and less risk averse – entrepreneurs who are freed to think more broadly.

The less equity (note debt has limited impact on this) you have taken on and the more control you have, the more flexibility and leverage you have to get to your first milestone and then go beyond. While your dream of the billion dollar business may continue to guide you – and for many a VC it may be the only outcome they really get excited about  – far smaller outcomes can create significant wealth and enjoyment for entrepreneurs who have been prudent with their capital structure. It’s important to remember that the number of billion dollar liquid exits (vs billion dollar paper valuation) is extraordinarily small. Those homeruns are what garner all the press but that’s the survivor bias of the press. The majority of the stories are the small exits and failures that you have never heard of.

Understand the financial incentives of everyone at the table A company that has created $100M of  liquid capitalization (meaning it could sell to someone for $100M in cash) might be effectively worthless to the entrepreneur if they’ve mismanaged their capital structure by raising too much capital. Imagine a $100M offer for a company you founded but where you’ve raised $30M of VC and took the last 20M of it at a very high price (say $70M). You own 20% of that company so if you sell, you take $20M in pre-tax cash home with you. That could be pretty compelling – especially if you don’t think it’s likely that you can – on a risk adjusted basis – create a company worth $300M+. After all, not every business can become a business worth many 100s of millions of dollars – some categories are just too small. But unfortunately for you – the entrepreneur – the VC fund that invested the most recent $20M of new equity at a $70M valuation has no incentive to sell at a $100M valuation. Smart VCs obviously try to avoid situations like this in the first place. They want companies that can hit a homerun and if they think that you as the entrepreneur don’t have a similar goal – they’d be foolish to invest that much money at that big a price. But the reality is that despite all the diligence before the investment is made, at the moment a VC invests there is a lot about the future that is not knowable – including how big the ultimate opportunity will be for that particular company. And that is where the trouble begins – a company that has realized that $100M is a good outcome and has raised a small amount of capital is going to have a much easier time making the decision to sell than will a company where the expectations were set for something far larger. And while VCs do sometimes decide to sell in these situations (Mint is a fantastic example), it’s not necessarily common. Many VCs would argue that they have no interest in forcing an entrepreneur to work against her will but and most of them probably mean it. But instead of hoping for the best, create a capital structure that insures that you have options. For example, if you do decide to raise that additional 20M on a 70M premoney valuation, maybe structure the deal so that you can force the sale so long as they get their money back. VC incentives are often quite different than the incentives of the entrepreneur and that division can be more pronounced when you are working with a tier 2 or tier 3 firm and interestingly, your success or the potential of success can magnify the division. I’ll explain more later when I discuss why choosing the right VC firm is absolutely critical.

Understand your own motivations - it’s not just about understanding what motivates the VC firm (not the partner – I’ll elaborate later) – knowing your own incentives and motivations is critical. Do you really want to hit a homerun or can you live with “only” $20M? This is unique to each person – not everyone views the world in the same way. And your perspective on this can change over time as a result of your circumstances chaning. If you started the company when you were single but you are now married with kids, you may need a cash to pay for a house and tuition far more than you need – or want – the massive payout. As you think about your financing strategy, keep your options open and  remember: Capital structure and control structure is destiny for a business.

In the next posts I’ll cover various topics related to the financing process

• Entrepreneur vs VC economics and how these can differ greatly, particularly when you’ve raised money from a VC fund that is not performing well
• IRR vs ROI – why IRR is largely irrelevant for VCs
• Selling control – don’t do it
• Raising a lot of capital = selling tomorrow’s equity at todays price
• Digging into the details – Understanding the variables on a term sheet. Price is but one of them.
  • Liquidation preference (and multiples on them)
  • Participating preferred
  • Board structure
  • Specific rights that the preferred shareholders may seek that make them – and not the board – the arbiters of certain strategic decisions (like selling the company)
  • Information rights
• Hired gun “professional CEOs” and why it’s a part of the VC playbook that you should control the execution of.
• Who should make the strategic decisions at the company you founded – the advantage insiders (day to day operating executives/founders) have versus outsiders (board members) when making strategy decisions
• What great VCs do well
• Being CEO does not mean you have to be the most experienced or most accomplished person in your company at every task or competency that your company has to have to be successful.
• Your VC relationship is with the  fund, not the partner who sits on your board
• Premoney valuation does not equal how rich you are or how rich you will be
• Taking money off the table – do it
• Small companies with big company processes and structures have the worst of all worlds – they don’t have the financial resources of a big company and they don’t have the nimbleness of a startup. And yet VCs often want to “professionalize” the management of a startup and make them look more like a big company.
• Understanding how taxes impact how much you put in the bank
• What is a dead VC firm and what does it matter to you how the VC firm that invested in you is doing?
• How you can become a victim of your own success in the company you founded

To be continued