enture capital is a relationship business. The most important of these relationships is between the investor and the founder. In a very profound sense, a deal between a venture capitalist and a founder is a marriage with all of the legal, financial and even emotional consequences that that entails. While investors often have some cushion because their risk is typically diversified through myriad investments in a wide variety of startups across different industries, founders can be quite deleteriously impacted by a rocky relationship or breakup because they are almost always “all in” on a venture. This is why it is so essential for both parties but particularly founders to understand the dynamics of the investor-founder relationship so that they can effectively manage it when the inevitable challenges arise.
The Primacy of Goals
A critical part of effectively managing the investor-founder dynamic is for founders to have a clear answer to the most basic question: What do you want to achieve? While investors are generally interested in making money and venture capitalists focus on the necessity of making enormous sums of money to cover their inevitable losses on their other investments in this risky asset class, not all founders are solely interested in money. For some a business is a lifestyle choice.
They are dissatisfied with the corporate grind and regard the freedom to run their own business as priceless. Others are motivated by a desire to make an impact on the world by bringing a life changing medical or other technological innovation to market. Some enjoy the intensity and novelty of the startup phase of building a business but are happy to step aside and cash out after the business has scaled and is ready for acquisition. Still others are just as interested in making enormous sums of money as the typical venture capitalist is. Understanding your personal goals and being able to prioritize them is essential for founders because ultimately they must decide if they want investors.
Trust and communication are the foundation of a strong and healthy relationship and this is no less true of the investor-founder dynamic. A precondition to trust is that the investor and founder share the same vision and goals. While it is true that all businesses need to be ruthlessly practical to survive, great firms have a vision—something greater than just money to motivate the high quality human beings required to build the enterprise. Are your investors on board with that vision and are they just as passionate about it as you? Unless there is alignment and agreement on this basic matter, the relationship will not work in the long run and the founder should not take the investors’ money.
Consequently, a critical task for founders is to conduct extensive due diligence on potential investors. Often founders are so desperate for capital that they neglect to thoroughly perform this essential function. Due diligence is often regarded as essential for investors but it is even more important for founders. A founder has only one business while an investor has multiple investments.
It is essential for the founder to investigate the background, mission, investment thesis, operational history and portfolio composition of the venture capitalist. Are there other startups in their portfolio that could be conflicts of interest with your business or lead the venture capitalist to push critical resources to your competitor instead of you? This is far more common than startups realize and can lead to the venture capitalist silently undermining a firm, especially as venture capitalists are increasingly required to provide not just capital but access to an ecosystem of resources including contacts, personnel, strategic advice, etc. There can be no trust if conflicts of interest produce fears that the investor is not completely on board with the startup and ardently devoted to helping it succeed.
Trusting relationships also require good communication that is characterized by honesty and consistency. A red line for many venture capitalists is any lie, exaggeration or obfuscation with regards to critical information. They know that there are going to be challenges but since they are not involved in the running of the company on a daily basis, it is essential that they be immediately alerted so that they can help to resolve the issue. Again, this is a people and relationship business so any willingness to engage in prevarication raises serious issues about the character of the founders.
There needs to be brutal honesty about what is going on in the company through the use of sound, well thought out metrics, reporting regimes and data analysis tools. Throughout the relationship, communications should be frequent with a demonstrated willingness to volunteer information instead of the venture capitalist having to work to extract it. Likewise, a willingness to listen to the advice of the venture capitalist is essential. They often have a great body of wisdom from previously failed investments as well as successes that founders should be actively seeking to leverage to maximize their chances of surviving in the high stakes world of startups.
An important factor in the investor-founder relationship is the difference between smaller and larger venture capitalists. Smaller firms tend to invest their own capital directly while larger firms hire investment professionals to invest money from a fund gathered from other sources of capital such as pensions and other institutions. This has implications for the founder because of the backgrounds of these investment professionals who largely come from the finance and consulting fields.
These industries are highly data driven so there is a bias amongst these investment professionals to invest in companies that can present hard data over a period of time. But what if your industry or startup is so new that there just isn’t a lot of data available? In addition, due to their backgrounds, these investment professionals tend to prefer founders with name brand resumes—Ivy Leage education, Fortune 500 experience, etc. Investments in a person with a name brand resume are regarded as more “defensible” than investments in a founder with great practical experience and skill but a non-traditional background. This is a big part of where the bias in venture capital comes from.
Founders need to understand this bias as they do their due diligence on the venture capital firms that they wish to work with as a great amount of frustration can be saved by trying to work with investors who are more open to those of your background to begin with. It may be better to seek an investment from an angel investor or smaller venture capital firm that is less likely to be imbued with these biases and can offer the benefit of a more intimate experience since they are managing fewer investments. A corollary is attending a small college rather than a large university. The intimate teaching experience at the former can make all the difference and so too can more hands on and extensive contact with an investor lacking conflicts of interest.
Is Venture Capital For You?
An important consideration in the investor-founder dynamic is to understand that venture capital is not for everybody. As an asset class, is venture capital right for you as a founder? Firstly, due to their risky business model—lose on 8, break even on 1 and win big on 1—venture capitalists are in the grand slam business. They are interested in ultra high growth businesses in billion dollar markets with a minimum of a $100 million exit and preferably a unicorn valuation of $1 billion.
Anything less and it is not worth their time. The problem is that few businesses meet this description or the time horizon required to get there is not in tune with that of the venture capitalist. That time horizon is typically about the life of the fund (6-8 years) so as to generate returns for the venture capitalists’ investors which is why rapid growth is so essential to the VC. Pressure to grow the business at all costs can lead to decisions that are detrimental to its long term viability. It’s like an army that extends its lines beyond the capacity of its personnel to defend the territory.
In war, and business is war, thin lines can be exploited to the detriment of the organization. There are also many great businesses that do not have annual double digit growth or are worth less than $100 million—indeed these businesses are the bedrock of the economy—so explosive growth is not required for relative financial success.
Secondly, if you are not interested in selling your company or taking it public, you should not seek venture capital. Venture capitalists are looking for a liquidity event to cash out on their investment which usually entails an IPO or an acquisition. Being a public company or being acquired usually means a loss of control so if you became an entrepreneur to maximize control over your work life then venture capital is not for you and the relationship will not work.
Relatedly, investment capital, while it is key to the establishment and viability of the startup, usually dilutes a founder’s stake in the company with attendant consequences both financially and in terms of corporate control. The more money a firm raises, the less of a stake the founders have and the less control they have as well since investments are usually associated with board seats and voting rights.
Another factor to consider is the actual value to be obtained from venture capitalists’ advice. Undoubtedly, this will vary from venture capitalist to venture capitalist but renowned venture capitalist Vinod Khosla actually has contempt for the advice of the typical venture capitalist. According to Khosla: “most venture capitalists haven't done sh*t to help startups through difficult times, and he estimated that "70% to 80% percent [of Venture Capitalists] add negative value to a startup in their advising."
One way of avoiding this pitfall is to seek relationships with investors who don’t just have name brand MBAs and consulting experience but have actually worked extensively in the industry that you are trying to enter or disrupt. Finally, raising large amounts of venture capital while it can provide much needed attention and validation in the eyes of potential customers, does not necessarily equate to success.
Researchers have discovered that there is simply not a strong correlation between the amount of money a company raises and successful market outcomes and the amount of money raised by a startup is often inversely correlated with success. Just as innovation is often a function of scarcity, so too excessive amounts of venture capital investment may undermine success by inhibiting the prudent and disciplined action that startups with less capital are forced to cultivate so as to survive. These are the landmines in venture capital that founders should understand so as to have a clear eyed perspective required for a healthy investor-founder relationship.
The objectives of investors differ based upon the type of investor. Angel investors who are typically previously successful entrepreneurs who invest their own money at the seed stage are usually interested in not only making money but also in working hands on with young entrepreneurs who can benefit from their wisdom and experience. They also want to gain frontline exposure to new technologies and markets that may be of interest to them. Corporate investors invest strategically.
They are seeking to work with startups that are disrupting their industry so that they can stay ahead of the innovation curve and position their company to survive and thrive in rapidly changing markets. They are typically excellent sources of customer contacts and industry expertise. It is not unusual for a startup working with a corporate venture capitalist to be acquired by the parent company.
Venture capitalists are the most financially oriented. They want to demonstrate a sufficiently high enough return on their current fund to raise their next fund. As noted, they are focused on high growth businesses in billion dollar markets that can achieve exits in the hundreds of millions of dollars. At a more detailed level, this is how venture capitalists evaluate startups:
Understanding these perspectives is essential to the development of a healthy investor-founder relationship. Expectations are less likely to be disappointed if the founder respects and appreciates those expectations from the outset.
Trust is an important part of the relationship between investors and founders but so is power and founders should be keenly aware that power can be abused. An intelligent founder is always cognizant of how power is structured in their relationships with investors, employees, suppliers or anyone else associated with their enterprise.
At the beginning of the relationship, the investor has more power since financial capital is essential to the launching of the enterprise. In addition, concepts such as term sheets and voting rights can be very arcane to founders. It is therefore essential that term sheets be rigorously scrutinized and founders interview other entrepreneurs who have worked with a particular investor to obtain contextual knowledge as to what it is like to work with them in practice. Once the founders have the check this will begin to change as they will have access to better information in their role as the day to day operators of the startup. But during the interim period, the power dynamic is shaped by what is known as information asymmetry.
A good relationship requires that neither party abuse its power when it has the upper hand. If the enterprise survives, as it matures and becomes financially viable, more power will gradually accrue to the founders and this should be welcomed by the investors because it means that their desired exit is approaching.
One of the ways that power can be abused is through the replacement of the founders by the investors. The most famous example of this was when Steve Jobs was forced out of Apple to the detriment of the company. This is not uncommon as between 20-40% of startup founders are replaced at the demand of investors.
Indeed, few people realize that Tesla was not founded by Elon Musk but by Martin Eberhard and Marc Tarpenning in 2003. Musk, who was an investor, took over in a palace coup in 2007 that is a cautionary tale for founders. It is extremely difficult to assess whether or not replacing a founder is generally beneficial to the enterprise since many factors come into play such as the availability or lack of availability of good replacements due to laws governing non compete agreements, the underlying reasons for the replacement, the timing of the replacement and such. What is clear is that founder replacement is more likely to occur when there is a new round of financing and when the board contains more investors.
While there can be straightforward reasons for replacing a founder: fraud, inability to retain key personnel, consistent underperformance in meeting KPIs, an important but unstated one is ego. While Vinod Khosla may not be impressed with the strategic acumen of the typical venture capitalist, they most assuredly are impressed with themselves. They will therefore feel the need to “professionalize” the startup which is code for replacing the founders with people that they more directly control.
The problem is that this can destroy the soul of the startup as the founders are typically the embodiment of the vision of the organization and many key personnel may leave with them. In a sense, this is where we see the difference between management and leadership. The small percentage of companies capable of growing into unicorns require leaders who have the vision, capacity for inspiration and people skills that transcend the stiff, operational capabilities associated with “management”. Visionary, inspirational founders are even more rare and important than great technologies. Steve Jobs, while he was not perfect, is a great example of this. He was not an engineer or computer scientist but he understood how to build products that people want.
VCs vs Founders
Venture capitalists and founders have interests that are not necessarily aligned and should be taken into consideration before they begin a relationship that is inherently fraught with risk.
For venture capitalists, the most important initial consideration is not so much money but is it worth the time to do due diligence to investigate the potential opportunity further. For founders, the issue of shared alignment of vision is essential as they have everything invested in the firm. This is where the investor-founder relationship will start and both parties must understand this from the outset to have any hope of establishing a successful dynamic.
Venture capital is not for everybody. There are a wide variety of ways to finance a new business and intelligent founders should be aware of the pluses and minuses of the many different forms of entrepreneurial finance. Angel investors, corporate venture capital, government grants, crowdfunding and even small business loans can all be a part of a founder’s investing solution. But the basis of healthy investor-founder relations is trust. Trust requires an understanding of one’s self and due diligence on the interests of the other party. It requires a commitment to consistent communication and keeping one’s word. Ultimately, the investor-founder relationship is a marriage with all of the gravitas that that commitment entails so choose your spouse wisely.
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