This article originally appeared as a five part series in The Consulting Masters.
“The biggest startup successes, from Henry Ford to Bill Gates to Mark Zuckerberg, were pioneered by people from solidly middle-class backgrounds. These founders were not wealthy when they began. They were hungry for success, but knew they had a solid support system to fall back on if they failed.” Eric Ries, author of The Lean Startup
When and how should an emerging company raise money from venture capital sources? This is one of the most common questions I get as a strategy consultant to entrepreneurs and CEOs of startups. As an entrepreneur, you want enough capital to build and grow your business, but you also want to preserve as much value of the company for yourself, your co-founders, key managers, and employees. The use of venture capital (VC) as the source for this money is a larger issue.
As a professional manager for a couple decades, and a CEO of three different start-up companies for the last 15 years, I have intimate hands-on experience in the process of building businesses and raising capital. I’ve raised hundreds of millions of dollars of private and public financing and have purchased a number of companies. I have been both a buyer and seller of companies with VCs on both sides of the transaction, served on boards of directors, driven companies through rapid phases of growth, and developed relationships with many CEOs and executives that have been involved in the same processes. I’ve also worked in an industry that has historically relied heavily on VC money to fund emerging growth companies. As such, I have met with well over one hundred VCs over the years, and have raised money from a couple handfuls of them.
Through this process I’ve had the opportunity to build relationships with dozens of VCs and very close relationships with a few. Venture capital investment helped propel my most recent company, Entropic Communications, through a rapid phase of growth and eventually to an initial public offering on NASDAQ: ENTR (Entropic was recently purchased by MaxLinear (NYSE: MXL).
Company founders that have a good business idea with no independent source of capital will likely need to eventually have outside funding to help their ideas and companies grow. Venture capital is the most natural place to seek the growth capital needed for a startup.
With that said, I think a good rule of thumb about the question, “When should I raise money from VCs?” is: Wait as long as possible before you go to VCs to finance your company. And, if possible, never raise VC sourced capital. So, why do I say that? I know that this answer might surprise or even upset some of my friends, former colleagues, and former board members that work in the VC community, but I feel strongly about this.
A big part of my answer is also based on some of the myths and realities about raising VC money. This analysis is based on my experience and discussions I’ve had with other company founders and startup CEOs. The key myths are as follows:
• Myth #1: Getting a VC investment validates my business plan
• Myth #2: VC is the best source of funds for my startup, and the only place where I can raise sufficient capital to fund my business plan
• Myth #3: VCs can add a lot of value to my company and board of directors based on their experience
• Myth #4: I can raise some “dumb money” from second tier VCs and preserve my valuation
• Myth #5: Getting seed or Series A investment from a top VC will pave the road to later rounds of financing
I’ll explore each of these myths and the practical realities about raising VC money in this series of articles.
Don’t get me wrong; VCs can provide a very important source of growth capital for emerging technology companies, and they have been a critical part of the innovation and growth engine in the USA, Israel, Western Europe, and parts of the Far East. Sometimes VC partners provide real differentiated value as mentors and board members. In fact, I’ve had some excellent experiences with VCs as board members. Even high quality VC companies and their highest quality VC partners may not be the right fit for an entrepreneur depending on a variety of factors including industry background, domain knowledge, and personality fit.
Bottom line, raising VC money and having VCs on your board can be a real mixed bag. An entrepreneur needs to be very careful and selective in selecting investors who really become part-time business partners with a lot of authority.
Myth #1: Getting a VC investment validates my business plan
“It’s really rare for people to have a successful startup in this industry without a breakthrough product. I’ll take it a step further; it has to be a radical product. It has to be something where, when people look at it, at first say, ‘I don’t get it; I don’t understand it; I think it’s too weird; I think it’s too unusual’.” – Mark Andreessen, co-founder of Netscape Communications
Reality: The only things that validate a business plan are generating revenue and growing profits. I’ve seen dozens of companies raise what I consider to be enormous sums of money only to squander every cent and end up with a failed business. This result happens with hundreds of companies, even if they are backed by top-tier VC like Kleiner-Perkins (http://www.kpcb.com/), Sequoia (https://www.sequoiacap.com/), and Bessemer Partners (http://www.bvp.com/). VCs are making bets. No one cares about the success of your company more than you do as an entrepreneur. The company founders, management and employees are investing the “sweat equity”, and in many cases their own money. Of course if a VC invests in your company they want a positive payback, and will look for that 10X return. However, like any smart investor, a VC has a number of investments. They do not have a diversified portfolio like a large pension fund (http://en.wikipedia.org/wiki/Pension_fund), nor do they have the ability to “short” companies like a hedge fund (http://en.wikipedia.org/wiki/Hedge_fund). VCs will make a number of bets on the industries, markets, and products that they feel have the potential for explosive growth.
It is through a “hands-on” approach to their investments that VCs believe they can influence the outcome of a company. At the end of the day, I personally believe that the best way for a VC board member to be “hands-on” is to select good teams, hire a good CEO, and influence the outcome by more of a “hands-off” mentorship approach, running the company with only minor interference with management. The management team, starting with the CEO and key founders, are primarily responsible for driving the overall success of the business. They are the only ones close enough to the business to make the right “game time” decisions; which means developing compelling and differentiated products or services that solves a real problem and has real value for paying customers. My recommendation to a VC is if things aren’t going well, to dig-in enough to try to understand why. This takes a real “hands-on” focus with the leadership of the company. Is the problem management? Is it the market? Is it the idea? I would say, resist the urge to “take the wheel of the car” and try to “drive”. Mentor the CEO, but let him or her manage. If he or she is not the right person, then replace them, but try to make sure that is the real reason for the struggles. Don’t just refer to the “VC playbook” that replacing the CEO will fix any problem. It just is not true.
For any company, there needs to be a big enough market and enough differentiation that it can drive revenue and profitable growth. Early in my career as an entrepreneur, I heard that Kleiner would much rather invest in an A Team with a B Idea than visa versa. In reality, they want an A Team with an A Idea, of course. The key here is that an A Team can drive success even when a business model gets challenged and the company needs to adjust and adapt. The B Team just can’t do that as well, if at all.
Overall, a VC does not validate your business plan, and they cannot really do that. It is up to the leadership team and a passionate, focused and driven workforce to create value in a company. Even with the best ideas, it always comes down to people.
Myth #2: VC is the best source of funds for my startup, and the only place where I can raise sufficient capital to fund my business plan
“Running a startup is like eating glass. You just start to like the taste of your own blood.” – Sean Parker, founder of Napster
Reality: Generally, this simply is not true, even with companies that may need a seemingly large amount of capital to fund their business. A key case-in-point is a company in an industry that I’m very familiar with: the semiconductor industry. Broadcom, when it was a startup, never raised any capital from VCs. They did eventually raise money from strategic partners, but they also paid their employees sub-market cash compensation for years, even after they were public, in favor of above market equity compensation. Eventually this model broke as they became a larger public company with major public shareholders, but that was way after their startup days.
My point is more about “boot-strapping”, or self-funding the company for as long as possible, and finding creative ways to raise capital through angel investors, super angel investors, and strategic partners. Enterprises that are selling to consumers can also use innovative approaches like “crowd funding” (http://en.wikipedia.org/wiki/Crowdfunding) to raise money without giving away equity in the company. One of the most popular crowdfunding sites is Kickstarter (https://www.kickstarter.com/). Another approach to driving pre-product revenue is to sell engineering services on a Non-Recurring Engineering (NRE) contract basis. This can help pay some bills for the company, validate customer interest, and facilitate learning.
Bottom line, there are really two main reasons to delay taking a VC investment:
• Once you bring a VC investor into the company, you effectively lose a large amount of control of your company. This isn’t only about the size of the VC’s investment or their percentage ownership of the company. It is about a VC taking a board seats and influencing the governance of the company. It is about the non-financial deal terms of the financing. It is about blocking rights. It is about issuing preferred stock with special right. It is about putting employment contracts into place for founders and key executives. All of these things may eventually come to pass, but why not delay them if you can?
• If your business model is not far enough along the validation process, you will not be in a strong position to negotiate the terms of a financing. Real validation of the business model includes the acquisition of customers, revenue, strong gross margins, a clear path cash-flow break-even, and a verifiable path to positive operating margins. Waiting for these business results may eliminate certain VCs that want to invest at a seed or early round stage, but who cares? If the business is successful, and you as the entrepreneur or one of the key executives owns a bigger piece of the company, since you didn’t experience the dilution of bringing-on a VC, isn’t that a good thing?
There may be special circumstances where there is an extremely large market opportunity, the need to quickly establish a beachhead in that emerging market, establish a first-mover advantage, and brand recognition. In these cases, the capital needs are high, and the amount of money you need to spend early in the life of the company can be quite large to support rapid market expansion; Facebook and Google are two such examples.
I’m not saying don’t ever raise money from VCs. Some extremely successful companies including Intel, Apple, Cisco, Google, and Yahoo raised VC money when they were startups. What I would urge is that you think through the alternative sources of capital in a very sober and serious way before raising money from VCs.
Myth #3: VCs can add a lot of value to my company and board of directors based on their experience
“Startup success is not a consequence of good genes or being in the right place at the right time. Success can be engineered by following the right process, which means it can be learned, which means it can be taught.” –Eric Ries, author of The Lean Startup
Reality: Answers.com (http://www.answers.com/Q/What_are_the_limitations_of_venture_capital) states that, “VCs can provide mentoring, access to a network of partners (alliances), and help to facilitate exits.” While this can be true, it may come at a very large price. Depending upon the knowledge base, ecosystem relationships, and mentorship capabilities of the VC partner involved in your company, this could be a total mixed bag. If you have a VC on your board that really doesn’t have any of these skills or abilities, you could have a real problem, especially as a young entrepreneur. This can even happen with a top tier VC investor, if your company gets relegated to a more junior or weaker partner, even at a relatively strong VC company. In this case, there could be limited value, no value, or negative value. The Answers.com article goes on to talk about the limitations and disadvantages of raising money from VCs, including the timing to recover their investment being three to five years, and well as tougher pricing of the deal, intrusion, and loss of control. The negative parts of the analysis almost always exist to some extent. The positive non-financial aspects of a VC investment are typically over-rated, and in some cases non-existent.
In my experience, the best mentors and board members for a young entrepreneur are former executives with lots of operating experience, including current and former CEOs and CFOs with strong operating backgrounds. Some VCs come from a strong operating background as well, but be careful to make sure it is relevant and recent experience.
Myth #4: I can raise some “dumb money” from second tier VCs and preserve my valuation
Reality: This is almost the opposite argument of Myth #3. First, let’s define “smart money” and “dumb money”. Smart money drives down the company valuation deeply to ensure a better return, and demands more onerous non-financial deal terms, corporate governance, and company control. In exchange, the smart money investor brings something special to the table: deep industry knowledge, customer or supplier relationships, access to key ecosystem partners, and in some cases, a combination of the above. The smart money investor also, theoretically, will devote a large amount of time to the deal. Dumb money is the opposite. They provide little to no value to the company except money. They really don’t know the business or have any connections. They may be smart, but typically not in the product or market space of the company. Dumb money investors may also be less valuation sensitive or have less ability to assess valuation.
Obviously, these are extremes. My caution about raising what you think is dumb money are as follows:
• When the proverbial “shit hits the fan”, as it ALWAYS does with any company in the real world, a dumb money investor is more likely to panic. If the non-financial deal terms give a board seat, or any significant type of influence or control, this is a real problem. This can be mitigated somewhat by bringing industry experts onto the board to be a reference point for the investor board member, but this sometimes is not enough.
• Dumb money investors made their money somehow, and they have egos like anyone else. They want to be heard, and this takes time away from management, and from doing real work that drives value. It may be a small burden or a big one, but it is something to think about. Frequently, this type of investor is more susceptible than most people to what I call “transfer of credentials”. That means the person may be smart in one area that is completely irrelevant to you and your business, but because they are smart in one area, they thing they are smart in all areas. At a minimum this can be a huge time sink, and in a severe case can cause real damage to your company.
• Dumb money investors could be an inhibitor to later rounds of financing, and good investors typically want to follow good investors. This may not matter, but if there is a revision in the strategy that delays the timeline for profitability, as is often the case, this could matter a lot.
It is important to be careful when taking VC money for your company from someone that will have a large influence on the company in exchange for the investment. This is the case with both the best VCs and the worst. Do as much as you can to ensure you have a good fit with the lead partner from the VC that will be involved in your deal. Try to identify VCs that will add real value and not just money, or, at a minimum, someone that doesn’t add negative value.
Myth #5: Getting seed or Series A investment from a top VC will pave the road to later rounds of financing
“There are a lot of ways to make people not like you, but one of the most powerful, if least fair, is to be really, really successful. Nobody resents the guy who just lost his job. But the guy whose Internet startup made him a billionaire at 25? That’s a whole different kind of envy.” – Jeffery Klueer, author at Time magazine
This is really more of a half-truth, and reminds me of a story I heard at a venture conference. An entrepreneur was taking two VCs back to the airport (this part of the story is already pretty funny, since most VCs won’t make an investment that is further away than a 45 minute drive from their office…in traffic), and the entrepreneur’s car ran out of gas. Luckily, a filling station was nearby, and the VCs got out of the car and helped to push the car to the gas station. A friend of mine, who was on the panel listening to the story, who has been on many boards and is a great leader and well known figure said, “I’ll bet that is the first time you saw the VCs do ANY work!” It is particularly funny since most VCs are always telling entrepreneurs how hard they are working, and an entrepreneur is thinking to himself or herself, damn, I just clocked 80 hours myself this week!
VCs who have tons of deal experience, strong relationships with people in your ecosystem, a good set of partners at their firm, a solid track-record of investments even when deals grow some hair, and a terrific reputation with other entrepreneurs and startup executives are the ones you want on your board. These types of VCs are typically well respected by other VCs, and they can be helpful with providing general insight and access to follow-on sources of capital. But don’t loose sight of the fact that the startup CEO is ultimately responsible for raising capital. If you rely on the VC to do this, then you’ll be in a world of hurt. Every VC I have ever met feels they are the ones that add value, yet only about 5 to 10 percent really live up to that expectation. Something is definitely amiss here.
In conclusion, venture capital can sometimes be a very good source of financing for your entrepreneurial startup. However, wait as long as you can and bootstrap as long as possible, if it doesn’t damage the company prospects. Keep your eyes open to the pitfalls and risks of bringing-on a VC investment. Consider angel investors, super angels, strategic partners, and in some cases crowdfunding or NRE for your emerging company. The true professional, experienced entrepreneur typically keeps a greater percentage and more control over his or her company. To fill the void of not having a VC on the board of directors, a good source for advisors and mentors is current and former operating executives that have “been there and done that” from the hot seat, instead of from a board seat…or even worse, a board observer seat.
I welcome your thoughts and feedback. Please share your experiences and insights!
This is Patrick Henry with The Real Deal…What Matters.
by Patrick Henry, CEO QuestFusion, and former CEO Entropic