Venture Financing - Reality versus Rumor with Dick Brown
Understanding VC’s - Of all the players in “the entrepreneurs’ game” the most vilified is the “VC” (venture capitalist). The supplicants seeking money blame VC’s for everything: failing to supply them capital; wanting to run all the companies they finance; owning too much of each venture; and, wanting to make obscene sums of money. Why?
Not surprisingly, these comments are most often made by the newest, most immature entrepreneurs. They seem determined to indict all VC’s … yet, they have scant knowledge and it’s based largely on industry myths … most of which are false. The most vocal of these folks have never met a real, live “VC” and would be tongue-tied-terrified to be sitting across from “a real, live one” at lunch.
The entrepreneurs’ role-model for modern VC’s lies close to Shakespeare's “Shylock, the money lender” Similar to that character, latter-day VC’s are accused of providing money at exorbitant rates … thus extracting their "pounds of flesh" from the innocent and noble money seekers. In reality, as in “The Merchant of Venice”, most VC’s have enviable human qualities (“If you prick us, do we not bleed?”) and can become not only sympathetic characters, but staunch, invaluable allies in most ventures, particularly the successful ones. Let’s look at typical VC’s and the truth behind some of the misconceptions
VENTURE CAPITAL – INSIDE, LOOKING OUT
Venture Capital companies invest OPM (Other People’s Money). Each VC company usually has Managing Partners (MP’s) that invest this money, some of which is usually their own. MP’s are measured (and paid) to generate more profit than the pure investors (“LP’s” or Limited Partners) could make putting their investment somewhere else with similar risks.
A typical Managing Partner is a male somewhere between 40 and 60. Although some MP’s were born with the silver spoon, most made their money by starting ventures that grew into successful companies. They are usually well-mannered, aggressive, experienced executives that have survived more than a few battles. They are adept in money matters and can smell a shaky financial deal better than the most experienced CPA. They have heard every excuse imaginable for failure, yet rarely offer one for their own errors. Although they are considered to be among societies’ “successful”, their past glories become unimportant as they strive to beat their VC contemporaries to that top rung of recognized champions in that industry.
Entrepreneurs Versus VC’s
Scenario #1
Entrepreneurs: We had this fantastic concept for a new venture. We did a great business plan and sent it to some VC’s. None were interested. They’re just too dumb to recognize our potential.
VC’s: Entrepreneurs believe we are sitting with bated breath at each mail delivery, wired and waiting for their business plan. They don’t know we can receive hundreds of e-mails a day and well over 1,000 a year. Most are sent by email and are quickly “chucked” unless they show immediate and unusual promise. The majority of the BP’s we receive predictably fall into disposable categories: small business proposals disguised as ventures; Bill Gates look-alikes (“we’re going to beat his growth, but quicker”); inventions that have already proved impossible to implement or market; deals that require multi-million dollar investments from people with no business or management experience. If you send us a BP that will cure cancer at a prescription cost of $1.49 and do not alert us that it’s coming, you might be better just putting it in a bottle with our address and tossing it into the ocean.
Of every 100 BP’s we receive, 95% are automatic rejects. Of the remainder, three may get funded. One company “makes it”.
Scenario #2
Entrepreneurs: We had this fantastic concept for a new venture. We did a great business plan and sent it to some VC’s. We only needed $150,000. They turned us down. They’re too dumb to recognize our potential.
VC’s: Our latest fund was capitalized at $35 million. We won’t get involved in any deal that needs less than $2 million. We sit on the board of each investment and can’t invest in small deals that will take as much of our management time as large ones. If each returned 20%, which ROI would you pick? (You’ll get our same response for a BP seeking investment in a local company that might grow to regional sales of $750,000 in 6 years. If it ain’t goin’ to be big and potentially dominant, forget it!)
While we’re at it, we also don’t like start-ups. If you were going to invest $2,000,000 would you prefer an existing, rapidly-growing company that’s profitable and needs expansion capital or a raw start-up … albeit with a promising idea … to be managed by some grad students from Stanford? We love bridge financing of existing, profitable companies.
Also, we need to keep an eye on our investments and we nearly always have one or two seats on the Board. These usually meet once a month. If our office is in Dallas, we’re not going to invest in companies in Seattle.
Scenario #3
Entrepreneurs: One of our guys met a VC at a church social. He said they vastly preferred to invest in people they already know and that have proven track records. That’s not fair!
VC’s: Nobody said “the game” had to be fair. If you were in my position, who would you pick? Raw neophytes? Want to get our attention? Take 2 or 3 of us to lunch and make a great pitch. Maybe then you’ll begin on the path to become “someone we know, trust and believe in!”
Scenario #4
Entrepreneurs: The guy that met the VC at a church social said VC’s generally expected an investment to return 5-10 times on their money in 3-5 years. That’s obscene and outrageous!
VC’s: He neglected to mention that’s for one of our successes. If we invest in 10 companies, 3-5 will go bust; another 3-5 will survive as “the living dead”, but never go anywhere. One will be a moderate success and one maybe will result in the 5-10 times case. We work hard to increase these numbers. Overall, our ROI varies from year-to-year but historically has run 8% to 30%, depending on our luck, the general economy and a couple of pages of other variables. Sometimes, we even have losses.
Incidentally - in business there’s no such thing as an “obscene profit” and we’ll grab all we can find that are legal.
Scenario #5
Entrepreneurs: One of our guys met a friend at a college reunion. He’d heard bad stories about VC’s and warned against having anything to do with them because “VC’s all want to run your company.
VC’s: That’s pure nonsense. A Silicon Valley VC once described it this way: “We want to supply the bullets, not fight the war.”
Sometimes this label gets stuck on us when one of our companies gets in trouble. By now, you should know we’re in business to make money. If one of our investments starts going bad, we must try and save it. First, we do the best we can to work with current management. In extreme cases, we may need to replace some of these people. This is a last resort and very dangerous for the company, our investment and our partnership. When pushed to the wall, we’ll bring in a “troubled company” consultant, but not one of our own people. If one of our companies “tanks” all the MP’s get a ton of grief from the LP’s.
Finally, I have already run three companies and have no desire to do this again. Right now I’m a MP here and helping to run this partnership. We are not only under severe pressure to make profit, but when our current fund becomes fully funded we’ll start a new one. We’ll go to our current investors first and if they’re unhappy with our performance and the returns, they’ll say, “No”. Our investment community is very small and bad news travels fast. We could have a tough, tough time raising new capital.
Scenario #6
Entrepreneurs: We had this fantastic concept for a new business. My father knows a VC at his country club. He invited us both to a round of golf and over drinks; the VC asked me and my team to make a presentation to his firm. I noticed he wore the gold “beaver” ring, signifying he had graduated from MIT.
I brought three others of our team and since I guessed my father’s friend was an engineer, I decided to have our “chief technical guru” make the whole presentation and prove how smart we all are. Our guru went at it for 45 minutes and filled his talk and white board with dozens of obscure abbreviations and advanced techno-jargon. When he finally took a breath, one of the VC’s interrupted and asked for a “pit break”. Five VC’s left for the break and only one, the most junior, returned. A week later we got a letter. They turned us down. They’re too dumb to recognize our potential.
VC’s:
We’re interested in making money, not trying to understand every facet of new technology. New, but professional, management teams split up the presentations, use slick visuals and stress: how unique the opportunity; how tempting the market; how safe the entry; and, how huge the return. If I want to be overwhelmed by technical data, I’ll rent a Stephen Hawking CD.
Scenario #7
Since we’re almost finished, I thought I would “fess up” to one area where we may just take a teeny, tiny advantage – on rare occasion – and, of course, only in limited circumstances.
We’re financial experts and “survive in the streets” by negotiating deals. When we prepare to offer an investment, we spend a lot of time establishing our “valuation” of the deal. That is simply, what we think the whole opportunity is worth and how much we’re willing to spend for what percentage. We all agree on the numbers and set up a meeting with the entrepreneurs.
We enter fully-prepared. I usually start-off by innocently inquiring: “We think we might be interested. Tell me how much money do you need and, assuming we do a straight equity deal, what percentage ownership are you willing to part with?”
As many times as this has happened, I still get amazed. Their team has not considered how to answer this basic query. Further, there probably isn’t a real financial guy on their team and they’ve adamantly refused to pay for sophisticated legal and knowledgeable financial counsel. After an awkward silence, the CEO usually blurts out something like: “Well, we know we need at least $3,000,000. What do you folks think is fair?”
In that one sentence, they have just “given away the store”. Next I respond: “We’re prepared to give you this check for $2,750,000 (reaching in my pocket and putting it on the table in front of them) on Monday in exchange for 90% of your stock”. They’ll mumble and caucus, groan and caucus, complain and caucus until they “reluctantly agree to 82%” and we close.
For years after they’ll tell how greedy and vicious we were, never understanding it was their own fault for not being prepared for a tough, “knock-down” with highly-experienced negotiators. And, think of their awe if they knew the percentage we’d internally agreed upon before the meeting was 43%
You can’t send little kids out to play hardball against the Yankees and expect to win … but, with a lot of preparation you may be able to score a couple of runs. We come complete with an impressive amalgam of well-connected, powerful business associates and can help fledgling companies avoid making similar, dumb mistakes.
… That’s the end of VC stories for today.
Entrepreneurs: Thanks. Maybe we just learned something.
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For more information, please visit Dick's TNNW Bio.
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