Fixing Venture Capital

Several of the comments to Cringely (continued) and Fisking Calacanis asked me if I had read the Change This manifesto called Fixing Venture Capital by Joel Spolsky.

Yes, I have read it.

Joel makes some good points, but I think he's wrong that the venture capital business needs to be fixed.  Some VCs should be fixed, but the business as a whole works pretty well.

Here are the major points Joel makes in his manifesto:

• VCs only want 100 to 1 returns and are willing to risk everything to get them while entrepreneurs want a safe high probability bet.
• VCs are so inundated with business plans that they become focused on the process of whittling down opportunities instead of finding the best opportunities.
• The "standard VC deal" is unfair to entrepreneurs and smart ones won't take it.

Some of this is familiar territory as Jason's rant articulated a few of these themes as well.

The first two points are accurate about some VCs, but not the best VCs. The third is the classic situation of one side not understanding the other side.

I'll take each of them in order.

• VCs's only want to hit home runs - I don't think this is true. I've worked in three venture capital firms and have worked on over 150 deals with probably close to 500 firms in the 18 years I've been in the VC business.  My experience is that VCs are interested in making every investment work and are not in the "hits" business. It is true that if the investments don't work, the VCs have an interest in getting out of the deal so it doesn't consume any more capital, but that happens in about 1/3 of all early stage venture capital deals. The other 2/3 end up turning into businesses that the VCs are happy to work on and commit more capital too for as long as it takes for them to become sucessful.
• VCs are too overwhelmed with incoming deals to pay attention to the good companies - This is absolutely true of the bad VCs. But they don't end up staying in business longer than a couple funds. The best firms don't focus to much energy on looking at everything that comes their way.  They identify a set of markets they like, articulate their strategy clearly as possible, and then go out and find the deals that fit into their strategy.
• The standard VC deal is unfair to entrepreneurs - Joel focused on two aspects of the "standard VC deal", the "liquidation preference" and the "no shop". 
  • Brad Feld has a long post on the liquidation preference that anyone interested in this topic should read. This term is designed to protect the VCs from having the company sold by the entrpreneur at a price that gets the entrepreneur a good return, but results in the VC losing money. Not only is it fair, but its been standard practice in the VC business since the 1970s and very few deals are done without it.
  • The no shop isn't designed to stop the entrepreneur from shopping his deal. It's designed to stop the "shopping" process once the entrepreneur has selected his preferred investor so that the VC can complete his due diligence and hire lawyers to get the deal documented and closed.  It makes perfect sense that once both parties need to start spending money on deal expenses they should have an exclusive period to close the deal.

I hope nobody takes this as a criticism of Joel's piece because I think its good that he and others are putting the entrepreneur's views out there for discussion.

My goal is to get the VC's views out there in response and insure that a healthy and educated debate results.

I'd love to hear everyone's comments, either in the comments to this blog, or even better on other blog posts.

Comments

[Stefan Smalla]

Here are comments to an earlier version of Joel's essay.

[will]

The problem with liquidation preference is not its existence but its magnitude. If the liquidation preference is only “designed to protect the VCs from having the company sold by the entrepreneur at a price that gets the entrepreneur a good return, but results in the VC losing money” (and not for any other reasons), then the highest liquidation preference that a VC should be able to JUSTIFY is 1X (and nonparticipating preferred).

Most reasonable entrepreneurs would agree that VC’s should be protected from situations in which an entrepreneur raises a round with a pre-money $5M valuation with $4.9M investment ($9.9M post), and immediately sells his company for $9M, thus pocketing ~$4.5M (~50% of stock) while the VC loses ~400K (4.9M-4.5M) immediately. In situations where VC’s own more the 50% of the company and control of the board, I’m not even sure if common stock holders can sell the company w/o board or VC approval. (someone can enlighten me on this).

Kevin Laws has a great post on this . .

http://www.ventureblog.com/articles/indiv/2003/000185.html

Given that liquidation preference in the valley ranges from 2-3, I’m not sure how the “protection from entrepreneur” argument holds. The truth is that VC’s are using the liquidation preference as a financial engineering tool to guarantee themselves some baseline level of IRR or simply to increase their IRR. Don’t get me wrong, there is nothing inherently insidious with liquidation preferences if VC’s simply call it for what it is.

Entrepreneurs needs to realize that similar to warrants and options, the liquidation preference term in a term sheet has “value” and is a source of dilution to his or her equity stake. (I wonder if there is any academic research on how to “price” this type of “security”)

Furthermore, I call for fellow entrepreneurs to also realize the true potential and valuation of his/her business and what is the preferred exit strategy. If the entrepreneur is looking to sell his/her company, be extremely cautious of typical VC advice of “never turn down any money” and “raise as much money as someone will give you.” With a high liquidation preference and volatile market conditions (causing volatile valuations for your venture) it is highly likely that you are digging your and employees’ common stock a huge hole to climb out of. Simply put, you could be holding “extremely out-of-money options” and not even know it. Of course, the decision must be evaluated on a case by case. In the end, stick to the fundamentals (and clichés, also doled out by VC’s :) ). . . treat VC’s money as your own, don’t waste money, make every penny count. . . for many ventures, $10M should get you to profitability or even a IPO. In which case, you wont have layers and layers of liquidation preference to worry about.

[Damian]

A quick comment regarding liquidation preference - first of all, I think it's pretty absurd to think of an entrepreneur, of which you've done good due-diligence, would look to sell the company immediately following a round of funding unless the buy-price is really good. Using that "worry" as a justification for liquidation preferences just strikes me as silly - call them what they are: VCs getting first wack at the cash.

That said, I understand why they exist - to compensate the VCs for the risk of putting money in a business. I agree with the previous poster's comment, however, that VCs frequently make absurb liquidation preferences - particularly when they feel they have the company in a tight corner. Again, that may well be justified - they're probably in a corner because they were poorly run, so raising money just be more expensive because of the risk.

[B Watson]

I am just a little confused here. At some point, the entrepreneurs are going to have to come to understand that we live in a free market economy. VCs charge the price that the market will bear. As more capital comes on line, the power will shift toward the entrepreneurs to be able to rid themselves of the deal terms they find unfair. Until that time, it is what it is. There once was a time where valuations were what entrepreneurs used to make firms compete against each other (remember 1998 anyone?). Going forward, think about the terms that are going to get you the best return as an entrepreneur, if that is what you are after.

The earlier you need the capital, the more expensive it is because of the risk, and the lack of abundance of it. It's a real simple supply/demand curve here folks...

[Mark]

I've found the problem with VC is that if you want something like $200k, they aren't interested, so you have to pad everything to get any money. It's an insane waste.

[a_vc]

If you think all venture firms aren't interested in $200K deals, you're just talking to the wrong venture firms!

Also, one factor that has been ignored here is that liquidation preferences typically have a cap on them. Meaning, that after, say 2x or 3x the preference has been returned in total, the entrepreneur "catches up"

Here's how that works in practice. I fund your company with $10M and own 50% fully diluted ($20M post-money), with a 2x capped redeemable preferred with a 1x liquidation preference.

If we sell the business (not IPO, but a true "liquidation") for $30MM, I'll get my $10MM, and 50% of the remainder, or $20MM, and the common will get $10MM.

If we sell the business for $40MM, I'll get my $10MM, and 50% of the remainder, or $25MM, and the common will get $15MM

However, that hits the 2x cap and everything beyond that will go 100% to the common until they "catch up" to 50%. This means I won't see another dime until the valuation hits a point where a 50/50 split nets me $25MM... or a $50MM valuation.

Yes this creates payoff curves in which a venture capitalist wants to play on and in which an entrepreneur may want to sell. This makes sense because when things are going well (which they obviously don't always do), the VC wants to play on enough to earn a great return, and doesn't want the entrepreneur trying to force a sale too early on.

The reality here is that in any financing event (buyout, IPO, capital raise), these terms are the starting point for a discussion, and it's all really just a negotiation. How successful would a transaction be where the VC really wants to sell and the key employees don't want to be sold? How about where employees want to sell and the board is uncooperative?

[Duncan Lamb]

Could you write a little something about how VCs can use a liquidation preference to squeeze out the entrepreneur at times? In your example, if the company is still valued at $20MM after a couple of years, you could fors a liqiodation event and leave the entrepreneur with $0, and the investors owning the company outright. This happens.

For example, take this post... you ignored my comment before

http://avc.blogs.com/a_vc/2005/01/patient_capital.html#comments

Is it relevant? I like your explanation of "catching up," it seems pretty fair, but do you also seek to protect an entrepreneur's investment if things are devalued in the short term, or do you use those opportunities to maximize your own?

I'm being serious, not trying to be a troll. This just lookes like a real problem entrepreneurs bring up, but that VCs pretend is something nobody should worry about.

[a_vc]

first I should disclaim that while i posted as a_vc, I'm not the same "A VC" who writes this blog, but one remaining anonymous. Sorry for that, won't use the name again.

Anyway, the short answer is that YES, in a recap situation the founders/management get squeezed. It makes sense that they should get squeezed, as they haven't created sufficient equity value for the capital consumed. If they had, they would have found another investor who would have paid more for the equity value they had supposedly created.

That being said, you can't squeeze a founder/prime mover/management team to zero percent ownership. Not many quality managers are willing to take startup risk without startup equity. So, what you typically see is management owning, at a bare minimum, 10-20% of a business (usually depending on how capital intensive the business is -- hardware businesses less, software more).

In fact, even in cases where the founders haven't been recapped out, and the company sells for less than the liquidation preference, there usually is a "carve out" in which the management team fully participates, or in some cases even takes money off the top. This happens because it's hard to sell an asset without people, or when the people key to selling it don't stand to make a dime. They'd just walk. So would I.

So when you see companies that sell for less than total capital raised, you can bet that while the investors took out the lions' share of the proceeds (which they should), the management team didn't wind up with zero. And in the end, nobody ended up with the riches they all wanted.

[Duncan Lamb]

Thanks for taking the time to answer, whoever you are. Even if your answer just created more questions (such as, if the VC controls the Board of said company, and has placed key executives, should they get squeezed for equity instead? I have a feeling your answer would be never, which takes quite a bit of air out of that argument.)

Regardless, thanks.

[John Furrier]

I think it is arrogant of Jason to take his view. Yeah ventures get started without venture capital but many do and create industries and new markets.

Jason and others: don't bite the hand that feeds you.

[Danny N]

I'm sorry, I just don't get it.

VC's sell money, they need to get as best a price as possible, some may charge the lowest prices, others may throw in some additional services, some of them will differentiate them selves on that point...and those that don't may get wiped out.

I think, with my slender talents, that trying to facilitate this infinite harmony between entrepreneurs and VCs is misguided- the two parties have opposing interests to begin with, and that’s the way we like it.

Sure, if you want to completely align interest; fine- get the VC's to charge exclusively “fees for success”; no liquidation preferences or any other protective measures- VC's only get paid in case of IPO or M&A. This, of course, is tough gig.

So forget it, people; let the VC's compete with them selves. Reputation spreads quickly and the vultures will inevitably die hungry.