Thinking of taking venture capital? Don't!

Here’s a thought for those of you considering taking venture capital – don’t do it.  Seriously. It’s not worth it.

Ok – so I’m not 100% serious. I’m trying to make a living investing in companies and would therefore be out of business if everyone followed this advice, however I think that for the majority (50%? . . . 80%?) of entrepreneurs taking venture capital money is a mistake. As I explain why this is the case, please read from the perspective of someone who is actually trying to encourage people to go into the process with their eyes open more so than I’m truly trying to scare people off from raising venture money. The worst thing you can do when you take venture capital is to go into the relationship with a misunderstanding of what each party expects – an example of that in a minute.

While I obviously believe that venture capitalists add real value to the businesses they invest in (perhaps the subject of another post), there are two things that come along almost by definition with venture capital that not every entrepreneur probably really wants:

1) VCs have opinions and they are not want to share them.  This should be obvious, but rare is the early stage VC that gives a company money, asks for quarterly updates and then pretty much lets them alone. For starters, we have a fiduciary obligation to our investors (known as limited partners or LPs in VC parlance) to be good stewards of their money and part of this obligation is to keep regular tabs on the companies in which we’ve invested.  Mostly though, VCs believe that they have something to add to the mix.  We see lots of different business situations, experience similar challenges across businesses and believe we can offer the benefit of both our own operating experience (since most VCs have some type of operating background) as well as the experiences of the rest of our portfolio. 

2) The goal of a venture investment is to make money – i.e., sell the business or go public. This as well should be a pretty obvious thing, but I’m not entirely sure that it’s always understood.  In the VC business we take a box of money from our LPs and attempt to give them back that box with more money in it.  This requires us to ultimately get out of every investment – either through a sale of the business or an IPO (there are rare cases where companies redeem investors’ shares at a specified premium, but this almost never happens).  Since most venture funds have a 10 year life this means that there will be pressure on you and your business to grow quickly and sell (or go public) within this period (which shrinks if your investment is made in subsequent years of the fund).

Rather than belabor the point (or come up with the 10 item list rather than a 2 item one) I’ll tell a quick story of a very good friend of mine who should not have taken venture capital.  He did, of course, and after the bubble burst and with his business in a poor investment sector (telecom IT) his investors (both very large and well respected VC firms) were ready to call it quits.  He retrenched and came up with a new plan that leveraged the existing infrastructure and tried to convince his investors to stick it out. Ultimately they decided to pull their money (about ½ of their investment was remaining). 

My friend went around for a bit trying to drum up capital for his business.  I remember talking with him during this time and trying to convince him not to take any more venture capital.  He had a great team assembled, had equipment from the business that he was allowed to keep when his original venture firms pulled out, and had a vision for how he wanted to run his business that frankly was not necessarily compatible with taking venture money (really because of #2 above rather than #1). He wanted to run a business for a while, grow, but at a measured pace and experiment with some ideas he had on how to build a solid culture and a lasting business. Ultimately he came to the same conclusion and together with some of the other management team came up with enough money to finance the business. 

Fast forward 3 or 4 years now and he has built a solid business.  He’s cash flow positive, growing at a reasonable pace and he has created the type of company that he always wanted to work in.  He’s clearly benefited from having to figure this out on his own and while he has a board, he answers to himself (and a few friends) as investors.  He was telling me a few weeks ago that he really wants to keep running this business for a while – he wouldn’t sell it now even if he could. 

So think before you take the venture capital leap – and do so with your eyes wide open. 

Comments and thoughts are, as always, welcome.

Comments

[Jack Krupansky]

How come nobody has put together a simple little pamphlet or quiz to test whether professional venture capital investment is the best course for an entrepreneur?

Part of the answer is that there is such a wide range of investment criteria for VCs, but it seems like a handful of categories or "business evolution paths" could be layed out. Maybe simply some short descriptions of businesses that were solid VC investments in the past, and some guidance as to the business factors that made those investments work. And give the entrepreneur some comprehensible way to evaluate whether their plan really fits any of those "success models."

-- Jack Krupansky

[Brian Cabezud]

I think Joel Spolsky made some good points in an old blog here: http://www.joelonsoftware.com/articles/VC.html

My takeaways…don’t take VC because of their desired 1) RETURN: VCs interests misaligned with founders (time frame, market choice, etc) and 2) RISK: founders would prefer reasonable success with high probability, versus the VC swing for the fences attitude.

To Jack’s question, I’m at a loss. There are a number of sites out there that explain what it takes to be 'VC ready', but few that can make a recommendation of whether or not you should take VC money. I know The Venture Alliance has some score reports it produces when judging whether or not to try to help fund a company, and I'm pretty sure SBIR has some surveys. Anyone know of anything else?

[James]

Seth - You've forced me to post twice in one day...http://purevc.typepad.com. I think the essential question for every entrepreneur is - what kind of entrepreneur do you want to be?

[Amit]

1) VCs have opinions and they are not want to share them.

Did you mean, ".. and they are not shy to share them" or something to that effect.

Good post.

[Jeff Clavier]

It is horribly risky to generalize, but a company that does not have a prospect of reaching $50M to $100M in revenue, and provide a return of 10X to its investors based on "reasonable" exit assumptions, might not be such a great VC investment.

[Steve Sawyer]

#1 is a reason that a smart entrepreneur might WANT VC investment. Many VC's bring a wealth of experience and knowledge that can help the entrepreneur succeed. While VC's have a fiduciary responsibility to their LP's, they are still looking for aggressive performance and aren't likely to offer advice that would restrict a company.

--Steve--

[Dave Jilk]

The comment above regarding risk profile is, in my opinion, the most critical one. Entrepreneurs tend to see opportunities as opportunities and thus pursue them. VCs see opportunities that do not help the "big vision" as distractions. Consequently the VC seems irrational to the entrepreneur, when in fact it's just a different risk profile.

If your goal is to build a substantial business (someone mentioned $50-100m, that's a good number), and you'd be WILLING TO SHUT IT DOWN if it doesn't look like you'll get there, then you might be a VC money candidate. If it turns out to be a $10m business growing slowly, and you'd want to keep running it in that case, you shouldn't take VC money.

[Daniel Nerezov]

Good comment there Dave!

I don't think I've ever met an entrepreneur who'd shut down a perfectly good, profitable venture that they built with their own sweat and blood- simply because it doesn't meet the risk adjusted hurdle rate, or isn't posting triple digit growth- on a way to meeting listing requirements.

Cutting losses in general is very difficult. Even writing this, I've no idea what I'd do if our venture doesn't skyrocket. Will we be able to mothball it? Of course we don't want to be left with a walking dead - but having the guts to close everything down...it's a psychological nightmare.

Sure if the venture is nearing bankruptcy- yeah! But a perfectly good business (from a non VC point of view)...whoa Nelly. You show me one person who's done it, 'caus I certainly would love to talk to them.

Sure there are solutions to the problem- entrepreneurs investing under 10% of net worth and time per venture, entrepreneurs seeking to quickly diversify into many ventures…..but knowing what it takes to run one rapidly growing venture backed business, do these solutions stand up to scrutiny?

[Will]

Intersting post.

I think you meant to say:
"1) VC's have opinions and are wont to share them"

I have some friends in WA that recently (last year) turned down ~1-2M in VC funding for some of the very reasons you describe.

[Pelle]

I agree with most of what is said here as well. Mainly because I feel it's much better to focus on your business. Too many entrepreneurs get trapped into the constant chase for funding, when they really should be in a constant chase for business.

There are a million ways that you can bootstrap your business up and most online businesses nowadays really do not need that much funding. Many can probably survive doing a 9-5 for a while during the pre revenue phase. Chasing VC and writing business plans take surpising amounts of energy and time, much like a 9-5 job.

I'm trying to do this myself right now based on good and bad experiences in my own and other startups in the past. I'm also trying to blog about it as a hopeful inspiration or warning to others like me.

[Peanut Gallery]

"VCs have opinions and they are not want to share them" -->? "VCs have opinions and they are wont to share them"