VCs vs. entrepreneurs

To be successful, any sort of business deal must align conflicting interests. In thinking about venture capital, the decision of entrepreneurs to seek (and accept) VC investments assumes that both parties want the company to succeed, and the only conflict is over the terms of the investment (particularly the dilution).

However, a couple of recent blog posts highlight a second, equally important category of conflicting interests: control over the timing of exit.

On AngelBlog, Basil Peters recounts an example of a tech startup with a chance to exit via acquisition, one that would produce a 3x return for VCs, and perhaps 10x for the angels and 100x for entrepreneurs. The problem is that the VC needs a bigger return (the home run) from its winners to cover its losers. This is consistent with the story of VC investment math told by Bob Zider a decade ago in his HBR article, “How Venture Capital Works.”

Of course, such an early offer may mark a peak in the company’s valuation — in an increasingly competitive segment (as in the Peters example), the total return will only go down. Once faced with an obviously worsening situation — whether firm-specific problems or an increasingly unprofitable industry — VC are known to pull the plug prematurely, saving management attention for the likely winners rather than spending more time salvaging a “dog.” In my SD Telecom study, we had to interview one founder in the final few days before the VCs closed the door forever.

The other point is that, come hell or high water, the VCs will liquidate their investment before their investment fund matures and must return capital (and earnings) to its principals. As VCs freely admit, this means they seek a quick exit — ideally 3-5 years, with 7 years at the outside. Blogger Sigurd Rinde of Germany notes the disconnect between achieving VC objectives, and the goal of many tech entrepreneurs of creating long-term value.

I had a slow growth, bootstrap startup, which never sought (nor was suitable) for VC. This had its pluses and minuses, but it’s clear (as I used to say back then) that taking VC is like starting a time bomb: you have to come up with an answer before it goes off, or you’re dead.