4 Things a Venture Capitalist Will Never Tell You
To hear them tell it, venture capitalists aren't too different from entrepreneurs. They build great companies. They greate jobs. Maybe yours has slept under the desks at their own startup -- and yes, the desks were doors thrown over sawhorses. In short, they feel your pain.
But one of the first steps to a decent relationship with your VC is accepting just how different the two of you really are. You and your VC may be aligned on the vision for your company, but that's only going to take you so far. Compared to entrepreneurs, VCs have different loyalties, sometimes diametrically opposed interests, and a lot less at stake. Not to overwork the planetary cliché, but entrepreneurs are from Venus and VCs are from, well, Sand Hill Road.
Here is what a VC will never admit to you:
1. I love your company, but my balls belong to the Yale endowment
VCs are not the free agents they may appear. They have bosses, too—namely, their investors. Yes, some VCs do put some of their own money into young companies. But primarily, they're investing other people's money—that of institutions like college endowments and pension funds, with some rich individuals sprinkled in. VCs have a fiduciary responsibility to those investors, meaning they have a legal obligation to put their investors’ interests first, even before their own interests. And certainly before yours.
That doesn’t mean that your VC can’t be sympatico with you. He can (and should) be savvy about your industry. She may even have been an entrepreneur hereself. But as a VC, they have other priorities. As Mehdi Maghsoodnia, CEO of BookRenter says, “A venture capitalist is first and foremost a money manager. That’s all.”
2. You say premoney, I say post money
Consider this not-so-hypothetical conversation:
VC: I propose to invest $5 million, valuing your company at $20 million.
Entrepreneur: Wow, thanks!
Enterpreneur: (thinking): Woo-hoo! I got $5 mill to take my company to the next level and I only had to give up 25%.
VC (thinking): This poor kid doesn’t realize that I just proposed taking 33%.
We have just witnessed the birth of a very ugly misunderstanding. The confusion is between pre-money and post-money valuation. Premoney is the presumed valuation of the company before the VC showed up. Postmoney is the premoney value, plus whatever cash the VC invests.
While the math isn’t that hard and the valuation always gets spelled out in the term sheet, VCs have little incentive to set confused entrepreneurs straight at their initial discussion. In his book Venture Deals: Be Smarter Than Your Lawyer and VC Brad Feld, the VC who is a co-founder of both the Foundry Group and Tech Stars, calls this “the first trap that VCs often lead entrepreneurs into.”
So what would your proper response in the example above? Feld suggests saying, “I presume you mean a premoney valuation.” You force the VC to come clean about his offer. And if he did indeed mean a premoney valuation, says Feld, at least you didn’t let on that you really don’t have a clue what your company is worth.
3. I’m part of the 1%. Worse, I’m part of the two and 20%
A typical venture capital fund pays the VC a management fee of 2% a year, plus 20% of whatever profits the fund makes on its investments. (And yes, your VC only pays 15% taxes on that 20% “carry.”) Venture funds share this “two-and-twenty” structure with hedge funds and private equity funds. In terms of fairness to investors, it probably deserves its own Occupy movement.
What this means to you is that your VCs have a significantly cooler perspective on your company’s fate than you have. While you’re living off ramen and Red Bull, a VC who has raised $50 million has $1 million coming to him annually (the 2% fee), even if every one of the fund’s portfolio companies fails and every founder is thrown out on the street.
4. I don’t know what the next hit will be any more than you do.
The VC expects many, if not most, of his investments to fail. The VC diversifies his or her own risks by spreading the funds’ money among many startups. The hope is that one or two will really take off, and more than make up for the losses on the rest. But your VC has no idea which ones will succeed. “If he did,” points out Maghsoodnia, “there are a lot easier ways for him to make money.”
In some ways, a VC is like a general who sends soldiers to attack a beach while hanging back himself. He knows that some soldiers will get shot to enable a few to get through. In this system, entrepreneurs are capitalism’s cannon fodder. That’s not a judgment. It's just the way it works.
This doesn’t mean you can’t have a great relationship with a VC. But when you hear VCs talk about how they build great companies? Think again. They don't. Hopefully, you will.
ERIC SCHURENBERG | Staff Writer | Editor-in-chief, Inc.
Eric Schurenberg is the president and editor-in-chief of Inc. Before joining Inc, Eric was the editor of CBS MoneyWatch.com and BNET.com and managing editor of Money Magazine. As a writer, he is a winner of a Loeb and a National Magazine Award.