Dear John

What happens when the venture capitalists find profit in your company -- but don't see profit in you?
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Founders who go after venture capital can find themselves with bulging coffers -- but without their old job as CEO

Phil Trubey had the awful feeling that he was about to be mugged. Not by some unknown derelict on a dark street but by the well-heeled venture capitalist who was sitting across from him at lunch.

It was August 1998, four months after Trubey had received $6 million in venture financing for his software-resale business, Netpartners Internet Solutions. Since founding the company, in 1994, Trubey had bootstrapped it into a $6-million business and had developed a popular new product that enabled companies to restrict employees' use of the Web. Hoping to fuel growth and position his San Diego-based business for a public offering, Trubey had gone after venture capital and had accepted a deal led by New York City giant Morgan Stanley Dean Witter Venture Partners. Now, over a pricey lunch, the VC who had joined Netpartners' board was sizing up Trubey's strengths as CEO. That assessment made Trubey fear that everything he'd built was about to be snatched away.

The VC bluntly informed Trubey that Netpartners had outgrown the founder's management skills and that senior executives had lost confidence in his leadership. Then came the cruelest blow. "He said, 'As I look at you, I don't get a sense that you really feel like you are a CEO," remembers Trubey. A pang in his gut told Trubey the VC might be right. "But I was worried about losing control of the company," he says. "I pushed back and said, 'No, no. I want to be CEO. I can learn."

Looking back, Trubey realizes it was pointless to put up a fight. The VCs hired a management consultant, who swiftly compiled a report that sealed Trubey's doom. A few weeks later Trubey found himself voting in an interim CEO (picked by the VCs). The new man told the board that he would assume the helm only on the condition that he could fire Trubey -- which he did, right after the VCs sought (unsuccessfully) to wrest a majority equity stake away from the founder. "It became an untenable situation," says Trubey, now 37. "Nothing in my life had prepared me for that."

In the end, Trubey and his company emerged from the ordeal significantly better off. A new permanent CEO took the company public under the name Websense Inc. Today the business counts 239 of the Fortune 500 and 10,000-plus other corporations among its customers. "It was a very painful situation for Trubey, but the outcome has been phenomenal," says a Websense board member. Still, Trubey's story is a cautionary tale for any founder eyeing outside investments. Having recently handed off the CEO title at his second venture-backed start-up, Trubey faults his own inexperience for much of his misery at Netpartners and urges that other entrepreneurs wise up to the hazards of venture financing before accepting an investment. "You don't know what you don't know," he warns.

Like it or not, if you opt for venture capital, the day will probably come when your investors will shove you aside. Granted, there are notable exceptions; Michael Dell, Larry Ellison, and Bill Gates come to mind. At most venture-backed companies these days, however, the influx of professionally managed money signals "professional" management as well. Last year alone, VentureWire recorded new picks for the jobs of CEO, president, and chairman at 925 venture-backed companies. "I've become convinced that making a management transition at the appropriate time is one of the keys to success," says John Warner, president of a VC fund in Greenville, S.C. "You need a new CEO to take the company to the next level."

That's true for established businesses, too. San Diego's Stellcom Inc., for example, had been in business for 15 years and had annual revenues of $30 million when founder Mark Fackler sought venture financing to expand the company's wireless-systems-integration service, in 1999. Nonetheless, Fackler says, VCs turned him away cold until he told them he planned to recruit managers who had a track record of positioning companies for some form of liquidity event -- a sale, merger, or public offering.

VCs, after all, live or die by the returns they earn for the institutional investors from whom they raise money. They specialize in assembling seasoned management teams. And in today's slowing economy, VC-driven CEO switches appear to be "happening more and more," says John A. Challenger, CEO of executive-outplacement firm Challenger, Gray & Christmas, based in Chicago. "For an entrepreneur, it's like you're losing your baby."


If you find the right match, a change in CEOs can be a great thing.


Indeed, when investors or board members broach the subject of a management transition, many entrepreneurs like Trubey cling to their companies for dear life. But passing off the reins doesn't have to be a grievous humiliation. At Stellcom, the new "professional management" has achieved in seven months feats that founder Fackler says he never dreamed possible, including sealing multiyear, multimillion-dollar contracts with Fortune 500 companies. And at Asheville, N.C., natural-foods supermarket Earth Fare, the CEO who was brought in by investors has ramped up business from two shops in 1997 to a six-store regional chain with revenues of $33 million projected for this year. "If you find the right match," says Earth Fare founder Roger Derrough, a change in CEOs "can be a great thing."

Unlike Trubey -- who has gone on to head up the San Diego Entrepreneurs Roundtable, a mentoring group for start-ups -- Fackler and Derrough stayed in the game throughout the VC-backed management transition. What they and others learned in the process offers insights for entrepreneurs who are wondering whether their own management skills are keeping pace with their companies.

If you come away with only one lesson from Phil Trubey's experience, let it be this: Don't reflexively snap up early investment offers. VC styles differ greatly among firms. Some VCs assume a collaborative approach with the companies they invest in; others do not. Although Trubey made presentations to 22 venture firms, he regrets that he never learned one-tenth as much about them as they learned about him. He forged no relationship to speak of with any of the partners at Morgan Stanley but embraced the firm's offer simply because it came from a name that carried clout. As a result, when management issues came to a head, Trubey and his VCs had no common ground on which to work things out together.

By way of contrast, Michael Terpin spent nearly a year scouting out potential investors for his Los Angeles public-relations and news service, Internet Wire. Terpin also logged long hours on the phone with colleagues who'd been through the venture process themselves. So when San Francisco's Hummer Winblad Venture Partners and Menlo Park's Sequoia Capital jointly offered to put nearly $18 million into Internet Wire, in January 2000, Terpin knew going into the deal generally how his new partners would involve themselves in management. And he took early, proactive steps at the board level to ensure that when the time came for a management transition (about 11 months after the first round of financing), he would have a voice in choosing a new CEO as well as a continuing role in the company.

For David Kaufman, founder of Inc. 500 company Trinagy Inc., based in Torrance, Calif., how and when investors might call for a CEO switch were among the top questions he asked of VC candidates. "Sometimes VCs are a little quick to pull the trigger, so that was one of the concerns that I raised. I wanted someone who would be patient and not just apply a set formula to how the company should move forward," Kaufman says. "It's appropriate to discuss those issues right up front."

Some founders go even further, working into their VC deal an employment package that provides for severance in the event that their jobs change or terminate soon after the financing closes. "When the day comes that you're put out as CEO, it's going to be an excruciating blow, and you're going to feel like you were screwed," says venture capitalist Erik Gordon, who also serves as director of M.B.A. programs at the University of Florida's Warrington College of Business. "And so you have to cut a deal up front that is strong enough, sweet enough, and clean enough that you can avoid a lot of bruising and bashing later -- squabbling that will only diminish the value of the stock."

Instead of holding out to stay in charge of your company (a wasted effort that will only sour investor relations), it's much smarter to facilitate a smooth management transition. Even if you're not the most experienced person when it comes to taking the company to the next level, as founder you undoubtedly possess some of the keenest insights into what your company will need to get there.

Consider translating those insights into written job descriptions for new senior managers -- a move that VCs say will gain you credibility and leverage down the road. Also, seize every opportunity for involvement in recruiting new hires, and look for candidates with a skill set that really matches your company's specific needs. Internet Wire's Terpin played such a role late last year, when he helped recruit his replacement CEO, Jim McGovern, an M.B.A. who had been running Business.com. A few other candidates Terpin sent up to Silicon Valley for VC review returned to Los Angeles "shot through with bullet holes," he says. Still, his VCs' severe scrutiny bolstered Terpin's confidence. Internet Wire ultimately landed the right new CEO -- even though McGovern hastily killed some of Terpin's pet projects. "He brings the discipline and the accountability that the company needs now," Terpin says with a shrug.

Terpin and McGovern have also taken pains to delineate their respective roles. Whereas McGovern has assumed charge of running the company, Terpin (now chairman and chief strategy officer) has directed his focus outward, seeking out high-level partnerships such as those he previously sealed with the Dow Jones news wire. "It's a substantive role," notes McGovern. "If it were a make-believe role, then there would be a potential for discord."

It's crucial, too, that founders keep an open dialogue with investors and level with them about problem spots within the business. At one Inc. 500 company, for example, a VC who'd based his investment on unrealistic sales forecasts forced a painful CEO switch. "It was a very unhealthy situation. The financials took a drastic turn for the worse, the company was bleeding badly, and I was just thrust in," says the CEO who was hired to replace the founder. "It was a worst-case scenario." Two years later the new CEO has cut losses -- from $1.5 million in 1998 to $100,000 in 2000 -- but regrets that the founder has become apathetic. "I've been able to keep the company afloat and grow the revenues, but I'd like to have more creative input on strategy," he says.

Obviously, some founders can't stomach the sight of someone else manhandling their prized creation. "Given the nature of entrepreneurs, it's very difficult from a control standpoint," says Mike Muench, who was hired at Inc. 500 company Line 6, a maker of digital guitar amplifiers, after the company received venture financing. "Inevitably, there are going to be times when the founders question whether the new management's decisions are consistent with their vision."

"Unless you really have an open relationship between the founder and the new management, and unless the founder is really willing to accept a complete change in strategy, the company will have a very hard time," agrees Larry Robbins, a lawyer who advises entrepreneurs in the Research Triangle area. "Even if you have the best intentions in the world, it's difficult to pull it off."

Difficult, but not impossible. "Once you get over the fear and all the psychological barriers to giving up ownership, it's a very freeing feeling," says Stellcom founder Fackler. "Follow your fear. That's how you became a CEO and built your company in the first place. And that's how you'll take it to the next level."

D.M. Osborne is a senior writer at Inc.


The Scorecard

What's the long-term prognosis for companies that opt for venture financing and all the management turmoil it entails?

A Stanford Business School study released in January concluded that VC-financed companies fared better over the long haul than those funded by other investors. The study tracked CEO turnover, management shifts, and a bundle of other factors at 170 companies during a period of 5 to 10 years.

The findings don't factor in how much of the companies' success was derived from "professional" management, however. "It's hard to assess the individual components, but you can assess the overall effect," says assistant professor Thomas Hellmann, who coauthored the report with associate professor Manju Puri. "Overall, the effect of venture capital is very positive."

Other highlights of the study:

  • Founders who funded their companies with venture capital were more than twice as likely to be bumped from the CEO seat as those who chose other forms of financing.
  • 40% of all founders at venture-backed companies remained involved with the business after bringing in an outside CEO.
  • 53% of all venture-backed companies reported that VCs had been helpful in developing their businesses' human-resources policies, while only 13% of non-venture-funded companies said the same about their investors.

Please e-mail your comments to editors@inc.com.

Last updated: May 1, 2001




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