The Reality of Raising Venture Capital
What's the equivalent to the Ivory Tower for consultants, columnists, and ex-VCs? I need to know because the e-mail from a Dallas-based CEO made me realize that I've been locked away.
He sent me this e-mail detailing his difficulties in finding capital for his company:
First, I live in the land of no VCs -- Dallas, TX (excuse me...firms that call themselves VC but don't actual provide capital). From my experience in today's climate:
- Unless your best friend in the world -- whom you happen to have embarrassing pictures of -- is a VC partner, please do not contact any VC. It makes no sense.
- Passion, experience, real-world results are not qualifiers for introduction to VCs. An MBA from some elite school with 20 board members who know Jack Welch personally, with an extremely complicated idea that has never been built, are preferred.
- Even though there are 5,300 mergers and acquisitions per year in the technology sector, many for less than several million, the preferred "out" is to go public. Investing small sums that return 10 times the investment does not make sense when a VC can put in $100M in a mezzanine-financing round and earn $20M. Of course, you may add that with bigger fund amounts they need larger deal flow, but really, is a $1B fund going to generate the same as a fund that has $100M...in final net return? Sure they get the 2% management fee per year, but based on historical records, deal funding less than $5M per deal generates a higher return rate than the $100M per deal investment.
These frustrations are understandable and, after reading his e-mail, I realized that I've lost sight of just how difficult it can be to raise money. Let me take a stab, then, at addressing some of his concerns. I suspect his concerns, opinions, and frustrations are fairly widely held.
I'll take his issues in reverse order. First, he's right to a degree that the preferred exit is a public offering. The simple fact is that the multiple the public pays on companies (the total capitalization of a company) is higher than that paid by other buyers, such as other private equity firms or other companies. Take Yahoo! as an extreme example. As I write this, Yahoo's market cap is $51.78 billion with a price to earnings ratio (P/E) of 99.63. General Motors' market cap is $22.31 billion and its P/E is 7.34. Forget for a moment whether or not you think Yahoo! is overvalued (and a P/E of nearly 100...well that feels awfully high to me). Which company in the world could afford to pay that price for Yahoo! let alone purchase it at a premium?
Want further proof? Google is trading at a P/E of 221.73. Did its investors and managers do the right thing by going public instead of selling out to, say, Microsoft? Remember this axiom and you'll understand all you need to know about a VC's motivation: Buy low and sell high.
He raises another point in the last bullet -- the point that smaller investments typically generate higher rates of return than larger deals. And he's absolutely right. But you need to understand two more things about venture capital. First, over the last few years, fueled by their need for greater and greater returns on investment, the pension funds and university endowments (the major sources of funds for VC firms) have significantly increased their investments in VC firms -- and the partners at those firms have gladly taken the money. While the trend has slowed considerably, we still have many funds with a half a billion or more to invest. Now a 2% annual management fee on a $1 billion fund is awfully attractive but that's NOT the math behind the actions. If the average VC partner can make four to six investments per year and be responsible for no more than, say a dozen to 15 early-stage investments (and that's pushing it), a $1 billion fund simply can't afford to "only" invest $5 million. They can invest that amount but only if they see that -- over time -- they'll be able to "put to work" say $20 million.
The second thing to understand is that venture capital is summed up in yet another axiom: you can't buy a car with IRR. Internal rate of return (or IRR) is a great measure of a fund's performance. But, in the end, the absolute dollar return is what drives most decisions. Put yourself in their shoes for a moment -- which would you prefer: a 10X IRR on a $5 million investment of a 2X return on $100 million (especially if your "cut" is 20%)?
Now let's look at the second and third points. Yes, I'll admit, having compromising pictures of a VC may help get a meeting or even a term sheet, but the larger point speaks to the network effect. Implicit in his frustration is a question I often got when I was on the speaking circuit while an active investor: What's the best way to get the attention of a VC?
Unfortunately he's right about the business school mafia that exists out there. Perhaps the single most important reason for getting an MBA is the network of alumni that comes along with it. I detest that fact. As a graduate of a public college in New York City, as someone without an MBA, I sympathize greatly with his frustration.
But he's missing the larger point; the point is that you MUST get connected. You know that business relies on people connecting with other people and that few great ideas are truly great enough to break through and emerge as successful companies without the founder/entrepreneur/CEO going out and pressing the flesh. So you don't have an MBA. So what? Go out and find a network you can join. If there's none in your area, start a chapter of the Young Presidents' Organization (YPO) or Young Entrepreneurs' Organization (YEO). Go to you nearest university and meet with the professors there.
Lastly, his point about the unavailability of real capital in certain parts of the country is all too true. I can cite all sorts of statistics that show certain parts of the country are simply ignored. Every economic development agency in every state other than California, New York, Massachusetts, and perhaps North Carolina knows this fact. Think you have it tough in Dallas? I have a friend who worked for an economic development in Wyoming: Try convincing a VC from Silicon Valley to come to Cheyenne to look at a company.
The simple truth is I don't have a simple answer. Though, I do have a few suggestions for him and others stuck in his situation:
- Call your local economic development agency. They can be a great organizing source for venture development fairs and the like to help pull together what capital there is in the area. Go further, and put pressure on them to put pressure on your state or local municipality to re-invest their dollars in the area. Every state has a pension fund for its employees and every one of those pension fund managers have a responsibility to invest those dollars. Pressure those funds to invest a portion of the dollars locally, in local venture capital firms who will commit to investing in the area.
- Contact Bo Peabody's Village Ventures. Bo Peabody, an old friend and the founder of Tripod, long ago recognized the opportunity inherent in your frustration and has helped seed dozens of small funds targeting under-served areas.
I'm kidding about that last one...well, maybe not. The fact is if you had to move your company to be closer to your customers, you'd consider doing it, right? Well, I wonder if the same consideration should be given to those giving out the capital. I hate saying that. But, unfortunately, it may be true.