Jason Lemkin has been on both sides of the table of start-up investing. As the founder of EchoSign, he saw the process of raising money from the entrepreneur's perspective. As a executive at other start-ups he's been through a few exits too, and now he's VC himself. So it's safe to say he knows the industry... warts and all.
Which makes a recent response he wrote on question-and-answer site Quora uniquely valuable. When a curious questioner wanted to know "What are the best kept secrets of venture capital?," Lemkin generously responded with a list of five hard truths. Not all of them will make pleasant reading for founders, but if you're looking to raise money, this is valuable information nonetheless.
1. VCs, as individuals, aren't that diversified and don't do very many deals.
VC firms, according to Lemkin, are pretty diversified. Individual VCs? Not so much. Which makes them more risk averse than you might imagine. "The average VC partner only does one to two deals a year. Just one or two. Yes, that's more diversified than you as a founder, of course. But not as diversified as you'd think. So their deals really need to work. So they don't really want to take much risk. It's one reason why it's harder to get VCs to take a risk on you than you might think, and why you need to have 100 percent of your ducks in a row when you pitch," he writes.
2. VCs, even as individuals, may end up owning more than you in the aggregate.
"VCs often try to own 20 percent of each portfolio company as a firm. But as individuals, they own a lot too. If the firm owns 20 percent of each company, and the VC takes 20 percent of the gains ... that's 4 percent effective ownership in your company. Multiply that by say eight investments per VC per fund, that's 32 percent effective ownership of one composite company. That's more than you. Plus those management fees," Lemkin explains.
3. VCs have their own investors and usually have to suck up to them, too.
Nope, it's not just founders who have to invest time and energy is courting those with big wallets. "VCs have investors, too, just like you -- their Limited Partners, or LPs. The very top VCs don't have to wine-and-dine their LPs. They just pick up checks. But most VCs have to sell up just like you do. In fact, they have to do more of it in some ways, because they probably have to do it to 15-20 core LPs, vs. a founder who just has one to four VCs."
4. Mark-to-market and valuation upticks really matter to VCs, so they want you to go raise a big round.
Given the reality of point three, VCs, like founders, are pretty much slaves to impressive-sounding numbers, according to Lemkin. "VCs of course only make the big money on a big exit. But they make lots of money on management fees too, and to get them, they need to raise multiple funds. To raise another fund, some and probably even most of the track record of the last funds is still going to be illiquid. They'll value that with the most recent valuations, the latest rounds, of their portfolio companies. Do a round at 2x-3x the price of last one, they can tell their LPs for the next fund how strong the IRR is on this investment as well, even if it's just paper gains. They can sell this when they raise the next fund, and tap into the management fees, and also, simply continue and grow the firm to the next level. If there isn't another fund, the firm just becomes a zombie."
5. Small VCs align with you, but can lowball you. Big VCs don't align as well, but can pay more.
Forewarned is forearmed, founders. "A smaller VC vs. a larger VC is one of the most important decisions you'll make. The smaller the fund, the more aligned with you they are. They make less in fees, and more on the carry. And more practically, they can't keep up with the dilution, like you. But because they can't write the large checks, they need someone else to. And small VCs also need to buy a lot for a small amount. If they can only invest $2-$3m and want to own 15-20 percent ... that pretty much puts a cap on Small VC valuation potential," Lemkin says.
Compare that to a big VC, who "can write a big check. In fact, they want to. But the return has to be huge to impact the fund. Fire the CEO, fire the founders, dilute you to nothing ... they care less. But they'll give you more money to go big. Both have pros and cons. Pick the one that best matches how you want to grow."