Even if you have not heard of Softbank and its CEO, Masayoshi Son, you are probably quite familiar with one of his most famous investing disasters: WeWork. As The New Yorker wrote last month, Son has taken what most venture capitalists do -- particularly in the case of WeWork -- to an absurd extreme.
As The New Yorker illustrates, Son's promise of making everyone on WeWork's board much richer wiped out their willingness to temper WeWork CEO Adam Neumann's persistently outrageous business strategies and professional conduct.
This raises four questions in my mind. What follows are my thoughts on each and what the answers mean for you.
What do venture capitalists do and why?
VCs invest money on behalf of their limited partners -- typically insurance companies, pension funds, foundations, and endowments. VCs are general partners who are paid a percentage of the funds they manage -- generally 2 percent -- plus about 20 percent of all the investment gains over the typically 10-year life of the fund.
VCs aim to generate very high investment returns by providing capital to companies that grow very rapidly and go public at high valuations. The typical VC portfolio features one or at best two companies out of 10 that multiply their investment by a factor of 20 to 100. These winners make up for the other eight that either fail completely or barely earn enough to pay back the VC's investment.
In my book Hungry Start-Up Strategy, I pointed out that VC is the worst form of financing for a startup -- with the best being profits from selling to customers. However, there is a time when raising VC is a smart move -- when your company is sprinting to an IPO (the third stage of scaling according to my book Scaling Your Startup). As we'll see below, taking VC is fraught with risk -- most notably that you are hiring a boss who could fire you with little notice.
What was so outrageous about what Son did at WeWork?
All VCs want their portfolio companies to grow. What Son did at WeWork was to provide Neumann with so much capital that he could grow much faster than his competitors based on a business model -- featuring prices set way below competitors' and WeWork's costs -- that would collapse as soon as WeWork ran out of capital.
Moreover, Son made it clear that Neumann's selling skills were so critical to this investment strategy that Son was willing to tolerate all of Neumann's outrageous workplace conduct to keep him happy. Son's idea was Softbank's capital would fuel WeWork's propulsive growth to a boffo IPO -- rewarding investors and justifying their decision not to crimp Neumann's unprofessional conduct.
It all seemed to be going beautifully until WeWork filed to go public last fall. Perusing WeWork's prospectus -- which revealed the company's mission to "raise the world's consciousness" and the details of a business model that would never make a profit -- sent potential investors running for the hills.
What should be the role of the VC?
In the ideal world, the VC should be a partner to a CEO so the company can offer customers a product with a competitively superior value proposition -- as venture capitalist Fred Wilson wrote. I also think VCs should support business models that generate positive cash flow.
In that partnership, the VC provides capital and value-added services such as help with winning customers, hiring talent, finding companies to acquire, and anticipating and solving problems that might block the achievement of the company's growth goals.
What should business leaders do to find a VC who can fulfill that role for them?
If you have not previously enriched a VC firm, you should not seek out VC until your company is well-established. By that I mean it has revenue of $40 million to $50 million and is growing at least 40 percent a year.
At that point, it does not take too much foresight to realize that your company could reach the magic $100 million in revenue in the next three to five years and then be in a position to go public.
If you get to this stage, you can make the case to a VC that their capital can help you realize your vision for growth -- say by opening up shop in new geographic regions. In so doing, your company and the VC will both be amply rewarded in an IPO.
Before accepting capital from a VC, talk to the CEOs of companies who have taken funds from each VC you are considering. Find out whether the partner who will serve on your board helps CEOs who get in trouble or quickly replaces them.
Don't end up as Neumann did -- kicked out of your own company.