Here’s some unconventional if not a little passive-aggressive perspective which might help entrepreneurs see things more clearly about the game they’re in. Trench warfare for sure. Let’s take a look.
First, remember that many technology venture capitalists (VCs) are self-assured because they have money to invest, because they’re rich and because entrepreneurs are always asking them for money. They’re not self-assured because of their innate intelligence or their technology or vertical industry domain expertise.
Challenge this assertion by engaging them in polite offsite conversations about technology trends. You will often be surprised at how quiet they become. Ask VCs – whose funds are focused on investing in “emerging technology companies” – what they think about the prospects for automated reasoning based on inductive versus deductive reasoning, or how mixed reality will penetrate the market (and why Apple’s VisionPro missed the mark). Or about large language models and generative AI chatbots. Ask about plugins and custom GPTs. Many of them will just order another drink, disappear to the restroom or take a very important call. Hardly any of them can participate in discussions about disruptive technologies or even macro technology trends – even though their investors gave them tens of millions of dollars to invest in emerging and disruptive technologies. (At least that’s what the offering memorandum said they would do.) This drill is not to establish dominance in the start-up jungle. It’s just to assert your power as an offset to theirs – assuming you know something about the technology list above!
Remember that VCs know a ton about valuation models, investor rights and lots of start-up legal minutia. They’re good at modifying deal terms too. They know about intellectual property. They’re good at employment agreements. They know all about SAFE. They can see between the lines of spreadsheets. They understand cap tables and can dissect – and challenge – revenue projections in their sleep (usually by discounting them or attaching them to valuation clawbacks).
Remember they’re spending other people’s money. Most of the success that VCs enjoy is due to their relationships. It’s amazing how much VC partners rely on the judgments and work of others to do their jobs. Without their networks, analysts, associates, principals, consultants and relationships, many of them would be completely ineffective. Entrepreneurs need to understand all this before engaging VCs to conduct “due diligence” on their company’s technology or digital business model for potential investment purposes. Entrepreneurs should also understand that this influence path can be manipulated. (Seek some insider consulting here.)
Entrepreneurs must speak two languages – venture-speak and tech-speak. Don’t get into the technology weeds with venture capitalists (unless you’re in a really bad mood or you’ve already decided they’re not a good fit and will not invest in your company). Get into the weeds with associates, principals and interns if they’re leading due diligence efforts (and if they’re capable of holding such discussions). Talk venture-speak with venture capital partners, before or after you talk tech-speak with the due diligence people. Then, well, you get the idea.
Who they invest with, the entrepreneurs they back, and the lawyers and investment bankers they hire, explain much more about VC success – and their desirability as investors – than their technical knowledge, experience or track records. If you look at the most successful VCs (defined only by their IRRs), you will almost always see repeat performers in their portfolios. Smartly, they go to the same geographical and technological wells mostly because it’s just easier to work with the same successful entrepreneurial communities than to continuously vet new ones. These communities comprise the most essential component of venture capital networks and so-called Keiretsus. You will also see the “one deal makes the fund” phenomenon which VCs and their investors understand so well. Entrepreneurs should too.
When their investments fail, VCs still get huge salaries and management fees, fly private jets and take elaborate vacations disguised as deal flow expeditions. When their investments are successful, they get huge salaries and management fees, fly private jets, take elaborate vacations disguised as deal flow expeditions and get “carried interest,” a percentage of the profits from their investments. The traditional 80/20 split (after huge salaries and fees, of course) makes a lot of VCs very, very rich. (By the way, carried interest is only taxed at a maximum of 20%.) Everyone should understand the financial incentives behind the process. (Yes, entrepreneurs also want to get rich.)
VCs get paid extremely well regardless of how well they perform. Some might believe that if a fund fails to return meaningful returns to its investors, VCs will have a hard time raising another fund. But the facts suggest otherwise: they usually get several bites at this sweet apple. Candidly, this all sounds really smart – and insider-ish – to me. In fact, the VC business model is brilliant – for VCs. All you need are some friends with money, a really smart orbit — and just a little — or maybe a lot of — luck.
If you’re an entrepreneur looking for an investment, or an investor looking to make some money, what should you look for in a VC? First and foremost, relationships: who does the VC know, and with whom do they invest, work, travel and win? Look for relationship pedigrees that include major law firms, successful entrepreneurial testimonials, happy institutional investors – and prospective customers. Interview (over [very expensive] coffee or drinks) entrepreneurs who have worked with the VCs. Assess their value as partners. Play golf, chess or Pokémon Go with VCs and everyone you can find in their personal and professional worlds. Let them win.
Performance: while VCs win whether they succeed or fail, you need to know what the empirical record shows, not lore or hearsay, but actual results, like the internal rate of return (IRR) of every fund they’ve raised, and the returns investors received. Take no prisoners here: this is the most important VC due diligence you will ever do. Call friends and colleagues especially those who have worked with the VCs you’re considering. Inspect VC performance across the sectors where they place their bets. Some firms are much better at biotech than digital technology. Where is your start-up? Match the firm’s best performance sector with your company’s sector.
Advocacy: assess the firm’s orientation – is its reputation and track-record entrepreneur-friendly or a firm that focuses primarily on itself and its investors? There are strengths and weaknesses with each bias but remember that entrepreneur-friendly firms have better deal flow than firms that have MD biases, and you’ll have more flexibility with friendly firms.
Knowledge: while few VCs are rocket scientists, they should know enough about themselves to know what they don’t know. There’s no more deadly combination than arrogance and stupidity. If you see this combination, run. You do not want their money even if it’s cheap. They will be impossible partners.
Professional integrity: it’s important to calibrate the integrity and ethics of VC firms. If you’re wondering why “professional integrity” is last on my rank-ordered list, it’s not because professional integrity isn’t important, it’s just that the other areas are more important – which tells you everything you need to know.
The best time to seek VC funding is from a position of strength – when the VCs want you – not the other way around. Financial relationships based on mutual respect will leverage what VCs and entrepreneurs bring to the table. It’s your job – even when you have no revenue – to convince VCs that you’re extremely valuable and if they don’t invest in you they’ll miss one of the greatest opportunities of the 21st century. But at the end of the day, the conversation must be about strategic — not operational – valuation.
If you chase VCs for money, they will give you as little as they can for as much of your company as they can own. If you’re financially weak, they will crush the valuation of your company. Why? Because they can – and because weakness is red meat to VCs, especially to so-called “value investors,” which is can be code for “bottom feeders.” Always remember why VCs exist – and it’s not to make you happy, create jobs or contribute to the community. No matter how many charity balls they attend, how friendly they are or how many political candidates they back, they’re in constant search of more and more (and more) money for themselves and their investors – in that order. Not that there’s anything wrong with that!
Just some thoughts about start-up trench warfare.
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