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posted: November 18, 2017
tl;dr: Entrepreneurs need to be aware of the major differences between themselves and VCs...
My intent in writing this is not to disparage venture capitalists (VCs) too much, but rather to lay out the facts as I see them so that entrepreneurs go into their relationships with VCs armed with some knowledge.
Money and power
Venture capitalists have money; the entrepreneurs approaching them don’t. If the entrepreneur did have enough money to entirely self-fund the business, he/she wouldn’t need VC money. VC partners are almost always millionaires, usually many times over, and some very successful ones are billionaires. In fact it is almost a legal requirement for a VC to be a millionaire: having a million dollars of investable assets is the typical way to qualify as an “accredited investor”. U.S. Securities and Exchange Commission (SEC) regulations for the most part prohibit non-wealthy individuals (or firms representing individuals) from buying stock in small, fledgling companies. The theory behind this sounds good on the surface: small companies are risky and some may be scams, so non-wealthy folks are prevented from investing and losing money that they might need to live on someday. The perhaps unintended consequence, however, is that only the wealthy can invest in the early stages of the next Google and potentially make a thousand-times return on their investment.
Venture capital is great work if you can get it. If anyone ever offers you a position as a partner in a venture capital firm, take it. Non-partner roles are nowhere near as lucrative as being a partner: non-partners (often called “associates”) are typically hard-working early-career graduates from top-ranked MBA schools. They work very hard to separate themselves from the pack in the slim hope of someday being made a partner, either at their current firm or by leaping to a new firm. In that sense the social hierarchy within a VC firm is very similar to a law firm: there is a huge disparity in power between the partners and the associates, just like there is a huge disparity in power between a VC partner and most entrepreneurs. It surprises me not one tiny bit that there have been instances of sexual harassment by VC partners towards associates and also entrepreneurs, the Ellen Pao case at the famous Silicon Valley venture firm Kleiner Perkins just being the most prominent example.
Only the partners makes the investment decisions. The associates are mainly there to gather, winnow, and sift information. VC firms get approached by many entrepreneurs and fledgling companies, and the associates function as a filter to reduce this flow down so that the partners only spend their time considering the best opportunities. If you as an entrepreneur are meeting with associates and there is no partner in the room, you are not meeting with any decision makers: you are meeting with people who, if you get past their filter, can perhaps in the future put you in front of the decision makers.
You may also be meeting with the associates purely so that they can gather information on your company because the firm is thinking about investing in your market and wants to gather data that can be used to choose to invest in one of your competitors. This is all perfectly legal, and the fact that VC firms refuse to sign non-disclosure agreements should send a strong message that any information you provide may be used against you. Given this, entrepreneurs should be careful not to disclose all the “secret sauce” or other detailed information about the company in the first meeting: it should be dribbled out over a series of meeting, if the VC firm truly appears interested in investing. It’s a difficult tightrope to walk: disclose too much information and you arm a bunch of VCs with knowledge they can use against you; disclose too little and you run the risk of not providing enough information for any VC to decide to invest. If your “secret sauce” is a brilliant, unique product idea, VCs can legally take your idea, hand it to one of their “entrepreneurs in residence”, give that person a bunch of money to hire a team to execute the idea, and you now have a competitor. The only way to completely avoid this outcome is to not have to raise money from VCs.
Risk profile
Entrepreneurs will typically put years of their lives into their companies, working long hours against formidable odds to build something from nothing and to eventually, hopefully, create a sustainable business. They will typically do this while suffering some degree of financial hardship, earning less than market salaries in the hopes that there will be a payoff down the road. VCs, by contrast, are already wealthy. They do not link their future fortunes to the success of a single company. They will invest in dozens of companies over the years, in the hopes of a small percentage of those investments being big winners and more than covering the losses from the companies that fail. A VC does not need any one particular company to be successful, whereas the entrepreneur cares very much if his/her one company succeeds. This situation is a bit like the old joke about the difference between a chicken and a pig in a breakfast of ham and eggs: the chicken contributes, but the pig is committed.
The only way for entrepreneurs to spread their risk across multiple startups is to become serial entrepreneurs, which takes a long time. Startup employees also can slowly spread their risk, by working just a few years at a series of companies. This is quite common in Silicon Valley: some employees will put in two years at a startup, vest in half their options, then leave to join another startup. While this leads to a lot of job hopping and turnover, I don’t blame employees for doing this: it is the only way for them to spread their risk as a VC does, although again it takes years.
Stock
While the above differences are the most important ones, there are also differences reflected in the equity structure of a VC-financed startup. In the traditional VC model, the VCs will hold “preferred” shares of stock, whereas the entrepreneurs and startup employees will hold “common” shares and options of common shares subject to vesting. The primary purpose of the preferred shares is to protect the VCs’ cash investments in the case of the business not being wildly successful and eventually being sold or liquidated for around the amount of the cash invested or less. If this happens, the preferred shares have a “liquidation preference” that basically says the VCs first get paid back their original investment (or perhaps more), and then if there is any money leftover, it gets distributed to the common holders. The VCs have downside protection; the entrepreneurs and startup employees do not.
Additionally, the VCs’ preferred shares are granted when the investment is made; but the common shares for the founders and employees will typically vest over time, requiring them to remain with the company for years to receive their shares. Founders who had shares before the VC investment was made may have to give those shares back to the company and re-earn them via vesting. There are some good reasons for this: it can protect the company in the case of a founder quitting early, before the company has made much progress, which isn’t necessarily fair to the other founders and early employees.
As with everything I have written here, this is just the way that it is. If an entrepreneur is terribly bothered by anything here. the best way to avoid these situations is to not seek VC investment. But of course that has its own set of issues.