Venture capitalists are stereotyped as being out to crush dreams. In reality, they can help entrepreneurial dreams come true. Here, we explore the roots of this misunderstanding.
This week, I met with an experienced CEO who had a new business idea that would require a substantial equity base.
When I mentioned the prospect of working with deep-pocketed media technology venture capital funds, the CEO snubbed the notion quickly. He said, “Nothing good can ever come from taking money from vulture capitalists.” When I asked him if he’d ever had any direct experience with VCs, he said no.
It’s true that venture capital fund managers need some favorable spin. My view is that much of the public’s mistrust comes from hearing about too many entrepreneurs who were “misled” or who “lost decision-making control.” Because entrepreneurship involves so much of an entrepreneur’s heart and soul, any conflict with a funding partner takes on a heightened sense of bitterness and disappointment.
Should entrepreneurs avoid pursuing VC funding? Not at all. VCs can help a lot of entrepreneurial dreams come true. The founders of Google, Facebook, Airbnb, Amazon.com and thousands of other companies wouldn’t be as successful as they are today without early VC support.
Here are three common but negotiable areas of misunderstanding between entrepreneurs and venture capital investors.
1. The string-along. When entrepreneurs pitch VCs for multimillion-dollar financing deals, they expect VCs to understand the upside associated with fast funding so they can beat their competitors to market.
But what about the downside of fast funding decisions? Since VCs invest other people’s money, they have a fiduciary obligation to ask questions. The due-diligence process of researching a company’s investment prospects can take a good six to 12 months — and that is only if the investigation is going well. What annoys entrepreneurs the most is investing their time in answering VC questions, only to get a “no” when all the VC partners bring the deal to a partnership vote.
To avoid the pain of a perceived string-along, entrepreneurs have to resist giving VCs arbitrary deadlines for making funding decisions. They should ask the VCs at the start about the fund’s decision-making process and how many general partners must agree to a deal before funding agreements are signed. Lastly, entrepreneurs shouldn’t misread VC friendliness and compliments as anything more than friendliness and compliments. If you aren’t at the point of negotiating a term sheet, the fund isn’t yet sold on your company’s investment prospects.
2. The phantom employment agreement. I frequently see letters in my inbox about a founder who received business funding but no promised employment agreement from an angel investment group or venture capital fund. During intense deal negotiations, entrepreneurs get distracted by transaction details. After investment funds clear the company’s bank account and one or two VC representatives join the upgraded board of directors, the founder’s employment agreement never seems to get signed.
My advice to entrepreneurs is to establish a respected board of directors and negotiate a reasonable employment contract with the board prior to VC funding. Alternatively, entrepreneurs can also ask their legal counsel to prepare the first draft of an employment agreement at the same time the VC’s legal counsel is preparing funding agreements. It’s the entrepreneur’s job to keep the agreement “on the table” during deal negotiations, not the investor’s.
3. No profit-sharing. First-time entrepreneurs often assume they’ll benefit from the sale of a company on an equal per-share basis as investors. But this only occurs if the entrepreneur owns the same class of stock as VCs, which rarely happens.
Most savvy investors buy preferred stock rather than common stock as a condition of investment. The differences are complex. If an entrepreneur doesn’t have a skilled securities attorney who works on venture capital deals all the time, that person stands a good chance of saying in the future, “I didn’t know what I was signing.”
VCs typically receive two forms of added benefits over common-stock owners: a quarterly or annual stock dividend to boost the investors’ return, and a “preference,” which can lock in a minimum profit at the time of business sale.
In simple terms, if a company raised $5 million from investors with a “two times” preference multiple, then at the time of business sale, the investors would receive the first $10 million in deal proceeds. Unpaid but accrued dividends add to this total, too. If an entrepreneur raises multiple rounds of investment, each with a different preference multiple, then the entrepreneur and all other common shareholders (typically founders, family members and employees who exercise stock options) move back even further in the payout line.
There are a few workarounds that can help entrepreneurs improve their position at the time of business sale. With a skilled attorney on hand, entrepreneurs can negotiate a “carve-out” that gives them some minimum participation in the sale. VCs are inclined to agree to carve-outs to keep entrepreneurs motivated.
Are corporate investors just as tough on deal negotiations as VCs? Possibly. Corporations may ask for a “right of first refusal” to buy an entrepreneurial business or its technologies. On the surface, this type of deal term can seem like a vote of confidence. However, it can discourage competitive bids from other corporations that may be willing to pay more to own a great company — perhaps just like yours.