If you are an entrepreneur looking to raise your first round of funding ever, you surely must be curious about the different kinds of investors you will pitch. You may be particularly interested in VCs because they have the deepest pockets. There’s something you need to know: it’s very likely that a VC’s investment objectives will not be aligned with your personal goals. I’ll try to explain why.
A VC fund typically has a 10-year investment horizon. In the words of Fred Wilson:
VCs are professional money managers. We are provided capital to invest as long as we can return it to our investors with a strong return in a reasonable amount of time. A strong return is 3x cash on cash. A reasonable amount of time is ten years max.
It is known that for any portfolio of startups, the returns follow a power law. If a VC expects to turn 150M into 450M over ten years, one or maybe two investments must contribute hundreds of millions of dollars. At the time of a big exit the VC will usually own a relatively small stake in a company, so it must be worth billions of dollars. It follows that VCs want every single one of their investments to have that potential. If they believe that an investment will never return more than tens of millions, it’s just not worth their time from a financial perspective.
Now let’s talk about you, because you are more interesting to yourself. You are the founder and CEO of GulpMonger, three years out of college, fresh out of Y Combinator. Typical first-time SV entrepreneurs are not millionaires, so let’s say you have 100k in the bank (maybe you’ve made some money from stock options). For most people the utility of going from a net worth of 100k to a few millions is huge. It many cases it means to not have to work for a living. Paul Graham calls it “solving the money problem.” Also for most people, the difference in utility between 5M and 50M (or 500M) is not as significant.
I’ve spoken with dozens of first-time entrepreneurs in the past year alone. Pretty much all of them admitted that they would party like it’s 1999 if they could get a few million out of their startups. I’ve also seen quite a few of such exits; because of the power law distribution of returns, their odds are disproportionately higher than those of becoming a multi-billion dollar company.
Let’s say you raise money from a VC because you are honestly open to all sorts of outcomes. You don’t know how big and how fast GulpMonger could grow. Given what you know today, you are willing to go as far as possible. The VC believes that GulpMonger has a high enough chance (say 3%) of becoming the next Dropbox or Twitter. The VC also believes that the odds that the company will take an early exit if it’s doing well are relatively low. This is crucial to a VC: if Facebook had sold to Yahoo for one billion dollars in 2006, the 10-year return for Meritech Capital Partners would look very different (and not in a good way).
Now let’s say that GulpMonger starts doing well, and attracts the interest of potential acquirers. Perhaps you get a serious offer, and you do the math: saying yes would make you a multimillionaire with 100% certainty (let’s leave the issue of vesting aside, as it may not change the order of magnitude depending on what you negotiate). You could also choose to go long, and hope to continue growing. Perhaps in two or three years the company would be worth ten times more, and the odds of that could be 30%. You guess that there’s also a 30% chance of being worth diddly-zippo-nil by then.
If you believe what I just stated, it would be irrational not to sell GulpMonger. On the other hand, things look very different for a VC. A 30% chance of 10x (and maybe a 3% chance of 100x) makes much more sense than a 100% chance of x. The rational thing to do is to oppose the sale. Of course, this only makes sense if opposing the sale doesn’t hurt the above chances.
At this point things can get ugly. If the CEO would be very unhappy going long, he/she could get replaced. The VC may use a divide-and-conquer approach on the founders to block the sale and/or oust the CEO. There will be resentment one way or the other. It happens all the time, but in most cases people don’t hear about it.
What can you do to avoid the above scenario? Two things come to mind: one, decide what you want before you start playing the game. E.g. do you want VC money? If so, when? Two, educate yourself. If at all possible, meet with experienced entrepreneurs who are not invested in your outcome. Learn as much as you can from their experiences. You’ll still have to make it up as you go, because experience transfusions have not been invented yet (I’d like to hear that startup pitch). However, knowing is some percentage of the battle. I wouldn’t affirm it’s fifty, though.
If you found this post interesting, I recommend that you invest 90 minutes in watching Something Ventured: a documentary about the history of venture capital in the Silicon Valley (hat tip to Elad Gil). Keep in mind that these guys are trying to look their best, so read between the lines 🙂
Final caveat: what I just said does not apply to ALL investors who call themselves VCs, and does apply to investors who prefer other labels. Your mileage may vary. Shop around. Void where prohibited. Offer valid for residents of Silicon Valley mostly. Safe travels.