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On Venture Capitalists

Page history last edited by Alex Backer, Ph.D. 7 years, 11 months ago

When a stupid man is doing something he is ashamed of, he always declares that it is his duty.

--George Bernard Shaw, Caesar and Cleopatra (1901) Act III

 

 

If your start-up needs capital to start, choosing the right investors and the right corporate structure may well be the most important decision you face early on.

 

I have seen VCs lose a CEO within 4 months of his tenure despite quarterly net revenue growth exceeding 160% (which annualizes to 4500%) and 100% employee retention. I've seen VCs keep a CEO after 12 months of his tenure despite negative net revenue and gross profit growth in the midst of massive personnel loss and lies to cover it up, with a higher burn rate to top it off. Both of these cases with revenue numbers of the same absolute order of magnitude.

 

All generalizations are wrong, but what causes some VCs to make such irrational decisions? The ones I have seen tend not to be stupid, so that's not it. One contributing factor seems to be ignorance about the company. VCs manage portfolios of several companies, and spend a large fraction of their time looking at large numbers of potential new investments. They are thus inevitably less informed than management is about what is really going on inside a company.

 

A second contributing factor is the opposite: experience. Brains tend to interpret any new situation by analogy to the closest thing they have seen before. This is as true for the brain of a venture capitalist as it is for any other person. The difference lies in what venture capitalists are used to seeing. As James Baldwin put it, the price we pay when pursuing any art or calling, is an intimate knowledge of its ugly side. Venture Capitalists are used to seeing most of their companies fail --it's the nature of venture-backed start-ups. So for pretty much anything a VC sees, there is a company he's seen or heard of before that has done something similar and failed. This makes VCs nervous by nature. And fear is not good company to any decision-maker.

 

A third contributing factor is that they tend to be overly eager for rapid returns. I have seen VCs who initially spoke of being there for the long haul get nervous when a product with major innovation took more than four months to build, even with more than 90% of cash reserves unused. I've seen them put a significant investment in but then be amazed when it actually took a significant chunk of the money to get the company going --because in VC's ideal world, they get asked to put money into companies that do not really need it. Except that entrepreneurs don't tend to want to share ownership with investors just for the fun of it. Indeed, investors should be wary of a technology that is too easy to develop, for it will lead to plenty of copycats and competition. The basis for a successful start-up is a technology that is not too easy, and not too hard, but just right --see The Accidental Entrepreneur, a great essay by Gordon Moore, co-founder of Intel, on the matter, talking about how Intel (Moore's second company) had 7 years lead before the big established companies got into their technology.

 

A fourth contributing factor is pride: once VCs make one mistake, it can compound into others just for lack of the guts to admit that the first decision was a mistake --I have heard from people who have spent a lifetime working with VCs that bad VCs would rather drive a company into the ground than risk showing that they made a mistake. Except, of course, that the mistake can become obvious anyway, due to the success of entrepreneurs in other companies without the same VCs --case in point Steve Jobs.

 

Fifth, VCs tend to drive for an unnecessary degree of focus. In The Accidental Entrepreneur, Gordon Moore explains how Intel's success was due in part to their early investment developing three alternative technologies, only one of which became the basis for a successful company. As Stephen Jay Gould liked to say in his classes at Harvard, variety is one of the three fundamental ingredients needed for evolution. But VCs focus their diversification efforts at the portfolio level, and tend to erroneously believe that is enough. So I have seen companies with completed prototypes of potentially revolutionary technologies that never saw the light of day in the name of focusing on another technology that may never take off.

 

A sixth contributing factor is the very human tendency to favor those who are like us and discriminate against those who are different: VCs have a tendency to prefer CEOs of similar age, background and nationality as themselves; people who look like them, smell like them, walk like them. And they tend to overvalue experience. When, if you look at the world's most valuable companies, they tend to be grown by smart and passionate founders, not very experienced people. Case in point Microsoft and Bill Gates, General Electric and Thomas Alva Edison, Dell Computers and Michael Dell, Hewlett-Packard and its namesakes, and Google, whose product direction is run by Sergey Brin and Larry Page. All the more so these days, when the world is changing so rapidly that what worked once before is of little guide to what will work next. In order to come up with innovative approaches, it often helps not to be used to solving things the old way. What a start-up needs is innovation and an open mind, not following a beaten trail.

 

 

Finally, a last contributing factor is given by the structure of American corporations, where a Board gets input about the corporation's CEO mostly from a single source: from the CEO herself. But that is the topic of another essay.

 

I have seen VCs be of help in a consulting role, providing advice, introductions, and of course, all-important investment. But a Board dominated by VCs (even in a minority, having put the money seems to give them a sort of moral authority, which, combined with a forceful personality, can cause much of the rest of the Board to acquiesce to them) can wreck an investment and a promising start-up. VCs' tendency to do this, second-guessing their initial judgement to back an entrepreneur, may well be responsible for the bad average track record of VC-funded start-ups. After all, there's plenty of innovation left to do, and plenty of dollars to reward those who blaze new trails.

 

So what's the lesson for the entrepreneur? If you can, get investment from accomplished entrepreneurs --they have a proven track record building a successful company, have the credibility associated with this, and will tend to let the entrepreneur build her vision with more of a long-term outlook. Sell only a minority of your company, and retain control of a majority of the Board, which ultimately governs the company. And in choosing investors, as in any reference-checking exercise, ask not whether someone is good (a futile exercise fraught with problems), but who is best. Finally, care less about the VC firm, and more about the specific people you'll be involved with.

 

 

Up to Entrepreneurship.

 

 

 

 

 

 

 

 

 

 

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