Venture Capital – An Entrepreneur’s View (continued)
For many entrepreneurs, there will be a right time for an investment by venture capitalists (VCs). Here are some lessons I learned about when venture capital is the right answer, when it is not, and how to select and work with VCs. Yesterday I blogged lessons #1 - #4 in this series so, if you’re interested, you may want to start there.
Lesson #5: ask VCs about their firm’s “exit strategy”.
I didn’t do this, didn’t know to. The VCs exist to make money for their limited partners (LPs) – the people and organizations which gave them money to invest. You are a vehicle for doing this; you were the beneficiary of the LP’s money that needed to be put to work. At some point, the VCs will sell or distribute the stock they hold in your company. Whenever it is, you won’t like it; but it is better to understand this in advance than to be surprised.
They may sell out because you are failing. Fortunately, we didn’t have that experience but we didn’t have a clear understanding of how they would make that decision if the time came. We should have. This wouldn’t have been a contractual commitment, just an understanding of how they work and think. We could have gotten this understanding by asking what they had done with other companies but we didn’t think to.
They may sell because you’re succeeding. Our VCs sold at a handsome profit in our secondary. That we expected and it didn’t hurt. Being well in the black on the deal after the secondary, I think, made them more patient later.
They may sell or distribute because your stock is going down. That’s the one that hurts because it makes the stock go down more. But VCs aren’t really in the business of speculating with public company stock so, once you are public, the exit is only a matter of time. We would have been less surprised had we understood this better. Of course, when we raised our money we knew that the market would continue to go up forever so we didn’t think to ask:-}
Lesson #6: look for VCs who can and do distribute.
When the time comes for a VC to liquidate some or all of its position in your company, it can usually either sell the stock outright or distribute it to its LPs. I believe that distribution is better for the company than an outside sale. For one thing, it doesn’t send the same signal to the market as a huge sale by an initial investor which may have to be reported publicly depending on how recent your last equity event and the size of the VCs stake.
More important, all of the stock doesn’t hit the market at once in a distribution. Some of the LPs will not sell immediately. This is not a panacea. Many LPs do have a policy of selling every distribution automatically and immediately; it is just a cushion.
Some venture funds can’t distribute either because of something in their charter or because they don’t have limited partners. Intel Ventures, for example, is a subsidiary of Intel. When they decide to move out of a position, they don’t have LPs to distribute to. They can only sell. They are good investors to have in other ways so this doesn’t mean to avoid them but it is something that we didn’t know to take into account.
Lesson #7: check VC references.
The VCs will check your references diligently. Be sure that you do the same. Most importantly, you want to talk to companies which the firm invested its prior funds in. They have had longer experience with the VCs than those who received an investment recently.
You want to know about the whole life cycle of dealing with the VC. How were they initially to deal with? How were they as board members? How were they when the company was in trouble? How and when did they lighten up their position? How did the they help or hinder the company in dealing with change?
You will know which partners and associates of the VC are initially involved with your company. Particularly if it is a big firm, you want to make sure that you are checking the references of the individuals you will deal with. Obviously, personalities and abilities differ even within firms.
Lesson #8: Choose VCs you’d trust with your own money
Mary and I are or have been LPs in funds offered by most of the VC which invested in ITXC. We invest in them because we think they know how to manage investments well and will make a profit for us.
You should never accept a venture investment from a fund that you wouldn’t invest in yourself. That doesn’t mean that you have to invest in every VC that invests in you. You probably don’t have a lot of loose cash when you’re in startup mode. Not all firms take small investments. But, if you don’t think the firm is going to make money for its LPs, you don’t want them in the way of managing your company.
Lesson #9: use your VCs relentlessly.
Your VCs will make many demands on your time as a CEO; you’ve got to talk to them when they call. But you can and should turn the tables. There are many vendors you deal with who will care much more about the good will of your VCs then they care about your company.
For example, if you go public (it’s not “when” any more), the bankers look for continued deal flows from the VC firms. They’re only going to take you public once, maybe do a secondary or occasional other financing. A call from one of your VCs not only helps you get initial attention from investment banks, it can also be very useful in making sure the bank continues to give you the attention you need during the IPO process.
Ditto your financial printer – the specialist you need to print your prospectus!
Executive search firms are best approached through VCs. You won’t look for that many CFOs or COOs (or CEOs to replace yourself) over the course of a career. The VC firms will be part of hundreds of searches.
Since you have chosen a VC firm familiar with the business environment you’re in, that firm should have supplier and customer/prospect contacts. That can be a mixed blessing. They’ll call you on behalf of their other portfolio companies and sometimes you have to be able to say “no”. A good VC will understand that.
Lesson #10: push to speak to the Limited Partners.
Every VC firm I know has an annual meeting of the LPs and usually invites some of the portfolio companies to present or at least mingle. These LPs may become (or may already be) direct investors in your company. Most important: if the VC distributes your stock to the LPs, you want to have convinced them that yours is a stock worth holding in their own portfolios. You won’t convince them all but, if you do a good job, there won’t be quite the same rush to sell on distribution as there would be otherwise.