Wednesday, January 26, 2011

Don't let the dumb money lead

When I don't invest in a company it's because (a) I didn't like the company, (b) I didn't know enough about the company's business to actually add any value, or (c) I didn't like the terms of the deal.  But I recently said no to a company where I liked all three of those things. What I didn't like was the lead investor.

Because of the way this company's process unfolded, they ended up with a wealthy financier as the lead investor. And even when a professional venture investor later offered to lead, they decided to stick with the original lead.   I think this is a big mistake for both the company and the investor.

Throughout my startup-related career I have repeatedly run into very successful hedge-fund operators, investment bankers, real estate magnates and big company executives who wanted to invest in startups.  I think supporting startups is an excellent use of money and I have always encouraged them... to follow experienced venture investors in deals.  None of them have ever taken my advice*.  They all thought that since they were so good at doing the exceedingly complicated deals they had made their mark with, doing a simple startup financing would be a snap.

Finance is a set of disciplines separated by a common language. What is complicated in your public market/LBO/distressed debt/M&A deal is not what is complicated in a startup deal (and vice-versa, I should think.) Just because you can navigate a DCF, a shareholders' agreement, and Delaware law doesn't mean you can do successful venture capital deals.

For several years an acquaintance who was one of the top people at one of the most successful private equity shops in... I don't know... the world, ever** would call me up about some startup or other he planned to back. He's sharp and invariably had very good reasons for backing the company. But these conversations always made me uneasy. He didn't know what competitors were doing or planning (or even who the competitors were, other than what the entrepreneur told him), he didn't know what valuations were and why, he had zero idea what customers wanted, and the terms he asked for were far more onerous than standard venture capital terms.

This last one is what bothered me the most, even though onerous terms may seem as if they are in the investor's favor***. The problem is that he had dictated these onerous terms because he intended to use them. And it wasn't even the terms themselves that bothered me, it was the attitude that ownership is a zero-sum game, that the pre-investment negotiating tension between investor and entrepreneur continued unabated after the investment. This dynamic should be very different in a startup than in, say, a LBO. In much non-startup finance, for instance, missing your annual plan means a renegotiation of control and ownership. In a startup a plan is just that, a plan. Things never go according to plan, and good entrepreneurs anticipate that and adjust. Your investors need to know this. And more than know it, be comfortable with it****. When investors and company executives start to fight, value is destroyed. Someone who sets up and expects this dynamic even before making the investment is poison.

Smart people who know nothing about the startup world besides what they've read in the Wall Street Journal should not be your lead investor or a control person on your board of directors: there's an excellent chance that they will not only not help your company but will actually harm it.

So who should lead your deal? Founders of venture backed startups know both startups and venture capital; they are great. People who have lead deals for many years and seen the cycle from startup to exit a few times are ideal, of course. People who have learned the trade by following professional VCs in many deals and being very involved from startup to exit can fit the bill. And, finally, non-venture backed entrepreneurs can be valuable, so long as their journey wasn't too easy: having empathy for the founder when things don't go according to plan is critical in remaining constructive.

Now I've been all of the first three at some point or another (and vicissitudes, I've had a few) so you could accuse me of self-promotion here. But the beautiful thing about being me is that I'm not a professional venture investor right now, so I have no particular reason to be self-serving; I invest because I want to see a particular startup succeed, not because anyone pays me to do it. So here's my advice: if you have no other choice, take the money; but if you have a choice between non-venture investor money and venture money, take the latter.

* There is obviously a selection bias here.  If they were willing to take this advice, they probably would not have ended up talking to me in the first place.
** My not knowing the pecking order of PE shops or hedge funds is kind of part of the point. Your typical PE guy probably has no idea of the differences between, say, RRE and Venrock. And knowing these things is pretty important when you go to do your next round.
*** I don't believe this, but that's another post.
**** This isn't license to go missing your plan. If you miss your plan, you need to know why and what you're going to do about it. That's a big part of the point of a plan, after all.


Dave Lerner said...

awesome post jerry.... (I just dissuaded an entrepreneur from taking a term sheet from someone who did well in real estate- the term sheet was ridiculously onerous and you could tell the "investor" was going to mess w/ the entrepreneur once things went sideways if not before... there was also an element of bullying at play)...

bhalliburton said...

Jerry's approach to footnotes is to hide all the punchlines to his jokes in there. Novel!

Jerry Neumann said...

I have taken burying the lede to entirely new levels. Thanks for noticing.

Mary Johnson said...

Great idea. character is more important than money... your appraoch is real