Entrepreneurs approach venture capitalists to raise equity financing. Venture capitalists
then fund the entrepreneurs and become partners. As partners, venture capitalists
will have a say in the direction of the company. At times, this might make entrepreneurs
skeptical of venture capitalists true intentions.
Whenever entrepreneurs think of getting a venture capitalist on board, they tend
to be suspicious at a subconscious level and fear unforeseen ramifications. Entrepreneurs
generally have the following questions in mind when they approach venture capitalists:
- Will they steal my idea?
- Will they take over the company, fire everyone, and bring in their own people?
- Are they risk averse?
- Is it true that returns and the exit strategy are all that matter to them?
Although it can be reasonably argued that entrepreneurs should be skeptical of venture
capitalists, let us analyze the role of a venture capitalist from a broader perspective
before examining the above questions.
Venture capitalists invest the capital, which is provided by third-party investors,
in the equity of high-growth potential companies. These third-party investors are
very careful in choosing the venture capitalist who will be managing their funds.
Given this situation, the credibility of a venture capitalist is extremely important.
Third-party investors are averse to giving money to a venture capitalist with questionable
motives. If a VC gets the reputation that s/he has the capability to unethically
fool the entrepreneur, what is the guarantee the same venture capitalist is not
going to hoodwink the third-party investor? Every third-party investor thoroughly
checks the background of the venture capitalist before s/he provides the funds.
Credibility of VCs is extremely important. Just imagine this situation: will California
Pension Fund let an unethical venture capitalist manage its $200 million dollar
Moreover, the venture capitalist & entrepreneur community is small. Given this situation,
almost everyone hears all the horror stories—true or not--where venture capitalists
behave unethically and dupe entrepreneurs. Given this situation, if entrepreneurs
want to raise money, they would not approach a firm that employs venture capitalists
who have tainted records. Therefore, venture firms tend to fire general and venture
partners who have tainted records. It is therefore better for the venture capitalist
to adhere to the true spirit of venture capitalism and generate good revenues than
get into dubious deals and earn money in the short term. Credibility is everything
for a venture capitalist. Now, let’s examine the above questions:
Will the venture capitalists steal our idea?
This is a popular misconception whose origin can be traced back to the time when
venture capitalists decided not to sign non-disclosure agreements when they considered
a business idea.
Over the years, venture capitalists have observed that different startup ideas come
in clusters or groups. For example, social networking on the internet started in
the past three years. Email companies like Hotmail and Yahoo started around 1996-1998.
Similarly, many search engine companies started around 1997-2000. Whenever a new
revolutionary idea comes out, entrepreneurs come up with different business models
that are based on the very same idea. Each business model has its own set of pros
and cons, targeting a specific niche market. To understand this better, look at
the social networking market. There are about 34+ funded social networking companies
that focus on different market niches. Some companies focus on networking teens,
whereas others focus on networking people who are interested in kayaking. There
are various business models that target specific niches.
Now, if a venture capitalist signs an NDA, looks into the business plan of one of
these business models, and decides not to fund that company, the whole VC firm will
be obliged not to fund any startup with a different business model in the same area.
Venture capitalists do not consider this reasonable. As a matter of fact, there
have been cases where entrepreneurs who were declined funding by a VC firms sued
the same firms for funding other companies in the same market space. VCs stopped
signing NDAs primarily to avoid unjust lawsuits.
Since then, entrepreneurs occasionally suspect that venture capitalists can steal
the idea and start a similar company once they say “no” to the entrepreneur. This
intellectual theft rarely happens. If a venture capitalist steals a business idea,
the story spreads among the financial community instantaneously. The venture capitalist’s
credibility would be lost. Entrepreneurs will stop presenting their ideas to the
venture firm that employs the tainted VC.
Will the VC firm take over the company, fire everyone, and bring in their own people?
This is a pure misconception. Venture capitalists invest in killer teams who are
able to bring an idea closer to actualization. If a killer team is working on an
idea, the venture capitalist can rest assured that s/he does not need to micromanage
the company in order to create value. VCs do not interfere in the company affairs
as long as the process continues at a reasonable pace. However, if implementing
the ideas does not go well, venture capitalists get the temptation to fire some
of the executives. Let us say, for example, the marketing executive frequently comes
up with bad marketing strategies that always fail. What should VCs do? Evidently,
the executive should be replaced with a more competent executive. Now what if that
executive is the founder of the company itself?
VCs do not hesitate to fire the founder of the company if they find him/her incompetent.
Not all founders are competent enough to meet the targets that they set for themselves.
Executives will be able to maintain their positions as long as the company performs
well. Problems only arise when the company is not able to meet the targets that
entrepreneurs set for themselves. Although firing founders or executives is a hard
act, it is reasonable, considering the amount of money venture capitalists invested
in the company and the odds of making the company successful.
Note that there are a few exceptional cases where venture capitalists deliberately
fire the founding executives even when the companies achieve milestones. Examining
those cases is beyond the scope of this article. Interested readers are encouraged
to search the web. It is important that entrepreneurs thoroughly research the venture
capitalist to whom they are about to pitch their business idea.
Are venture capitalists risk averse?
While some venture capitalist firms prefer to fund only companies that are not associated
with too much risk, others do not hesitate to fund truly revolutionary ideas. For
example, we have a whole new breed of venture capitalists in the San Francisco Bay
area funding clean energy technologies, which are considered risky. Similarly, a
majority of companies currently fund only risk-free late-stage companies. The answer
to this question primarily depends on the subjective risk management strategy of
the individual venture capitalist.
Is it true that returns and exit strategy are all that matter to venture capitalists?
There are some venture capitalists who believe in the true spirit of venture capitalism.
They fund companies primarily to make a better place to live in, following John
Dorr’s example. John Dorr funds companies only if he sees great potential and then
wholeheartedly works with the entrepreneurs to take the company forward. He has
the greatest number of successful company startups under his belt.
Of course, other venture capitalists may be solely interested in the investment
returns. It is necessary for entrepreneurs to research the venture capitalist that
they plan to approach for equity financing.
Pradeep Tumati (Principle, go4funding.com)