Friday, January 18, 2008

Raising Venture Capital: A Primer for 1st-time Entrepreneurs

A lot of the young entrepreneurs I work with ask me about raising venture capital. I usually paraphrase Churchill's famous quote about democracy--venture capital is pretty much the worst form of financing...except for all the others.

Venture capital isn't a bed of roses for entrepreneurs, but it's usually the best option available. The following is my short primer on the potential drawbacks of raising VC, and what you, the entrepreneur, need to keep in mind as you travel down this road.


Raising venture capital does two potentially bad things--it raises expectations, and it reduces your control. Of course, it's often the right call--I don't think that Google, Amazon, eBay, Yahoo, Cisco, and so on regret raising money.

In terms of expectations, VCs invest to make money. And unlike public company investors, because they are running major risks, they require major rewards. If you give a VC a choice between a sure 50% gain and a 1% chance at making 100X your money, they'll go for option B in a heartbeat.

Remember, they have a portfolio of investments, so what matters for them is expected value. They expect most of their investments to fail.

A good rule of thumb is that about 10% of venture-backed companies actually become successful. This may sound bad, but it's a heck of a lot better than the average success rate for non-venture-backed technology startups.

So when you raise VC, it really marks the beginning of the process, not the end. The only time you can relax is when you finally exit the company via acquisition (if you IPO, you still have to gut out the lock-up period and pray that the public markets hold up).

Let's talk about expectations. If you raise $5 million, and then sell your company for $10 million, you might feel pretty good. Hey, you made $5 million! Wrong.

First of all, you have to take into account the liquidation preference. VCs insist on at least getting their money back before you the entrepreneur sees a dime.

This is actually a pretty reasonable precaution on their part. Otherwise, if you raised $5 million in exchange for 50% of your company, you could simply liquidate the company as soon as the check cleared, and make a cool $2.5 million (sticking the VCs with an instant $2.5 million loss).

That's why you'll never see anything less than a 1X liquidation preference, unless your VC is smoking crack AND mentally incompetent. In the bad old days of the bust, desperate entrepreneurs even agreed to 2X or 3X liquidation preferences. These days though, 1X is pretty standard.

But the liquidation preference isn't the only factor.

If you raise $5 million with a 1x preference, and you sell for $10 million, you've still get $5 million to split, $2.5 million for the VCs, and $2.5 million for you and your employees.

However, your VC is going to look at that piddling 50% return on his money and think, "What a useless investment!" VCs will rarely let you sell for less than 3X your last post-money valuation, because they want at least a 3X return on their investment in a successful company, and prefer 10X or 100X.

Side note: Google and Sequoia paid a total of $25 million for a 20% stake in Google. Google currently has a market cap of $190 billion. Even assuming close to 50% dilution (which I think is too much), that's $25 million for $100 billion, or a 4,000X return. That, my friends, is a grand slam, hat trick, and 100-point game all rolled into one.

So if you raise $5 million on a $10 million post, good luck trying to sell for less than $30 million.

When you're pre-VC, a $10 million exit can make you rich for life. Post-VC, you'll never get a $10 million acquisition past the board, unless they've truly given up on the business.

And remember that 10% success rate rule of thumb. If you've got a chance to sell your bootstrapped startup early for $10 million, just to get the equivalent expected value, you'd have to get a $200 million exit ($200 million X 50% stake X 10% chance of success) to justify the risk. If you get that exit and make $100 million, great, but there's a 90% chance you go home with a year's supply of Rice-a-Roni. I don't know about you, but a sure $10 million sounds a lot better than a 10% shot at $100 million.

Don't forget, Jonathan Abrams was offered $30 million in pre-IPO Google stock for Friendster, turned it down to take money from Kleiner Perkins at a $53 million pre-money, and ended up with nothing.

Of course, most of us aren't lucky enough to get early buyout offers, so we're generally going to end up raising VC sooner or later.

Raising a Series A also really changes how much control you have as an entrepreneur. Generally, you'll end up with a five person board, with two VCs, two folks from management, and one "independent" board member.

Pop quiz: If you have someone like an attorney or accountant as your independent board member, whose good side would he rather stay on? Yours? Or Sequoia's?

The Board does two main things--it sets the compensation of the CEO, and it decides whether or not to to fire the CEO.

Another pop quiz: If your company runs into trouble, would the VC rather put their faith in you, the first-time CEO they've just met, or an old friend who has come through for them many times with past deals, and has made them hundreds of millions of dollars?

Even if you do manage to retain board control, your VC exercises considerable power simply because she has the option to withold additional funding. Believe me, it's not easy to raise another round if your existing investors refuse to pony up.

Let's sketch out the hypothetical scene: You take money from Mike Moritz at Sequoia. You end up clashing, but because you retain a board majority, he can't get rid of you. Now it's time for you to raise more money. You have a great meeting with Kevin Harvey at Benchmark. He loves the deal. Then he calls up Mike.

Kevin: Hey Mike, how's the private jet? Listen, I was just wondering what you think of and Joe Entrepreneur. I saw you did their Series A.

Mike: The company is doing well, but Joe is a nightmare to work with. Run away!

Kevin: So you're not participating in the B round?

Mike: Hell no.

Kevin: (To himself) It's seems like a good company, but do I really want to invest in a guy that screwed with Mike Moritz? Not bloody likely. Unless I can figure out a way to stack the board so that I can bring in Meg Whitman as CEO once the round closes....

If your existing investors won't support the company, you have a 0% chance of raising more from traditional VC. And VCs know it.

And you know what? The VCs are trusting you with millions of dollars. You're damn right they want some level of control. You would too if you were in their shoes.

So to summarize:

Raising a VC round comes with a lot of drawbacks. It limits your exit flexibility. It reduces the amount of control you have. It increases the likelihood that you'll be replaced if something goes wrong. But in most cases, it's still the right thing to do.

Just remember that VCs do deals to make money. They have a portfolio strategy where they'd rather swing for the fences with individual investments, trusting that the numbers will even out in the end. Their interest lies in maximizing shareholder value...and in some cases, they may feel (possibly correctly) that shareholder value will be enhanced with you, the entrepreneur, out of the picture. But then again, shouldn't you be focused on shareholder value above all else?


My Agapic Life said...

GREAT post laying out the picture in a very methodical way. Some really sensible advice. I guess one of the big wild cards, as you mention, is whether or not the CEO can see what it really is and roll with that.

Oopala said...


Thanks for an excellent primer on venture capital funding. I linked to your post in my blog for the Innovators-Network ( ) in hopes that some of my readers will visit your blog and read the complete piece.

Straight talk might not always be easy, but it can pay off in handsome dividends if used as a matter of course.

Best wishes for continued success,

Anthony Kuhn

philcrissman said...

I'm always curious about how much VCs want to see at first.

I know there's seed funding, where there's not even so much as a prototype when the venture starts... not sure how rare that is. I've always felt I'd have to have at least _something_ built _before_ approaching a VC.

Showing up wearing only an idea and a smile seems a bit unnerving.

Chris said...


Whether you can raise money without a prototype depends largely on your track record.

If you have made people lots of money in the past, investors will be willing to make the assumption that you'll be able to get a product out the door.

If you're a first-timer, investors will not be willing to assume away that risk. Moreover, given how cheap it is to prototype products these days, any would-be entrepreneur who can't beg, borrow, or steal the resources to build some kind of demo-able prototype is pretty unlikely to be able to deliver, even if given the resources.