Care and Feeding of the Venture Capitalist

Fri, 27 Nov 2009 22:49:22 -0800

You think raising money was the most difficult part of your relationship with the venture capitalist? No, my friend. The tough parts are in front of you. By accepting venture capital funding, you’ve fundamentally re-prioritized your role in the company, re-defined your future with the company you founded (or co-founded) and ceded control of decision-making authority for pretty much everything except day-to-day executional-level activities. And, you have brought a whole new group of quasi-personal-level relationships into your life.  Let’s look a few of the major ways in which the venture capitalist impacts you and your role as senior manager of your small company, along with ideas on how to navigate (not control, regulate or dictate...) the impact of your investors.

• Make Your VC Your Friend - whether you like him or not
The single biggest mistake small venture-funded-company CEOs make - regardless of whether they are seasoned executives from Fortune 100 companies or in the senior manager role for the first time - lies in poorly developing (or simply ignoring) their personal relationship with each venture capitalist on their Boards. At the end of the day, few venture capitalists today have the experience, knowledge or time requisite to effectively understand their portfolio companies at a depth required to make informed decisions at the Board level. Instead, most VCs rely upon their faith in the CEO as their guiding force on critical decisions regarding follow-on investments, strategic acquisitions and exit opportunities. Do not kid yourself - your personal brand may have gotten you the CEO role, but it will not sustain you with your Board beyond the two-year “honeymoon” period. If you have invested sufficient time in building a one-to-one relationship with each of your key investors - dinners, co-ordinated business travel, face-to-face meetings - you will have their proxy when it comes to critical Board-level decisions. If not, you have created the potential for disaster - a handful of venture capitalists acting solely on their personal motivations while they make key decisions regarding your company’s future.

• Managing a VC through his business model
If you’re reading this, you are likely CEO of an early-stage company. In this “third generation” of venture capital, that means you’ve taken investment from a mid-size-to-large VC fund (>$500M under active management) - because smaller funds (the ones that still exist...) no longer can afford to invest significant portions of their capital into early-stage companies. Under the rules of Venture Capital Algebra, that means the individual at the venture capital fund responsible for your company is most likely not a Partner in the fund. Associate, Vice President, Sector Manager...the title is irrelevant. Unless the individual is a Partner in the fund, he or she does not have decision-making authority within the fund. That appears to leave you unable to directly affect the decisions made by the entity that owns a significant portion of your company.

This situation demands you become expert in the tactics of guerilla warfare - turn your weaknesses into strengths, turn your investor’s weaknesses into opportunities. Many early-stage CEOs of venture-funded companies see investing time with the Associate-level individual as worthless as screen doors on a submarine. Nothing can be further from the truth. One of the Associate’s key functions is to report status and provide advice on each portfolio company to which the Associate has been assigned in the weekly Partners Meeting. A CEO who manages the Associate well can actually be more effective in managing his VC investor than if he had a distracted, over-scheduled, over-self-important Partner on his Board.

The Associate’s role in a VC fund is simple: lighten the day-to-day management and investment burdens of the Partnership. Today’s VC Partners take more of their personal compensation from fees on limited partner investments than they take from return on portfolio investments. Thus, VC Partners spend more and more time raising more and more limited partner investments. The Associate is a critical piece in enabling the Partnership to continuously increase their fund size - and, hence, their personal compensation.

By working closely with the Associate, a CEO creates an advocate for his company and helps the VC Partnership to work its business model. As the Associate becomes more involved with the portfolio company, his asset value to the Partnership increases as he becomes knowledgeable in the company’s markets and technologies. (The Partnership’s investment in your company demonstrates their interest in said markets and technologies; growing the fund’s expertise in them is clearly to the fund’s advantage.) As the Partnership sees their Associate growing in expertise, your company appreciates its value to the Partnership. Never underestimate the value of intangibles in the relationship between the VC and its early-stage portfolio companies. Savvy CEOs have raised millions in follow-on investments for their pre-revenue companies through nothing more than making sure their Associate is “the smartest guy in the Monday Partners Meeting”.

• Use any available means to continually validate your business plan
The Golden Rule of Managing a Venture Capital Investor: Before all else, Validate the Business Plan. Of course, the easiest way to validate your business plan is through generating profitable revenues. But, as your early-stage company is either generating its initial sales or is pre-revenue, you don’t have that option. Fortunately, there are many subjective means for substantiating your business plan in advance of executing the revenue hockey stick. Consider bringing an “industry expert” (former senior executive at successful company in your general area of business) onto your Board. Not only can the expert validate your business plan through his experience, he also brings “inside information” about the markets and technologies that are the focus of your company - information that your VC will by definition take as proof you are on the right track. Regardless whether you were a senior manager at Intel or product line manager at a less-known company, you will benefit greatly from having an independent mentor on your Board of Directors. Someone who has senior management experience and with whom you have at least a professional relationship can validate your strategy - as well as your ability to manage its execution. Cooperative product partnerships with established suppliers in your markets are the next best thing to revenue; they reinforce a fundamental value to your company’s focus. And do everything possible to interact with senior managers within your initial target customers on at least a quarterly basis. If that means starting with engineers or procurement, fine, but make sure to work your way up the org chart with each successive meeting. Verify customer interest, back up market conditions, reinforce confidence in your strategy and decision-making ability - continuous validation of what you’re doing equates to continuous support from your investors. One nice benefit - a rational VC investor (that’s another topic) who has confidence in his CEO tends to spend very little time thinking about bringing in a new CEO...

Venture Capital Algebra

Fri, 27 Nov 2009 13:46:13 -0800

Over the first two generations of venture capital during the 1980s and 1990s, understanding the motivations of venture capitalists was relatively straightforward - they were driven by a combination of entrepreneurism and return on investment. Beginning in 2000, the third generation of venture capital morphed from entrepreneurial investor to mutual fund manager and, with this fundamental change, venture capital funds began focusing more on management fees than return on investment. Any vestiges of entrepreneurism were, at best, miniscule. The venture capital fund’s primary focus shifted from growing companies for IPO or M&A to growing the amount of funds under management from which fees could be taken.

As a result, entrepreneurs managing venture capital-funded companies today rely upon a new tool - what I call “venture capital algebra” - for understanding the motivations of their investors. A few of the key points are listed below.

• 2% of a Big Number is a Big Number
Venture capital has historically taken its operating expenses and profits on some variation of the “2 and 20” model - a 2% annual management fee on the total amount of funds under management (not on funds committed by limited partners, but funds actually working in portfolio companies) and 20% of proceeds from any IPO or company trade sale. Through the late 90s and early 2000s, the combination of the tech IPO bubble and the Baby Boomer-fueled expansion of public employee retirement and trade union funds made available to the venture capital community a tsunami of cash. While the $1B venture capital fund was nearly inconceivable in 1995, by 2005 multi-billion-dollar funds had become the standard operating model for venture capital. Hence, 2% replaced 20% as the primary motivation for venture capital partnerships.

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Care and Feeding of the Venture Capitalist

Venture Capital Algebra