Sunday, February 3, 2008

Who are those guys? What makes a good VC. Episode 3

This is the very belated third installment of my running saga about what makes a good VC. I have previously laid out a framework for identifying the skills that make a good VC, in rough chronological order through the process. Each installment covers a stage:

1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit

So here’s stage 3, a discussion of the skills involved in executing an investment that make a good venture capitalist.

This is the stage where the rubber meets the road. The previous two stages were window shopping. Here the VC is buying. The VC’s goal is to buy a share of the startup at the best possible price in return for his investment capital. But it isn’t quite that simple. For that investment to actually pay off, the VC needs to incentivize the entrepreneur and help grow the business. It is a very rare business where a VC can add funding and any idiot can turn it into a large multiple. First, there are no certainties. Second, every startup needs motivated, intelligent people to grow the business and realize a big increase in value. Finally, pretty much every startup entrepreneur needs experienced advice and critical contacts to fully realize that big increase in value.

So a good funding deal is one that leaves everybody incentivized to grow the company. If that doesn’t happen then everyone will equally share the loss. A VC who drives too hard of a bargain, and leaves the entrepreneur with too little of the upside, risks undermining the founders’ determination to put everything into the business. On the other hand, a VC who puts too high a value on the premoney of the startup, and therefore takes too small a share of the ongoing profit, will not last long in the competitive VC world. Further, they may make it harder for the entrepreneur to attract further investment in a later round by unreasonably inflating the entrepreneur’s expectations on valuation.

The entrepreneur is at a disadvantage. They are lucky to have a buyer. In contrast the VC sees plenty of deals, dozens a week, and will only fund less than 1% of the deals he sees. And there is the “golden rule”, i.e. whoever has the gold makes the rules. Only very rarely does an entrepreneur have exclusive control of such a disruptive idea that they can dictate terms to a host of VCs. Usually, the VC sets the terms and the entrepreneur can only improve them by generating some competition for their deal. And VCs will usually work happily together in a syndicate, and tend to know each other in their focus areas, so even the competition strategy can be hard to execute.

I’m arguing here that a good VC is thinking about the long term success of the deal, and not so much about extracting the maximum amount of benefit for his fund. In most cases, a deal has a limited number of bidders who are focusing on that market area and could fund that deal. But I believe the VC who “sticks it” to the entrepreneur because he knows he can, because the entrepreneur needs his money more than he needs their deal --- that VC is really undermining his own chances for a long term success. The entrepreneurs need to have incentive to give the business EVERYTHING they’ve got. A good VC needs to strike that balance.

So a first key skill is balance and fairness, finding that right mix of founders’ incentive and investors return.

Another important aspect of getting a funding done is crafting the terms of the investment to fairly cover all of the eventualities. A termsheet is often filled with pages of clauses that attempt to cover every possible outcome. There is a lot of technician work here that is often based on hard experience by the VC or by their attorneys. VCs do carry an advantage in this phase, because they do a lot of termsheets and their attorneys are specialists in this phase. In contrast, many entrepreneurs are seeing a termsheet for the first time. True – they will hopefully also be represented by experienced attorneys, but the nature of the venture capital business is that only a minority of startups actually get financed, and even fewer have multiple financing options in front of them.

So another skill set (or maybe it is better described as hard won experience) is the ability to see all of the possible outcomes in a deal and anticipate them in the funding documents. When something happens downstream and it is completely unanticipated, that is usually a place where things will get ugly. It is better to try to anticipate even unlikely outcomes and try to agree in advance how they will be handled. Since most VCs have experience with failed companies, they are again more experienced here, compared to the entrepreneur. In fact, entrepreneurs are generally selected for funding because they DON’t have a lot of failure experience. But the nature of high-risk venture investing is that many (even most) VC deals will not turn out as planned. A competent VC knows the downsides.

My goal in this posting is to further explore what it takes to be a good VC. I’m not going to delve into the details of termsheet construction. But creating a fair, balanced and comprehensive termsheet is a key skill for a good venture capitalist.

There are also related skills in getting the deal done. Being able to reach out to syndicate partners where needed, and ironically to become the deal advocate, this is also an important skill. VCs often need to be able to “sell” as well as “buy” at this stage.

Also, a good VC needs to gain the confidence of the entrepreneur who is ultimately going to be his partner if the deal is consummated. It can be very challenging for a VC to gain the confidence and trust of an entrepreneur, while simultaneously pricing his deal and imposing all these arcane terms and worst-case scenario constructions on the deal. So I believe another key skill-set is to be a good communicator and negotiator.

So to sum up this episode 3, “Doing the Deal”, I think the key skills of a good VC are balance, fairness, experienced anticipation of downsides, communication, negotiation and openness that engenders trust in entrepreneurs. One must never lose sight of the fact that a VC is only successful when the startups he/she invests in are successful. Any behavior by a VC that hurts the chances that a deal will be successful is counterproductive and plain stupid. VCs must be ultra-confident to throw their money and reputations at completely unproven startups. Ironically, that ultra-confidence can easily lead them to be overly aggressive “cowboys”. Such behavior is ultimately not in their best interest if it disincentivizes their entrepreneur or scares off syndicate partners.

In the next Episode, the VC and the Entrepreneur are now ostensibly in the same boat, working toward the same end. We’ll see…

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