10 Reasons to Shy Away from Venture Capital
We're going to raise venture capital!
Rookie Entrepreneur
This declaration is heard daily across the land from
first-time entrepreneurs. To the uninitiated it sounds
impressive and even glamorous to embark on such a path.
However, to veteran entrepreneurs it's a strong indication
of the rookie's naivety and lack of understanding
of the consequences of accepting money from outsiders.
While venture capital can be a tremendous boon to a tiny
fraction of the companies pursuing it, in the vast majority
of cases it presents the entrepreneur with a “Faustian
Bargain”. Venture capital brings with it tremendous
meddling and pressure from venture capitalists who in
this day and age typically lack both the operating and
industry depth of their predecessors. The effect of this
on fledgling ventures is loss of control by the entrepreneur
which then frequently leads to bad--and sometimes fatal--business
decisions being made.
Here are ten drawbacks of venture capital for the entrepreneur
to mull over before making a decision to pursue it.
- The decision to chase venture capital is often a
tempting distraction from the much more complex and
important entrepreneurial tasks of creating something
to sell and persuading someone to buy it. The pursuit
of venture capital is sometimes a means by which to
postpone the day of reckoning when the marketplace finally
decides if the idea will fly.
- Venture capitalists behave like sheep investing only
in whatever industry happens to be the flavor of the
month. Everyone else need not apply.
- Rookie entrepreneurs talking to venture capitalists
expose their ideas to increased risk because they cannot
distinguish between genuine interest and mere “brain-sucking”
to uncover corporate secrets.
- Once negotiations begin venture capitalists will typically
stall in order to push cash short companies to the brink
of bankruptcy as a way of extracting additional equity
and concessions at the last moment.
- Terms demanded by greedy venture capitalists frequently
work to erode and ultimately destroy the founding team's
motivation and commitment to building a successful company.
- With the first dollar of venture capital accepted
the entrepreneur's control slips away to 28-year-old
MBA wonder-boys with only the shallowest of operating
experience.
- As soon as venture capitalists become involved the
founder's role shifts from critical company building
functions to preparing reports, attending endless meetings,
writing memos, and hand-holding impatient and/or meddlesome
investors.
- An infusion of capital often shifts the founding team's
focus away from selling to spending money in an effort
to placate venture capitalists who often confuse bulking-up
staff and assets with real growth.
- Venture capital brings with it tremendous pressure
to create a liquidity event but this frequently results
in bad decisions being made to launch products too early
or enter into the wrong markets.
- The venture capitalist's knee-jerk response
to every problem faced by a portfolio company is to
fire the founders and evade any personal responsibility
for bad decisions.
Here's a bonus 11th reason why venture capital is bad.
It is by far the most expensive money an entrepreneur
can ever tap into. Let's do the math to see why this is.
Suppose you and a venture capitalist agree to a "pre-money"
valuation of $1 million for your start-up, and the venture
capitalist then invests $1 million for 50% of the equity.
After the investment, the company is said to have a "post-money"
valuation of $2 million. Being 50/50 partners sounds acceptable,
right?
Three years later the company is sold to a Fortune 500
corporation for $5 million. Do you and the venture capitalist
each get $2.5 million from the proceeds? Not on your Nellie!
The venture capitalist will have a so-called "liquidation
preference" built into the original investment agreement
which allows him to first take out 2 to 5 (or more) times
his principal before anyone else sees a penny. So, let's
say that in this example he takes out $3 million (i.e.,
a "3X liquidation preference"), plus any accrued
dividends on his preferred stock. After exercising the
liquidation preference and cashing in his dividends only
$1 million is left. You, the founder, and your team, will
then split this remaining money on a 50/50 basis with
the venture capitalist.
This is a simplified example of what happens. In real
life the founder and her team would probably receive far
less than even the $500,000 due to all the fine print
clauses.
At this point, you really have to ask yourself if it's
even worth the effort.
The good news is that there is a wealth of academic research
to support the contention that anyone wishing to build
a company for the long term will be better off by not
utilizing venture capital. As a result savvy entrepreneurs
devise startup strategies that allow them to focus on
generating cash flow during the first year instead of
chasing venture capital. Conversely, naive “entrepreneurial
wanna-bees”, such as those we observed in the recent
dotcom era, have a philosophy which can be summed up as,
“Give me X million dollars or this idea is dead!”.
If your entrepreneurial goal is a company “built
to last” it's usually best to forgo venture
capital. On the other hand, if your goal is a company
“built to flip” for a fast buck use venture
capital if it is available to you.
Peter Ireland, antiventurecapital.com
