Article 2: Common Ground December 17, 2009Posted by Lawrence Lenihan in Uncategorized.
Entrepreneurs have the right to dictate how much capital they take and how much dilution they take. VC’s, on the other hand, need to make a return but they should not require the entrepreneur to take more money than needed because the VC needs to “check a box”. However, the entrepreneur must realize that the VC will spend his time where he can achieve the greatest returns or where he has the most capital at risk.
Of course, the “greatest return” is relative to a number of things, most notable of which is the size of the VC fund. You probably often hear the phrase “move the needle” which means an action whose consequence is large enough to make a sufficient impact so as to be noted. Let’s arbitrarily call this a 20% impact on the fund. For a $500MM fund, that is a $100MM impact! For a $200MM fund that is a $40MM impact to move the needle. If the entrepreneur needs $4MM, the VC in the $500MM fund needs to generate a 25x return. Really rare and hard to do. On the other hand, the $200MM VC needs a 10x, to move the needle. Much more achievable! Assuming a fixed valuation, to have the same likelihood of “moving the needle”, the $500MM GM would have to put in $10MM and the entrepreneur would suffer an incredible amount of dilution. As they say in New York City, “this dawg don’t hunt…”.
The obvious entrepreneur response is “who cares? I’ll just take more money at a higher valuation so the dilution is the same, but I get more money.” I have even seen a number of cases where a company will offer a choice of terms like $3MM investment at a $3MM pre-money valuation or $6MM investment at a $6MM pre. Believe it or not, in many cases the VC will take the latter! While it sounds insane, it actually is not economically irrational for the VC since the amount of carried interest that would be earned in a successful outcome would be roughly the same, believe it or not (of course, the LP returns get crushed since more money in generates the same amount of cash return!). And, the VC gets to check his/her box for investment size. But this dynamic is at the heart of what is wrong with venture industry at this time: everyone suffers. First, the customers of the VC, our LPs, suffer by getting significantly lower returns for each dollar invested. Second, with lower returns, our customers will seek other asset classes where they can gain a higher risk-adjusted return. So, with no investors, we VC’s suffer too since we won’t be in business. Finally, the entrepreneur suffers. Not only is there excess dilution, but even when the entrepreneur gets a great valuation on the investment, the entrepreneur will need to pay the VC the preference on his/her investment. Too much money in a given return leaves less money for the entrepreneur because of the preference and/or preferred return. So, in the end, the entrepreneur suffers the most.
The only way to accommodate these two opposing requirements set forth in this second article is to agree on a fair valuation representing an opportunity for a venture-appropriate return for the venture investors with a reasonable amount of capital to get the entrepreneur where he needs to get to for the next value-creating milestone with a reasonable amount of dilution. If the VC insists on putting more money in, the agreement should enable more investment at higher valuations commensurate with value created during the growth of the company, thus mitigating the entrepreneur’s dilution while preserving high risk-adjusted returns for the VC (as milestones are achieved, risk is reduced so even higher valuations enable the venture investor to achieve similar returns adjusted for the significant reduction in risk of the outcome). Of course, the long-term way to address this problem is for the VC to manage a fund that reflects the new reality that enables companies to go much further with far less money. That is, we VC’s need to shrink fund size so the needle can be moved with less money in.
However, the entrepreneur needs to realize that the level of engagement of your VC partner will be directly proportional to the amount of value at stake. For tiny investments, there needs to be an enormous amount of value that is created. I would presume a VC would work his tush off with a 1% stake in FaceBook. On the other hand, a 1% stake in a company with a $50MM outcome, would probably not garner as much attention or energy. There has to be an honest and candid discussion about the mutual expectations for any investment. Without this exchange, someone is bound to be disappointed.