Getting to know us | Before you accept a venture capitalist's offer, make sure you know a thing or two about them
In the dance venture capitalists and prospective clients do with one another, both are in selling mode. The entrepreneur is selling us his best story about his opportunity, while talking down the many risks we will take on if we commit capital to the venture. Meanwhile, venture capitalists are telling our best story about why taking our capital, instead of money from other VC funds, would best serve the financial and strategic interests of the entrepreneur. Both should recognize they are selling and both ought to be intellectually honest enough to know their stories are only partial truths. Just as you are unlikely to highlight the weaknesses of your story, team or opportunity, so too is the investor selective about what version of his story he tells you.
So what about our side of the house? What is it about working with a professional venture capital investor you will later wish you had known before trading a piece of your company for capital? Here’s a list of what you should know about your investor, his fund, his process, and more.
Know who you’re getting: The venture fund manager’s professional background is more important to you than his fund’s track record. The one who sits on your board of directors is the one you want to ensure has the educational, operational and investing experience to meet your company’s needs. Many larger funds will impress you with their senior partners when selling you on working with them, but will subsequently put a less-experienced, junior staff member on your board. Make sure you know who you’re getting.
Know the fund’s life cycle: Venture capital fund managers raise their capital from investors and structure their funds in 10-year limited partnerships — the first five years are spent investing the funds, the second harvesting the funds. On average, the fund expects to hold the investment for four to seven years; if you raise your money from that fund at the end of the investment cycle (years four and five), the fund manager will be under the gun to gain liquidity for his investment, even if it’s premature relative to the opportunity’s development. So, if you’re looking to keep your investor at the table for as long as possible, pay attention to the fund’s life cycle.
Know your investor’s dark side: There’s a side of the VC you’ll see when moving toward financing and a side you’ll see after the deal is sealed. If you’re lucky, the two will be the same. If you’re unlucky, you’ll get Jekyll and Hyde — the reasonable partner you thought you were bringing on turns into a person who panics when things don’t go as planned, an emotionally immature person who needs to control the conversation or a power-monger who abuses his power in the relationship. Spend time at meetings, dinners or informal engagements to make sure you understand your prospective business partner.
Read the fine print: Most venture investors agree to purchase a minority of your company (typically 20-40%) in exchange for the opportunity you present. While the economics are split in a way that gives the investor less than half of proceeds (according to their minority interest), their legal agreements are written in such a way as to give them majority-like authority over key decisions like senior management hires and new financing. This is normal and appropriate, though not often made explicit prior to a closing.
Understand structure versus value: Professional investors require that their investment is structured in a new form of stock, preferred stock, which has many different rights over common stock, the class of shares owned by management. Preferred stock has many flavors (see next point), the most common and management-friendly version of which is convertible preferred stock, a form of security that can behave in two different ways — convertible preferred acts like a debt obligation the investor will prefer if things don’t work according to plan. If things do go to plan, the investor will convert to common stock, most typically at a time of sale or a public offering. So, the investor either gets his money back with interest or gets his preferred stock converted to common stock. Again, this is normal and not worth fighting about, but important to know.
There’s preferred and then there’s preferred: A less management-friendly version of preferred stock provides investors with their money back first, and then gives them their share of common as well. This structure is designed to address investor concerns about a valuation they perceive to be too high.
Investors enter talking exit: As noted above, investors have a defined life fund of 10 years and are obligated to always be ready to sell, whether for good reasons (an attractive buyer) or for bad (time to salvage what return of capital is possible). Know that your partner is looking at the exit even as he explores investment.
Michael Gurau, managing general partner of Clear Venture Partners in Portland, can be reached at mg@clearvcs.com.
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