Controversial comedian Dave Chappelle once compared his early contract negotiations to the Three-Card Monte. When the contract for his first big contract for the Chappelle Show with Comedy Central was presented to him, everyone—including his own legal counsel—said, “That is a good deal, you should sign it.”
Chappelle was young and inexperienced so he took their advice.
Ultimately, the contract was not good for Dave—it gave away all rights to future work on the show that bore his name. When he later reflected on the initial transaction, he realized that—much like the Three-card Monte—everyone involved was complicit. His legal counsel, agent, and everyone around the table were all part of the game.
Venture capital is also like the Three-card Monte. Everyone watching the game—legal counsel, angel investors, tech media, bloggers—are also making money on the game. Everyone, that is, except—in the vast majority of cases— the person doing all the work: the entrepreneur.
Like Dave Chappelle, inexperienced entrepreneurs are at a disadvantage when they don’t know the rules of the VC game before they agree to play. There are many pitfalls that can have major consequences to a business in the medium to long-term including equity dilution, loss of board control, vetoed decision-making, and even bankruptcy.
So why is venture capital still the go-to option for most startups?
This blog post explores three key reasons why entrepreneurs pursue the VC route:
- VC’s strong brand image
- Complicated term sheets
- The natural optimism of entrepreneurs
It also explains the consequences of a mediocre outcome on founders and VCs, and describes some more sustainable growth capital alternatives available to founders.
VC has a strong brand image
Because of VC’s strong brand image, founders are conditioned to associate VC funding with success.
Apple, Google, Facebook, and Amazon are four out of the world’s five largest companies by market capitalization—and they didn’t exist 30 years ago. This kind of success builds VC’s brand image. But venture capital backs thousands of companies a year, and only a very small fraction go onto any kind of success, let alone massive success.
The media is partly to blame for this. How many headlines have you seen in TechCrunch or VentureBeat celebrating funding rounds for tech startups? We rarely—if ever— see the media celebrating the award of venture debt or the modest success stories of bootstrapped exits.
Case in point: Ben Chestnut, founder of email-marketing startup Mailchimp was warned by venture capitalists about the company’s imminent demise should he not take VC money and advice. Ben resisted, bootstrapped, grew his company sustainably, and sold to Intuit for $12 billion this year. There was very little fanfare or media coverage of his success, as highlighted in this Bloomberg Wealth article.
In essence, the VC funding hype we see in the media drives the apparent creation of enterprise value. The reality is vastly different. Most startups that access VC funding—startups that may have had lots of potential in the beginning—find themselves in a situation where they can’t go public because they aren’t producing enough cash and they can’t be acquired because they’re overvalued.
While VC funding can be beneficial to the minority, the majority of founders can never pay it back and face increasing pressure from investors who expect a return, whatever the cost.
Term sheets are complicated and inaccessible
VC term sheets and their underlying legal agreements are also very difficult to understand unless you have deep financial knowledge and experience in negotiating them.
The term sheet will typically cover everything from the valuation given to the company by the VC to the control and post-closing rights that the VC will have over the company. However, founders often get so excited by the arrival of a term sheet, they are tempted to gloss over the finer details—usually on page 3—that can cost them greatly in the future.
Even small, seemingly insignificant terms in a term sheet can have a dramatic impact on the returns to common shareholders down the line—even if the company is moderately successful.
Natural optimism of the entrepreneur
Founders have a naturally optimistic disposition. Most are focused on a big outcome like a unicorn valuation and lucrative exit, despite the fact that the odds are against them—at least 75 percent of U.S. venture-backed start-ups fail.
In the case of a big outcome, the VC terms won’t matter. For example, if you’re selling your company for a billion dollars, liquidation preference, voting rights, conversion terms, etc. are rendered moot.
Every entrepreneur believes their company is going to be a huge success so they’re naturally inclined to look at the terms on the term sheet and say, “Oh that won’t be an issue for me.” Even founders that have a pragmatic side are conditioned not to question the terms. They don’t want to give the impression that they don’t fully believe in their own business model.
Despite the entrepreneurial optimism, the statistics don’t lie. The vast majority of startups are not wildly successful, they only achieve modest outcomes. And in those modest cases, the VC terms become incredibly important. They can mean the difference between a founder making a “modest” $25-$50 million exit or making nothing.
As the SaaS industry continues to become more niche in nature, the likelihood of a unicorn exit is much smaller. The terms are more important than ever since most startups will only ever have the potential for a modest exit.
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VCs don’t want average outcomes
Despite the fact that they have all these terms, venture capitalists don’t want average exits. VCs are personally responsible—and compensated—for finding and creating huge exits, irrespective of whether their decisions are right for the entrepreneur.
Think about it. If a VC has $100 million to invest in a portfolio of startups, he or she may invest $10 million in 10 different startups. Based on the statistics, seven or eight of those companies won’t perform, the VC will lose their investment, and the pressure will be on the final two or three companies to have big exits.
The founders of these startups might be happy to sell for $50 million—but the VC won’t be. The VC’s performance is measured on the success of the overall portfolio. So while $50 million is a good outcome for the entrepreneur who may walk away with $20 million, it is a bad outcome for the VC who may walk away with $30 million after investing $100 million in the overall portfolio.
Instead of taking the mediocre exit, the VC is more likely to take a “swing-for-the-fences” approach. They will pressure the board to try aggressive tactics to grow their valuation—hiring more sales teams and doubling down on marketing to drive top-line growth—and generally take risks that may result in bankruptcy within 12 months.
It is estimated that up to 50% of all venture capital is spent on Facebook and Google ads in an effort to drive up valuations in scenarios like this.
From the outside, the VC industry looks stable. Under the covers, most investors follow the same playbook: provide funding to start-ups to drive growth; demonstrate growth to secure more funding; rinse and repeat until the company goes public or bust. Unfortunately, for most start-ups, the latter is more often the case. We cover this topic in detail here.
Growth Capital Alternatives
Debt or revenue-based financing or RBF are alternative growth capital options that are overlooked by many founders.
Unlike venture capital, the investors don’t take any equity in the business and there are no cloak-and-dagger terms.
Debt and revenue-based financing place the focus back on business fundamentals — customer acquisition costs, cash conversion cycles, customer payback — and away from the ego-driven hype around new VC funding round press releases.
Overall, they create a fairer game for founders and a more sustainable standard, ensuring there are more winners than losers overall in the start-up ecosystem.
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