Editor’s note: Contributor Ashkan Karbasfrooshan is the founder and CEO of WatchMojo. Follow him @ashkan.
Alright, in my last post I argued that bootstrapping is just as over-rated as raising venture capital. But for those who decide to pursue fundraising, here are some things entrepreneurs should avoid when raising capital.
For all of the talk about how much excess capital there is, it’s actually hard to raise capital because very few projects fit the VC profile—even though many VC-funded projects come across as frivolous, me-too projects.
Life’s unfair. To quote Mark Twain: “Don’t go around saying the world owes you a living. The world owes you nothing. It was here first.” Personally, I’ve bootstrapped my company; initially because I didn’t have to raise capital and then because I didn’t play the game properly or refused to accept what came with the territory.
Do VCs Really Make a Difference?
In Chamath Palihapitiya’s leaked email to AirBNB’s Brian Chesky, he wrote:
I’m all for getting the best valuation you can, minimizing dilution and maximizing control (…) I don’t believe investors add much to a success story, so minimizing their impact is a great strategy when you are onto something that is working.
For the record, a good VC helps through advice and introductions and the best VCs also serve as amazing therapists and coaches.
Zynga’s Mark Pincus blames entrepreneurs for sometimes giving VCs the power to kill your business or take it away from you. So if you are going to raise VC, here are some things you need to accept and avoid before signing on the dotted line.
What You Need To Accept (it’s the system)
There are some seemingly unfair things about VC:
- VCs invest in Preferred Shares whereas founders and managers have Common Shares. This is actually not all that unjust, but many entrepreneurs don’t know the difference, even though preferred shareholders get paid first whenever there is a liquidity event.
- The VCs’ legal fees are paid from the money you are raising. That one is a bit more unfair, but it avoids protracted negotiations since VCs will offer you standard terms and don’t plan on deviating much.
- As the entrepreneur you have one baby whereas the investor has his eggs in multiple baskets, so they won’t care as much about your company as you do –that’s normal and to be expected.
While a term sheet contains more clauses and the subsequent unanimous shareholder agreement will include drag along and piggy back rights clauses, investors do need to protect themselves so expect things to be stacked in their favor. The Drag Along allows a majority shareholder to enforce minority shareholders to be dragged along in the event of a sale whether they like it or not so that they don’t waste the big shareholder’s time, basically. The Piggy Back allows a minority shareholder to sell their shares at the same price offered to majority shareholders.
What You Need to Avoid – Part 1 (it’s them)
Be careful how much power you give up early on at the board level because before you know it, you will have less than 50% of the voting shares and when the going gets rough, you will want to avoid boardroom shenanigans that may cost you your job and stake.
This one is tricky. If you’re the average technical founder, you may have no business (or interest) running a board. Even most business founders lack the experience of running a board. But the board is ultimately responsible to appoint the CEO and the Chairman runs the board, so if you can hold on to the Chairmanship, you should. It’s common for VCs to appoint one of their partners to the board – as they should. It’s also common sometimes for that VC to become the Chairman. But unless someone is a major investor in your company or you managed to land a big industry veteran whom you trust, they shouldn’t be the Chairman, though your company will hopefully get to a point where you may step aside and make room for a new Chairman.
The liquidation preference determines how the pie is shared in a liquidity event (M&A, IPO). In a fair situation: investors get their money back before anyone else does, even though the risk and return tradeoff would require that everyone wins or loses together. But with leverage a VC will be able to land a 1x liquidation preference; which is standard. If they ask for anything more than that, tell them to take a hike; you’ll never see a return.
It’s one thing for investors to back a founder based on a Powerpoint presentation or business plan – the proverbial idea on a napkin – but it’s another thing for VCs to join an ongoing party. In either case, VCs tend to require founders to essentially give up their equity and earn it back (hence vesting) over a period of years. In the latter scenario, this feels like marrying a woman after years of dating her but having to earn the right to share a bed.
I understand why VCs want to feel protected against departing or ineffective founders, but there’s a problem when VCs can both push a founder out and require them to vest their shares and earn them back.
What You Need to Avoid – Part 2 (it’s you)
Ok, now stop blaming others – what are you doing wrong?
Raise Money When You Can, Not When You Have To
One of the more popular adages is not raising money when your back is to the wall and instead raising money when you can, under better terms. As entrepreneurs, we’re occasionally too optimistic and this clouds our judgment.
But Don’t Raise As Much As You Can
Conventional wisdom suggests that you “raise as much money as you can” but that is good for investors but bad for entrepreneurs, raise a reasonable amount – don’t order with your eyes.
Don’t be too Fearful: These are your Partners
Yes, only the paranoid survive, but not all VCs are out to get you and dilute you of your holdings. Yes, some VC relationships go awry, especially if the company isn’t growing fast enough and the investment is at risk, but ultimately all partnerships risk going sour. If you go into a VC relationship thinking that they’re out to get you, you’ll poison things.
Don’t be too Greedy: Strike a fair valuation
Yes, greed is good, but too much greed will kill things. When an investor is considering making an investment, he is driven by greed; once he is involved with a company, fear becomes a factor. Unless you offer the investor a potential to earn an abnormal return on his investment, he’ll balk and back the next entrepreneur.
While raising capital is hard, what happens afterwards is much harder – make sure you stick around to enjoy the fruits of your labor.
(If you enjoyed this, then you may enjoy my old rant Top 10 Mistakes VCs Make).