VC has changed a lot since I was pounding the pavement on Sand Hill Road as a young entrepreneur in the late ’90s.
Capital was hard to come by, and founders had to practically beg VCs to back their company. Our options for funding were limited to a handful of blue-chip firms and networks of successful angels. Two decades later, there is more money flowing from more sources than ever, and equity capital has become a commodity.
In today’s market, it’s not uncommon to hear the sentiment that VCs have to work to sell their money. We’re now in the era of “value-add venture capital,” where investors need to show founders that they will do more for them than merely cut a check. It’s a change of power, and the sales pitch these VCs give to founders is that they’ll be true partners who will be with them every step of the way.
But all too often, founders discover the hard way that these value-add services have a short expiration date.
When we polled founders across our portfolio, we found that even the best-intentioned investors rarely provide much value-add beyond 90 days from when they signed the term sheet. At that point, the investor’s engagement is limited to their attendance at the quarterly board meeting — and that’s the lead investor.
While many VCs may think of themselves as financiers, they ultimately provide a service to their founders.
Many of the other participants provide no additional value beyond their check besides the occasional introduction. Based on what our founders told us, a solid 20% of cap table contributors don’t even help their founders make strategic connections. They throw their money in the pot and disappear.
In a world where investor money flows freely, the VCs that don’t provide value-add are dead weight. Yet, they invariably invoke their contractually negotiated pro-rata rights when it comes time to raise a new round. Their mere presence on the cap table disincentivizes other VCs from working harder for their founders.
After all, why should they do more for their founders than their peers if they both are guaranteed to keep a spot at the table?
“This is the way it’s always worked” isn’t a good excuse. It’s time for founders to hold their investors to a higher standard and insist that they provide continuing support as they scale their company. It’s time to abolish traditional pro-rata rights.
In a term sheet, the pro-rata clause guarantees an investor the right to maintain (or increase) their equity stake in the company by investing in future rounds. There are no strings attached, no KPIs that the investor must hit for their founders. Pro-rata rights are simply part of the deal.
In truth, pro-rata is an immense privilege that VCs take for granted. Now that capital is a commodity, founders can and should demand that the right to invest in future rounds is contingent on demonstrating value-add. Think of it as “performance-rata,” a new type of pro-rata granted only to investors that brought more to the partnership than capital.
Andreesen Horowitz was ahead of the curve in recognizing that money isn’t enough to attract the most talented founders. They recruited more than 100 professionals to help their founders excel in core business functions like go-to-market, talent, people practices, marketing and operations.
A firm doesn’t need billions of AUM to bring serious value to a partnership. Just look at investment shops like SignalFire and NFX, which offer clearly defined in-house services to help their founders succeed while differentiating themselves from other investors.
Performance-rata > pro-rata
The death of pro-rata starts with founders holding their investors to the same standards as a highly engaged team member.
A performance-rata clause will look different for each investor on a founder’s cap table. Larger firms might be able to offer a suite of services, whereas solo GPs and smaller funds might specialize in a particular business function like marketing, sales, design, engineering or PR.
Below are a few ideas founders can use to identify and reward investors who work for their pro-rata:
- Identify three support functions that lead investors need to complete each quarter. Before each board meeting, evaluate whether they have met those requirements and refresh them for the next quarter.
- Make one request of non-lead investors each quarter, but insist that every investor at the cap table — regardless of size — complete some mutually agreed upon task each quarter.
- Provide your cap table to your head of sales or the equivalent. Ask them to add all of your investors on LinkedIn and identify mutual connections that may become qualified leads. Track the investors who make introductions to those leads.
- Provide your cap table to your head of recruiting so they can work directly with each of your investors on potential hires. Track the investors who do not engage and note the investors who make qualified introductions within their network.
- Invite investors to internal company events like hack-a-thons, email updates, company all-hands or board meetings. Measure attendance and engagement. If you want to get granular, you can even measure open email rates.
That last suggestion isn’t as fanciful as it sounds. In fact, Coda CEO Shishir Mehrotra has spoken openly about making every board meeting open to all employees and investors.
“The way our company operates is very inclusive of our investor group,” Mehrotra said. “We have over 100 angel investors, and some wrote tiny checks in the company. But it’s amazing how many different skill sets they can contribute in their own diverse ways.”
The particular deliverable that each investor offers doesn’t matter as much as the fact that every investor on your cap table is empowered to deliver quantifiable value to the company beyond capital. It holds investors accountable and makes startups more effective by enabling their wider management team to leverage investors instead of just the founders and CEO.
Abolishing conventional pro-rata rights is a radical and nearly sacrilegious concept for VCs, but it is not without precedent. It reflects a model of client interactions familiar to most service businesses. Money doesn’t exchange hands in these industries without a clear understanding of what the client can expect from the service provider.
While many VCs may think of themselves as financiers, they ultimately provide a service to their founders. In the past, that service may have been limited to capital. Today, it must include the full gamut of support functions required to launch and scale a successful business.
Understandably, many VCs will have an allergic reaction to the concept of deliverable-based pro-rata. No one likes to work for something they used to get for free. But we think it’s a mistake to view it this way.
It’s easier than ever for anyone to launch a software company today, which has created a hypercompetitive startup environment. Companies that receive significant and ongoing support from their investors dramatically increase their chances of success and improve their investors’ outcomes by extension. It’s a true win-win scenario.
We can already see savvy VC firms transitioning to a measurable value-add deliverable model. For example, Alexis Ohanian’s venture firm, 776, provides monthly receipts or accountability reports to its founders that detail all the work the firm has done for them over the past 30 days.
This creates transparency, holds the firm to high standards and fosters a sense of a common purpose between the firm and its portfolio companies. Unsurprisingly, founders working with 776 love this approach.
Performance-rata is ultimately about giving founders control and optionality. Some investors may argue they are providing capital for the startup to hire their own people for these kinds of deliverables. That’s fine, and at least founders will be clear where those investors stand when it comes to value-add.
The goal of abolishing conventional pro-rata rights is to create what we like to call a “cardiac cap table.” It’s a situation where the investors who are working hardest for a founder are the ones who are rewarded with the privilege of working with the company in the future.
It’s a powerful way to align incentives between builders and their investors. VCs ignore the changing times at their own peril. It’s only a matter of time before the tide goes out, and the entitlements they took for granted — along with the best deal opportunities — are lost to a new way of doing business.