SmoothSpan Blog

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Evil VC Seeks Minions for World Domination

Posted by Bob Warfield on January 30, 2014

EvilSeeksMinionsIf we substitute “Venture Capitalist” for “Evil Genius”, the placard on the right describes the Silicon Valley Startup Culture perfectly.  Yes, you young hopefuls, your friendly neighborhood (that’d be the Sand Hill neighborhood) VC really does expect you to sacrifice your lives in a play for world domination.  They don’t care about building a nice little $100M a year software business–that’s peanuts, doesn’t move the needle on the fund.  Son, it’s just not enough tonnage.  Must be prepared to work 24-7 for fascist psychopath for close to no pay.  Yep, that’s about the size of it.  They won’t even try to hide the fact–they write about how you should accept as little pay as possible.  In 2008 Peter Thiel went on record saying the best predictor of startup success is low CEO pay.  Really?  That’s the best predictor VC’s have come up with?  Thiel is not the only VC to suggest it, not even close, and they’re largely successful at getting what they want–75% of founders pay themselves less than $75,000 a year.

What about that business of “Messy death inevitable?”

I suppose it’s a function of how you define “Messy”, but the “death inevitable” part rings true.  VC’s these days want startups capable of reaching $1B in revenue.  The reason, as one explained to me over drinks, is that they make their exit when the startup IPO’s.  But in order to IPO at a reasonable valuation, they have to be able to paint a picture for those buying public shares that the company has years of growth left.  That’s how the Greater Fool theory works–you can never let people discover they’re the last ones and the valuation has peaked.  So what happens to $1B Unicorns?  First, by quantifying things at $1B, we learn that the Utility Curve for VC’s is drastically different than for most Founders.  Offer Most People $10M after 10 months of effort when they’ve never made even $1M, and an awful lot of them will say, “Yes.”  The VC’s will resoundingly say, “No,” and they’ll tell you that anyone who says “Yes” never should’ve raised VC in the first place.  BTW, I have been through that scenario personally and I can tell you it was a harrowing experience.

Getting back to that $1B Unicorn, the odds are not at all good.  Only about 0.07% of Consumer and Enterprise VC-Backed companies become those Unicorns.  That means, Dear Impressionable Young Founder, that your odds are one in 1428.  The odds of winning on a single number at roulette are nearly 40x better, and you don’t have to bet years of your life on the roulette number.  One in 1428 odds of achieving World Domination.

That Messy End will come about because of the inevitable terms in your legal documents with your financiers and because of how the system operates.  Consider if you had worked hard to achieve a modicum of success and sold a company for millions but none of the founders or employees got anything at all out of it except a job with the buyer while the VC’s saw a positive (but inadequate in their eyes) return.  Wouldn’t that be a messy end?  The key term in your documents that leads to tears is the “Liquidation Preference.”  Supposedly the market standard is 1X but I’ve seen numbers as high as 3X in some cases.  Now let’s suppose you’ve got a company that is sold for $50M.  That’s a lot of money: many would regard that as a successful company.  But, it’s only successful to the investors to the extent it generates a return on their investment.  Suppose they’ve put in $40M and have a 1X liquidation preference.  That means they get back their $40M right off the top.  Now there’s $10M left to split between the investors, founders, and other employees.  You’re probably diluted pretty good at this time, so let’s say non-Investors are getting $4M.  Suddenly your $50M sale is getting you more like $1M than the $5M you and your co-Founder expected.  It gets worse–with a 2X or 3X liquidation preference, you get nothing.

Make no mistake–the VC’s feel perfectly justified in all of this and see it as emminently fair.  Fred’s example from that link sure sounds fair, but as some of his commenters point out, it attaches no value to the sweat equity of the Founders and employees.  They may have worked years of their lives at sub-standard pay ($75,000 a year?) and not be entitled to a dime in a scenario where VC’s are getting all of their money back.

“NO Weirdos?”

Yes, the VC’s prefer to invest in the Old Boys Club.  Minorities and women will have a tough time breaking in, not that they are Weirdos in any sense, but the homogeneity of the VC Startup Club and especially of the VC’s themselves is strong.  You need to have gone to the right school and have the right background.

The VC’s BTW, are (mostly) not really Evil.  But they have certainly done everything in their power to create a set of rules that overwhelmingly favors their own success, even at the expense of Founders.  Looked at in the cold light of reason, it’s hard to argue it isn’t pretty much as the plackard about Evil Geniuses suggests, at least metaphorically.  Why then do Founders seek Venture Capital?

After talking to lots of Founders seeking advice (I’m on my 7th Startup, have founder 4 of the 7, and have had 3 happy liquidity events), I have concluded the primary motivator for Founders seeking VC is that they want to reduce their risk.  It’s ironic.  VC’s these days don’t accept Founders until they’ve forced the Founder to remove as much risk as possible.  You have to create a Product, find an Audience, and demonstrate Traction before they’ll put a dime in.  Or, you have to give away a surprising amount of your company for surprisingly little capital if you go the Incubator or Angel route.  Yet, these Founders are largely worried about two things they believe can reduce their risk.  First, they want knowledge.  They want people who have succeeded to tell them how to succeed.  Second, they want connections.  The Incubator promises to put them in touch with the VC’s when the time comes.  The VC’s promise more VC’s, talented executives, and many other contacts.  Founders want to be part of the Network.

Experienced Founders are less about the connections or knowledge, they’ve realized they can get connections and knowledge more easily in Silicon Valley than almost anywhere in the world.  Scratch the push for connections and knowledge up to inexperience on the part of young Founders.  Experienced Founders just want the VC’s check.  They want to get where they’re going faster and with the certainty that plenty of money in the bank promises to bring.  VC’s hate to be courted simply for a check.  It eliminates their view of how they differentiate their firm and belittles the possibility they will make a contribution from the Board.  Yet, even many VC’s share the view of many experienced Founders that aside from Cash, VC’s often add negative value.  No less a personality in the VC world than Vinod Khosla says 70 to 80% of VC’s add negative value.  If you look at the impact forcing a company to take unlimited risk in the quest to becoming a $1B Unicorn has, I would suggest that many companies that could have been successful by any non-VC standards and happily profitable got pushed too far and left behind a smoking crater when they fell short of joining the Unicorn Club.

One of my favorite bloggers is Seth Godin.  He writes about this odd conundrum perfectly in his short post, “How much does it cost you to avoid the feeling of risk?”  He’s talking about the risk of putting yourself out there, and it’s no different for Founders.  The VC’s are asking you to do most of the work of creating a successful company before they put any money in.  They’re asking you to do it on your dime.  Unless you have it thoroughly in your heart and soul that  you won’t be happy until you’ve created a Facebook or Google-sized success, forget the VC.  Finish the remainder of the work to create a profitable company instead of raising VC.  That’s the real essence of reducing your risk.

Turning your happy little company into a VC Startup is the first step on the ladder of radically increasing your risk because you’re committing yourself to swinging for the fence.  No bunts, no singles, doubles, or triples.  Swing for the fence, and if you miss, you’re a failure.  Make no mistake about it:

VC’s increase your  risk.

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