When faced with the frustrating constraint of limited capital, many entrepreneurs contemplate venture capital (VC) as a potential solution. Armed with a compelling vision, marketplace traction and a high revenue growth rate, these businesspeople believe that the only thing standing in their way is their lack of cash to scale the organization. And, certainly, venture capital, approached with the right mindset, can unlock the potential in bootstrapped, fast-growth businesses.
I say that from personal experience: As the co-founder and CEO of Hireology, a talent technology company launched in 2010, I’ve raised more than $26 million in venture capital from top-tier investors and experienced the incredible opportunities that having the right VC partners affords you.
However, I’ve also seen many peers’ pursuit of VC funding lead to harmful, even destructive, results. Before you consider raising outside capital, here are five things most entrepreneurs don’t realize about the risks associated with raising venture capital:
1. Your business may not be ready for rapid scaling.
Your new VC partner will expect you to immediately deploy your newly raised capital. Most VC rounds give the company 18 to 24 months of runway. And you may think you understand your customer acquisition model — after all, you didn’t get to this point by not selling things to customers. But, when you double or triple the size of your sales and marketing operations in three to six months, you’ll find out quickly whether or not your model was ready for prime time.
The worst-case scenario occurs when you invest heavily in ramping up your customer acquisition operation, but the additional sales don’t come fast enough. At a minimum, if you aren’t getting $1 of revenue growth from each dollar of investment, you’re not getting the job done.
My company was in this situation in 2014 after raising our first institutional round. We ramped the team, and revenue was increasing, but not efficiently enough. We were spending $1.40 for each $1 of revenue growth. It didn’t take much analysis to realize that the path we were on wasn’t working well, so we retrenched to get ourselves back on track and get our selling model right.
2. You are on your investor’s time line, not your own.
A typical VC fund raises money from investors, such as university endowments, insurance companies and family offices — and that fund typically has a lifespan of 10 years. That means the VC has approximately a decade to make back all of his or her investments and harvest the returns so investors down the line can be paid back on time.
The rule of thumb for a newly raised venture fund is that VCs will deploy capital for the first five years of the fund and harvest their returns during the second five years of the fund. Your venture capital partner will be facing all kinds of pressure to return capital to investors as that 10-year mark draws closer; and that pressure may be directed squarely at you.
In the most common scenario, your VC could look to force a sale of your company sooner than you’d like in order to meet his or her fund’s investment targets. When your VC decides that it’s time to sell, there’s not a lot you can do to change this person’s mind.
A prominent example of this dynamic played out when Sequoia Capital forced Zappos CEO Tony Hsieh to sell his company to Amazon rather than go for an IPO. Despite the fact that Hsieh had brought the company to $1 billion in revenue and what was reportedly $40 million in EBITDA, his investor forced the sale.
3. You might not get along with your new boss.
One of the biggest changes that entrepreneurs fail to anticipate is the impact a professional investor makes on your ability to run the company. Venture capital investors will almost always rework your company’s governance structure to give themselves one or more board seats. It’s not uncommon for a large venture investor to hold two seats on a five-member board of directors.
As CEO, you’re going to be accountable to this group for your results. For many entrepreneurs, that’s a new experience, as they’ve gotten used to doing pretty much what they want to do, without formal oversight.
Indeed, post-investment, it’s pretty much guaranteed that major issues with your company are going to arise. Perhaps sales growth is slowing or customers are churning at too high a rate. Are you working with a venture partner who is patient and helpful and approaches problems from an operator’s mindset?
Or, your venture partner may be treating you as a loan officer from a bank would: He or she is all about the numbers, leaving you little to no margin for error, and hesitant to make big, bold bets. It’s those moments where you realize that you should have vetted your VC partner more closely before deciding to ink the deal.
You could now be facing years of misery ahead of you.
When you’re raising venture capital, then, understand that money is a commodity. What really matters is what you get in addition to the money. Is your new investor bringing you industry contacts, specialized expertise or connections to additional sales and marketing channels? Is the VC able to invest the appropriate amount of time thinking about your company in order to make an impact; or is your company one of 15 boards the VC company sits on?
What’s most important: Do your VCs help create a positive board culture?
The quality of your board meetings is directly tied to the culture of your board of directors. In my view, a positive board culture is one in which members — including the founder/CEO — are free to speak their minds and highlight the challenges and opportunities being observed.
When the board culture is positive, members are focused on listening and adding value to the conversation. In a negative board culture, fear and one-upmanship drive the discussion; one or more members pay more attention to getting what they want out of the meeting, versus making the best decisions on the company’s behalf.
As Sandy Lerner, the co-founder of internet pioneer Cisco Systems, famously said: “I did not understand an investor could be an adversary. I assumed our investor supported us, because his money was tied up in our success. I did not realize he had decoupled the success of the company from that of the founders.” Lerner was subsequently fired by Don Valentine, one of Cisco’s early investors, just after the company went public.
4. Your VC doesn’t want anything but a grand slam.
Being a venture capital investor is tough business. Out of every 10 investments made, one or two must have an exit large enough to pay for the other eight or nine investments that fail to meet expectations. Shikhar Ghosh, a senior lecturer at Harvard Business School, has calculated that a whopping 90 to 95 percent of venture-backed startups fail to beat their declared projections.
Thus, venture investors are going to push every single one of their portfolio company CEOs to swing for the fences. Mediocre growth doesn’t give investors the returns they need to keep their job as a VC, so there’s little incentive for them to accept anything other than an all-or-nothing strategy with each company.
It’s better for them to have a strikeout than a single because the only way to hit grand slams is to push portfolio companies to swing as hard as they can.
So, what does that mean? Here’s a scenario: You’re one year into your relationship with your new VC investor and things are good, but not great. You’ve grown the company’s revenue 40 percent in the last year, but nowhere near the 150 percent your original plan projected you to achieve.
You’re thinking that, since you have only nine months of cash left on the books, the smart thing to do is scale back your burn rate and continue to grow at 40 percent. Your VC, on the other hand, tells you to increase your burn rate to ramp up your growth, to increase the likelihood that you’ll attract additional financing. Even though you know that it’s likely your company will run out of cash as a result, there’s not much you can do.
If you manage, by some miracle, to get your growth rate back over 100 percent and thread the needle with an additional round of financing, you’ve made it through the gauntlet. If you fail to hit the numbers, your VC will cut losses and focus on the rest of his or her portfolio companies, whose CEOs are getting the job done.
5. You are putting your payout at risk.
When VCs invest in your company, they structure the investment with preferred stock. This class of stock carries all sorts of preferences for the venture investor, including a liquidation preference. This dictates how much money must be returned to the investor before you, as a common shareholder, see a single penny.
Here’s another example: Your company raised $10 million from a venture investor. That venture investor has written into your agreement that he will get two times his investment back before common shareholders see any proceeds from a sale. This is called a two-times liquidation preference, and it means that you owe your investors $20 million before you see a dime.
If you hit that grand slam and sell your company for $100 million, you’re in great shape: Your investors will get their $20 million and you’ll get to split $80 million with the rest of the shareholders. However, if you hit a snag and are forced to sell the company for $18 million, guess what? Your investor will get all $18 million, and you’ll get nothing. Unfortunately, this is one of the more likely outcomes for companies that have raised VC funding.
It’s also yet another reason to be very, very careful about whom you choose for a VC partnership, if in fact you need one at all.