VC: Financing of Last Resort

Roger Royse

by Roger Royse, Founder of Royse Law Firm

The holy grail of the startup company world is venture capital. There is a belief that getting funded by an institution that dares to call itself a venture capital firm will be validation enough to almost guarantee success. After all, these guys did not get rich by betting on losers. They will take their share and when the time is right, they will call their golfing buddies in the investment banking business and the next thing you know, your company will exit in an IPO or acquisition and everyone will be awash in cash. Right?

The reality, of course, is much different and a good rule of thumb to follow with VC money is to never, ever take it except as a last resort. Yes it is true that they may have access to cash for follow on rounds, and they may have connections that lead to liquidity, and they may even be able to add value beyond the dollars invested, BUT you the founder may not see much of all that great value by the time the company exits. Here is why:

First, although you will not usually give up control in the first round (Series A), not many companies get to liquidity after only one round. If your company is that good, that is all the more reason to find friendlier cash. Otherwise, plan on doing a series B round and plan on losing control at that point and, if you are still the founding CEO by then, plan on finding a new job after the founders have lost control. It is a rare CEO that stays with the company from formation to exit after multiple rounds, and VCs are not known for keeping officers around for sentimental reasons. To be fair (since VCs will be so fair to you), the skill set that a CEO needs to launch a company is probably not the skill set needed to manage that same company once it reaches the middle market. Just hope that you are fully or mostly vested by the time you get the hook.

Secondly, even if you do not lose control, the VCs (and any other Series A preferred stock investors) will have a liquidation preference in their stock. That means that when the company is sold, they get paid first. If you do multiple rounds, there will be multiple preferences so not only do the founders’ percentages get diluted as the company matures, but the amount that the company must be sold for before they see any money increases. More than one founder has ended up working for the VCs with no real hope of selling the company for an amount that will cover preferences and give them a pay day on exit.  There is a way around that result, called a “carve out plan,” but that is anotehr article.

Next, don’t expect a VC to want to exit at the same time as you do.  If you have given them redemption rights (commonly requested) or a drag along, the VC will have the ability to force a sale of the company. Keep in mind that they have many other investments that demand of their time, so their tolerance for distraction may not be the same as the founders’. In other words, the investors will often cut their losses and force a sale of the company before the founders are ready.

Expect to have a board that you are now accountable to. That board may or may not agree with your (“you” being the founders) views on how to run the business, but they will not be shy on offering their opinion and demanding answers if things do not go right. Depending on what managerial rights they negotiate, the founders may find the VCs quite involved in their day to day business.

All of the above issues are manageable, but there is one issue that is not. Probably the worst thing about VC money is that it comes with extremely high expectations. The economics of VC funds require huge returns on rather large investments. If it turns out that your company is not going to generate those huge returns, the investor may want to exit early and deploy elsewhere. Those skewed economics can make for unfortunate company dynamics if things do not work out according to plan.