David Beisel’s Perspective on Digital Change
Myth Busters: Debunking Seven Conventional Wisdom Maxims of Venture Capital
Compared to most other areas of finance, venture capital is practiced as more of an art, as opposed to a science. For that reason, it’s often said that VCs learn the business best through an apprenticeship model, under the wing of a more experienced pro. The art of venture capital also means that for entrepreneurs raising it, there isn’t one definitive playbook which can be used as a guide. Rather, over time, a series of collective experiences has solidified into a set of conventional wisdom which is shared repeatedly. Many common rules of the thumb are absolutely true (maximize the outcome of a fundraising process by approaching many firms simultaneously; deals should accelerate towards a close), but there are a handful of ones which just aren’t so:
MYTH: Entrepreneurs need a “warm introduction” to a venture capitalist to get a meeting.
REALITY: A warm introduction is neither necessary nor sufficient to get a meeting with a VC. What really matters is getting a VC’s attention. A truly “strong trusted endorsement” will do so, but that’s much harder to obtain than just a warm introduction. Otherwise, what I’d call a “credible introduction” is sufficient provided there’s also an additional piece of information (key founder background, specific space, etc.) It doesn’t matter how well the referrer is known, how “warm” it is, as long as it’s credible. The exception is if the referral is coming from a trusted inner circle and it’s a meaningful recommendation, not just an intro.
MYTH: VC’s need 20% ownership in their investments to make money.
REALITY: VC ownership targets depend on many factors and aren’t set in stone. The myth has been discussed and discredited in blogs for years, yet it continues to persist. And it manifests itself in pernicious ways. To make money, VCs should aim to have meaningful target ownership in their portfolio investments, but 20% is by no means some kind of magic number. The impact of a single investment on a fund depends on ownership percentage, as well as the fund size and the portfolio size (i.e. number of investments). A larger fund will want to have larger ownership targets than a smaller one for any given exit outcome to make an impact (… even larger than 20% for mega-funds). A seed fund with fewer investments will require smaller ownership than one with a broad portfolio to make the same impact. Entrepreneurs should remember that while these targets are real, they’re just that – targets. VCs who swear publicly that they’ll never make an investment with less than 20% ownership show up on cap tables in the teens… the 20% pronouncements are just posturing for negotiation.
MYTH: Goal of entrepreneur’s VC fundraising is a term sheet.
REALITY: Goal of an entrepreneur’s VC fundraising should be a closed investment, which includes both partnership conviction and an agreement of key terms. My recent blog post digs into these details.
MYTH: Venture capitalists are looking to replace founders with “their guys.”
REALITY: The earlier-stage an investment is for a venture firm, the more the bet is on the team, the more reticent they are to want to change the core DNA of the company. (The caveat here is for later-stage venture investments, the Founder/CEO role is sometimes seen by investors as a hired role which is currently being held by someone who has been there since inception but doesn’t need to persist indefinitely.) However, any early stage venture capitalist knows that many of the most transformative companies (read: profitable investments) in history are those which are founder-led throughout. At the early stages, the primary investment thesis rests on the team, rather than the idea or market (which are less unique and more easily fungible). When a VC backs a founding team, she’s doing just that, backing a founding team.
MYTHS: VCs add no value -or- VCs add indispensable value.
REALITY: Common polar viewpoints of either venture capitalists being literally useless beyond the cash they invest or VCs solely transforming their portfolio companies are vastly exaggerated – the truth is always somewhere in between. Even the most elementary venture capitalist has the privilege of serving on boards of a number of startups. That set of experiences alone provides a unique perspective about companies facing similar challenges which adds constructive diversity to board room discussions. More importantly, a handful of VCs are indeed truly engaged supportive partners with entrepreneurs in building their businesses. They contribute in ways from opening their personal networks to providing counsel during important strategic decisions. But hyperbolized claims about “platform offerings” replacing key team functions or the ultimate success of a startup hinging on an individual VC’s contributions are vastly overstated.
MYTH: Entrepreneurs should avoid larger VCs in seed rounds because of “signaling risk.”
REALITY: Larger VCs in seed rounds do indeed alter dynamics of future financings, but not always for the worse. Although the negative signal potential of a larger VC which participated in a seed round not continuing forward can damage the prospects of raising a subsequent round, there are both benefits to their participation and ways to mitigate those effects. A recent CB Insight study concluded that the highest follow-on rate occurred when BOTH a multi-stage VC AND seed VC participated in a seed round.
MYTH: The venture capital model is broken.
REALITY: Venture capital is a business driven by asymmetric outcomes and therefore asymmetric winners. People are accustomed to normal distributions, as they’re both intuitive and commonplace. Along many dimensions, the structure of venture capital is anything but normally distributed. Most entrepreneurs who seek venture financing don’t receive it, yet for the ones who do there is immense competition from multiple sources vying to invest. Most entrepreneurs who raise venture aren’t successful, yet those who are, are wildly. Typically one to three of these winners within a VC’s portfolio significantly drive overall fund returns, not the median investment set. And those winners aren’t normally distributed across firms and funds, so as an “asset class” VC performs poorly. But within the space, there are entrepreneurs, VCs, and LPs who all benefit… just not on average. Rather, the distribution of everything in VC is asymmetric, not broken.