Rude VC: Percent vs. value


euro-percentAt a conference the other day a fundraising advisor I know approached me about a prospective investment opportunity. The opportunity, a project in the mobile analytics space, fit well within our invest domain of interest. I was intrigued and listened attentively as the intermediary explained the product, the market need, the company’s progress to date, the profile of the founder, and the rationale for the fundraising, growing increasingly eager to set up a meeting with the founder. But then the advisor closed with a caveat, “One last thing, it’s important to be aware that the founder does not want to dilute below 50%.”

In a split second, this opportunity became a No-Go in my mind. I completely lost interest. Why? Because a startup whose founder has such a mindset is not suited for raising venture capital.

That doesn’t mean that the business does not have merit. Nor does it necessarily mean that the founder would not be a capable business owner (though it does raise questions here). It doesn’t even mean that it’s wrong or illegitimate for a founder to place his personal shareholding above everything else.

It does mean, however, that the personal goals of the founder and the inherent objectives of venture capital are incompatible.

The fundamental objective of a VC, in fact the fiduciary duty, is to generate an elevated rate of return on the capital committed to the VC fund by the fund’s investors. Since the risk is high (most startups fail to ever reach escape velocity), and since liquidity is low (most VC funds lock up their investors’ money for 10 years), the investors in the venture capital asset class expect a high return on their investment, often upwards of 25% or 30% per annum (here in Europe, our performance is woefully below this, but that’s another story…).

Accordingly, the pressure is on the VCs to deploy their capital into opportunities that, with the right leadership, market factors and financial support, can scale up to a level that can generate such rates of return. Let’s take the example of France. A typical French VC fund has to deploy around 5m~10m€ on average per portfolio company. Note that this is an average, as a good VC will usually stage investments and will only continue investing in portfolio companies that maintain strong prospects for success. If we take the midpoint of this average and assume a typical holding period of 8 years before successfully exiting, that means that the VC’s 7.5m€ investment needs to be worth 80m€ at time of exit. In other words, VCs need to be looking for companies that have the potential to reach a valuation approaching the 100m€ range and upwards.

For a company to reach this ballpark, it’s going to require the convergence of a lot of factors: ambitious leadership, the right product for a large and growing market, luck, etc. It’s also going to require capital, often at critical and unexpected moments (e.g. to finance acceleration of the business, or a cash crisis, or a strategic pivot, or an opportunistic acquisition, to name just a few).

If the founder is resistant to raising capital at these junctures — even if it’s in the best interests of the business — due to the impact on his personal shareholding, the company will fail to accelerate and cede ground to the competition, or miss an opportunity, or go into financial distress.

In the case of the company I mentioned at the beginning, given the stage of the venture and the initial funding needed, it would have been very unlikely that the founder’s stake would have diluted below 50% at the time of my initial investment. However, the founder’s state of mind that makes him view every opportunity through the lens of his personal shareholding percentage signaled to me that he was focused on the wrong thing, and that future conflict would be inevitable, regardless of the percentage at stake.

There is nothing morally wrong about a founder wanting to preserve a certain percentage of his company. It’s perfectly understandable. Furthermore, there exist plenty of tech companies that by not raising venture capital can not only succeed wildly but also enable the founders to make a lot of money, create jobs, and work on something they love. For that smaller proportion of companies that do fit the VC model, in my experience the best founders tend be more driven by value than by percentage.