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The
Real Life Experience of a Founder
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From The May Report: 01/25/2001: Ron, Please do not print my name/e-mail address. You may contact me via return e-mail if you'd like. I believe that the truth lay somewhere in the middle of the ongoing debate regarding Venture Capitalist. In an attempt to explain why I hold this belief, especially with regard to Curt and Bob's divergent VC opinions, I thought it informative to profile my experiences as a founder using venture capital to fund the growth of his business. I founded and lead a reasonably successful (and still operating) technology/dotcom business from '92 until I left in mid-'99. I began to approach the VC market at the end of '95. We took our first VC investment in mid '96. My company's VC relationship ended with a buyout of the VC as a condition of the sale of my company in late '97. The following summarizes my personal experience with one and only one VC. Rather that present a new structure for this discourse, I thought it helpful to outline my experiences in counterpoint and under the sections and comments Mr. Sahakian shares in his e-mail entitled, "When Dot-Coms Strike Out, Will Startups Strike Back Against VCs?" http://alliancetalk.com/vc.htm HOW THE GAME WORKS - A DIRTY LITTLE SECRET -- Our funding agreement expressly precluded us from raising capital without our VC's permission. I didn't think then nor do I think now that this is any sort of a secret. THE FIRST ROUND VALUATION IS THE REAL RED HERRING -- Our VC did their analysis, set the price at which they would invest (roughly a quarter of that which our PPM listed) and remained unwilling to change from their first valuation. "Take it or leave it," was pretty much their only comment. The VC did provide us with an earn-in clause for gaining a better initial valuation. The earn-in allowed us to improve the initial valuation if and only if we exceeded some unlikely operating and qualitative goals--we failed to reach these and the initial valuation stuck. Though I understand Curt's view, I didn't then nor have I ever heard of any VC knowingly investing at a falsely high initial valuation only to screw the Founder later. This is not to say that it doesn't happen but I did not have this experience. MOST VC'S AVOID LIKE ALL HECK GIVING A COMPANY ENOUGH MONEY...TO MAKE IT THROUGH TO PROFITABILITY -- I agree with this. But then, if the business only needs a smallish sum to reach profitability, why in the world would they seek venture capital? Even back in '95 I knew getting VC money would be time consuming and painful. Our VC agreed to invest the full amount we sought to raise. They did sell us on this ("You can concentrate on building the business."). However, after we got down the path a bit, our VC informed us that their investment would come in three rounds. Also, our VC required that we revise our numbers upwards saying, "Unless you can improve your performance, this deal doesn't make sense to us". We agreed. Of course we failed to meet the revised numbers (but, surprise, surprise, we did meet our original projections). In the end, to get our next swack of funding, our VC insisted that they receive additional inducements (a sweetened preference) with the next hunk of cash. They also gave us less than they originally agreed to invest (about half). If the truth be stated, in the course of 18 short months, our VC sliced $5 million into 7 separate hunks (the last three months/rounds allowed us to keep the heart of the business beating while we negotiated the terms of the sale to the acquiring entity). Each hunk of the later cash contained very onerous terms but by this time, we had our back totally against the wall--your basic do or die scenario. WHETHER THE VC OWNS 51% OR 20% OF THE COMPANY... IT DOESN'T MATTER, IT'S ALL THE SAME -- I totally agree with this. Until the 3rd hunk (they were so granular they didn't constitute "rounds" or "series" in my mind), we "controlled" the company. The simple fact of the matter was that we couldn't do anything meaningful to avoid taking the next infusion of cash. The VC held the purse strings and us over a barrel. We had only one trump card--to walk away. As this wasn't anything we seriously considered, we elected to do that which was necessary to live to fight another day--we took the cash and signed the papers. IT'S THE LAST ROUND THAT COUNTS -- I agree with most of what Curt says here, and though we were aware of them killing off three CEOs amongst their portfolio companies, our progress and rapid, positive growth meant that we got to keep our jobs. Ultimately, our business' growth was what mattered most to us. Preserving the "total amount of personal wealth [we were] able to harvest from [our] own company" was always secondary to building an organically successful company. The bottom line is that we needed to execute as intelligently and rationally as we could in the fast-paced and shifting dotcom market. We consciously chose not worry too much about what impact it had on our personal fortunes. Sure, the VC took advantage of our passion for the business but our passion, more than probably any other factor, was why they chose invested in us in the first place. THE GAME ISN'T CROOKED BUT ITS NOT FAIR EITHER -- I essentially agree. Our VC knew the game and constantly invoked little surprises and conditions with each thimbleful of cash that dolled out. The worst one occurred when the VC was bought out. They actually required that the founders take a lower per share price so that they could manufacture their 30% IRR target. Though this sucked, we believed then that building a successful company was more important than getting an equal deal. Without a doubt they took full advantage of our passion for making a go of the business. We, in turn, took their money and built a successful business. I don't see the sin in this sort of an arrangement. MOST VCs REQUIRE FOUNDERS TO SPEND MONEY ONLY IN CONFORMANCE WITH A BUDGET THAT MUST BE AGREED TO BY&THE VC. -- Totally my experience. We couldn't spend more than $10K without their approvals--even when we held more than 70% of the "voting" stock. But they didn't look over our shoulder too often so we violated this and other terms of our agreement repeatedly. I do agree with Curt's point that the way that the deals are papered makes it all but impossible for a founder to not violate one or more terms of the agreement. That's why it make sense to "play nice" as much as is humanly possible. HOW THE INSIDERS WORK TOGETHER AT THE EXPENSE OF THE OUTSIDERS --My experience wasn't as evil as all this. With the pain long gone I can honestly say that there's nothing wrong with the way our VC treated us. Any founder that fails to realize that a VC's overarching need is to generate huge returns will assuredly learn this lesson the hard way. As one friend put it at the time I was continually whining to him about how I was getting screwed, "...tigers eat their young, its what they do". VCs need to generate extraordinary returns, so that's what they do, any way they can. Unless you can do this for them without conflict, you will invariably realize that they are not your friends but engaged in the hard, hard business of driving out unusually large returns from highly risky endeavors. They have the capital and you need it. Its their rules. Grow up. REALITY -- Yup. The hard cold facts of a business that needs institutional cash. Accept it or simply don't follow your bliss. Why should a VC be required to inform an entrepreneur of all that you list here, Curt? If Founders are wise, they sure as heck can do the necessary research--especially with all that's available on the 'net. One must simply accept that when you do a VC deal, you're doing a deal with folks that don't make fast friends with those that fail to produce for them their required exceptional returns. THE CHICKENS MAY COME HOME TO ROOST -- Thankfully, one of my partners, a lawyer, was able enlist the support of his former law firm. Even if I didn't have him on my management team, I surely would have secured the best legal help possible. One interesting thing to point out is that when you're in the language phase of the deal, a VC has generally sunk at least $100K in the baking of the deal. You actually gain a tiny amount of leverage through this process by using little things to turn the document a few times. After their lawyers' fees begin to mount, you then go after more substantive items (bear in mind, you end up paying for this as most VCs use part of the first round to pay their legal bills). We were able to strike virtually every materially offensive provision in the contract through this approach. The bottom line is failure to realize that VCs will hide nasties in the contract is inexcusably naive. You know they're there, find 'em and kill 'em. And if you can't kill them all, learn to accept the ugly terms or don't take their money. My one lingering regret was that I didn't/couldn't find exchanges like Curt and Bob's when I was researching how venture capital worked. I sure think it would have eased some of my pain. Curt and Bob's dialog has helped make this information widely available to a very large number of reasonably likely users of venture capital. These two widely disparate opinions help those contemplating using venture capital get more informed. With the benefit of time and hindsight, and after learning all this the hard way, I can see the basic logic in the way that our VC dealt with us. They didn't really have any choice. I must admit that going through it was painful, at times degrading and stressful beyond belief--it basically sucked. But I'd do it all again in heartbeat. As I write this, I can honestly state that my VC experience yielded outstanding benefits. I for one took a chance and it paid off handsomely. Not just in term of the monetary rewards but in my growth as a person, the skills I gained and overall insights into how this wacky world of ours works. In the end, no one makes a founder take a VC's money. If you have a business model that requires a large infusion of impatient, institutional money, then face up to the fact that you're going to have to play by their rules. |
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From: "Curtis E. Sahakian" cpart2@corporate-partnering.com
Ron, Your 01/25/2001 newsletter contained an anonymous letter from someone who founded a company in 1992 and after 4 years took in a VC investor. The author supported almost everything I have said on the subject of VC transactions. I thank him for his support. I do need to point out two false assumptions he made. He said "I didn't then nor have I ever heard of any VC knowingly investing at a falsely high initial valuation only to screw the Founder later." Of course there is no objective way to determine if an initial valuation is too high or too low. I know of no founder who has ever believed or admitted that the VCs gave him too high of an initial valuation. So your reader's self assessment isn't a reliable measure. But despite the fact that the VC roughed him up in the negotiations on the first round, an over-valuation on the first round is exactly what happened in his case. The VC overpaid on the first round and then took it out of his hide later: The facts speak for themselves. He said "Our VC knew the game and constantly invoked little surprises and conditions with each thimbleful of cash that dolled out. The worst one occurred when the VC was bought out. They actually required that the founders take a lower per share price so that they could manufacture their 30% IRR target." I don't know what more evidence you could ask for to support the proposition that in this case at least, the VC thought he he invested at too great an initial valuation and then used the leverage from the relationship to correct that problem. TWO - KABUKI DANCE NEGOTIATIONS Your reader bragged about the lawyering and negotiating that was done on his behalf: "We were able to strike virtually every materially offensive provision in the contract through this approach." But then goes on to say that they signed an agreement of which, by necessity, they were in constant violation: "... so we violated this and other terms of our agreement repeatedly. I do agree with Curt's point that the way that the deals are papered makes it all but impossible for a founder to not violate one or more terms of the agreement." Think about this... The very same people who maneuvered him into a contract that was designed from the very beginning to keep him in constant violation are indignant that this is being pointed out in public in your newsletter. After setting him up, his VCs reneged on their non-binding verbal financing commitments (multiple times) and kept slicing away at the founder's equity like a piece of salami. The VCs don't need no Stinkin Contracts... they are for the little people... the founders. They won't do a deal without one sided agreements, filled with gotchas for the founders, containing almost no VC obligations... but with lots of loopholes for the VCs. As a matter of fact most VC contract negotiations are nothing more than a Kabuki dance. Though all the steps of the process are important to the dancers... they are of no great consequence to the people paying for the show. In most instances, the result (in substance) is predetermined from the beginning. The giveaways are already built in so that the founder's attorney can put on a show for his client... while his or her client is slowly worn down by the passage of time and mounting legal fees. What is important is that this founder should have been advised beforehand of the coming "little surprises and conditions." Sounds like he wasn't. There is nothing to be self satisfied about in being surprised as a VC shamelessly games the relationship... sort of like that creep who won the first Survivor Island. The real crime is that first timers shouldn't have to learn all this the hard way. There should be no reason that they can't learn from the experience of others who have gone before them. Instead what seems to happen is that they themselves want to emulate the VC and do it to others (a VC version of the Stockholm Syndrome??). Someone should have been explaining to him the true consequences of his actions. If not his own advisors, then the VCs themselves. It's the only decent thing to do. Hey guys... why don't you do it? handed it over the VCs. He was investing in them, not vice versa. By the way this "reverse securities fraud" theory is one of a number of innovative legal theories that can be used to sue VCs outside their protective contracts. Will "reverse securities fraud" hold up in court? I don't know. I am unaware of anyone having used this theory before. But in cases where the VC attorneys demand adjustments to the founder's equity structure as part of the transaction... I like it. The VC attorneys do this with great regularity (they seem unable to exercise any self restraint in applying their client's often overreaching bargaining leverage). Hey any VC security lawyers out there want to take a poke at this? Go ahead (try to keep the personal vitriol and name calling out of it though). This is just one of many legal theories that can be used to circumvent the VC agreements. All that is necessary in any one case is for one of them to work... and to get it to a jury of non-VCs. Given the Attila the Hun approach the VCs take with respect to their investment agreements... I just don't see why they are whining that some of their disgruntled founders might take the same approach to the use of lawyers and the law to obtain their own ends. The VC's favorite threat is that a founder that misbehaves will be blacklisted by the VC community. It's an empty threat. The vast majority of founders do only one VC deal in a lifetime. The VC community is not so all knowing and monolithic as it is made out to be. They are all time starved and have many more things to do than sit around gossiping about founders. Some of them even hold grudges against others. I have even seen them blackball each other. I can even imagine some of them taking delight in funding someone with a solid deal who earlier got into a fight with their VC adversary. For stronger serial founders, say like Filipowski, having an unpleasant run in with one VC on an early venture isn't a barrier to getting VC money a second or third time around. In the end I just have to wonder, the VCs dish it out with panache, why can't they take it? Why are they so threatened by it? "It's not personal, it's just business"... I'm certain many of them have said that to the founders of their portfolio companies. Why doesn't it work the other way around? Curt Sahakian PS: Here is an interesting quote: "By the time SGI went through a couple of public offerings, I ended up with only 1% of the company. In retrospect, that kind of hurts," Jim Clark expressing resentment at having to give up 40% of his first company to The Mayfield Fund and the other first-round VCs for only $800,000. |
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