The Unfair Game of Venture Capital
Venture capitalists rule the game. Entrepreneurs must deal with it. We must bring some balance to the system.
Imagine a game that is presented as friendly and in which every player can hope to win big. This game is made popularized by the media, which tells numerous nice stories about it daily—encouraging others to play. It is so popular that there is no room for everyone, but those with the opportunity to play can gain a strong sense of empowerment and hope.
Would you play this game? Most likely, yes, if you are unaware of the hidden rules.
First, the game is very challenging. If you decide to play, you must devote a large part of your life to it. Second, it takes years to know the result, meaning you must be very patient and persistent. Third, if you give up too early, you'll probably lose all your stakes. Fourth, it's not a zero-sum game. The winnings are divided among the players; some players are likely to end up with nothing. Fifth, your playing partner is much more experienced, and his or her chances of winning are also higher.
Yes, you guessed it. The game is Venture Capital.
And it starts when the founders sign an investment or shareholder agreement with a venture capital (VC) firm, meaning they have completed a fundraising round. The game ends when one of the parties exits, and they sell their shares. Everything that happens in between remains fairly confidential and opaque. The public learns about each play only when there is a liquidity event (e.g., new fundraising round or exit). Only a small percentage of VC-backed founders experience a successful exit.
Because of their experience, VCs are always in the best position to mitigate their risks and reap the rewards. They make sure that in the case of defeat, the founders lose first; in the case of winning, VCs win first. At the midpoint, the venture capitalists are served first and at the expense of the founders, who can end up with nothing.
The term used by venture capitalists is "information asymmetry", which sounds more acceptable.
Scott Kupor, Managing Partner at Andreessen Horowitz, author of Secrets of Sand Hill Road, Venture Capital and how to get it wrote:
The term sheet is where information asymmetry between VCs and founders comes into play the most, and often at the expense of the founder. This is because VCs have been through this process many times and have negotiated hundreds of term sheets. By contrast, founders only get a few shots on goal in a lifetime and likely can count the number of term sheets they have negotiated on one hand.
Gigi Levy-Weiss, General Partner at NFX, author of The Non-Obvious Guide to Fundraising wrote:
Investors play this game all day, and you only do it occasionally. So don’t trust your instincts too much. The more awareness you have about the limitations of your startup fundraising experience compared to those of VCs, the more empowered you will be throughout the fundraising process and beyond.
As a founder, awareness is crucial. If you are aware, then you can break the illusion of Wonderland and do something about it.
Develop a critical mindset.
No one—certainly not venture capitalists—wants to talk about their failure. That's why the stories in the media are heavily skewed. You hear only the success stories or trending stories. Very rarely do you hear about the failures or the hardships of the entrepreneurial journey. Here is why you should try to desensitize yourself to the media's fairy tales and start thinking for yourself.
Rethink your fundraising strategy.
Do you really need to play this game? Have you considered alternative options such as bootstrapping, venture debt, crowdfunding, and sweat equity?
If you do not have a choice, try these:
Gain time to create as much value as you can without funding. You'll be in a better position to attract and negotiate with VCs and minimize your capital dilution.
Right-size your funding round by valuing the capital you need to reach your next milestone, plus a 30% buffer. To do this correctly, you need a clear milestone and action plan.
If you show investors that you can create value and survive without them, that's a strong plus to rebalance the odds.
Assuming you have a strong product-market fit, team-market fit, and growth potential, you may qualify for the game. First and foremost, you should spend plenty of time learning all the tricky terms and their mechanics. An easy way to do this is to read books. Below are two references in addition to the previous ones.
Crack the funding code, How Investors Think and What They Need to Hear to Fund your Start-up, Judy Robinett, President of JRobinett Enterprises.
Venture Deals, Be Smarter than your Lawyer and Venture Capitalist, Brad Feld, Jason Mendelson, co-founders of the Foundry Group.
Hire the legal advisers working for VCs.
Legal advisors working for VC firms know this game very well. These are the ones you want on your side because they understand buy-side logic and negotiation techniques very well. Don't just choose the legal advisor you know or the cheapest firm. Choose specialists who deeply understand VC and M&A.
Do not settle for the first offer you receive.
Dealing with VCs is tough. That's why most entrepreneurs are tempted to jump at the first opportunity they get. However, your goal should be to use the initial term sheet as a hook to attract two or three more investors. Then you will be more relaxed and in a much better position to negotiate.
Follow a schedule.
Don't make the whole process too long. Give the VC enough time to do their research and due diligence and then set a deadline. You will probably lose some VCs, but the ones that stay will be more engaged and possibly less demanding.
Demonstrate your ability to negotiate professionally.
Investors will evaluate not only your company but also your ability to communicate and negotiate with them. It is a great way to differentiate from the crowd and show that you are mature, respectful, credible, and empathetic. Essentially, you want to show that you have the leadership skills to persuade your audiences.
Make reference calls.
A reference call with the portfolio founders will give you an idea of what to expect from investors when they invest. For example, what happens in downturns (which will inevitably occur); how do they deal with you if you need capital or don't reach your goal? How do they manage the exit process?
“Something you absolutely have to do when taking on investors is to make reference calls with their portfolio founders — and I don’t just mean two to three calls, but 20 or 30,” Christian Reber, CEO at Pitch.
Last but not least, don't celebrate too early.
Signing a contract with a VC is just the beginning of the game. Your goal is not to show off in the media but to play this game well in the long run and reap the financial rewards.