When I was studying finance, I read a book that outlined Warren Buffett’s 12 tenets of investing.
- Background and Context
To this day, I always think of Warren Buffett when I make an investment. In 2003, I tried to get him to buy the Montreal Expos and keep them in Montreal. Suffice to say, that went nowhere. When he began to look for a replacement, I thought of applying, but by then I was managing Mojo Supreme.
As such, since 2006, I’ve been both an investor and an entrepreneur. As such, I also think of Warren Buffett when I allocate capital at WatchMojo.com and manage the growth of the company.
The following is advice I’d give to most entrepreneurs, not all, but most. I certainly don’t think that all entrepreneurs should demand the following because it will certainly be a dealbreaker in some instances.
But, it’s a practice I’d preach if I were an investor.
I would personally not necessarily stick to the following advice as an entrepreneur because I understand that it’s a thorny issue, but entrepreneurs and investors need to look at the matter in a different light.
- The “Institutional Imperative”
Anyway, amongst Buffett’s 12 tenets is the Tenet #6, which asks if management of a company you wanted to invest in avoided the “institutional imperative”. Like many idealistic folks, Warren Buffett presumed that experienced managers of leading companies were honest and intelligent and automatically made rational business decisions.
Once out in the wild, he realized that the opposite was true.
This force, which drives managers with the most excellent credentials to invest capital in bizarre ways and adopt silly approaches purely because it seems to be what everyone else is doing is what Buffett calls the “institutional imperative”.
I’ve always bundled the “institutional imperative” with “conventional wisdom”: things that over the years toughen one’s stance but ultimately become, in the words of Buffett “self-destructive me-too behaviour”.
Buffett finds it is not the owners who are at the greatest risk of being blinded by the institutional imperative, but the managers themselves in their inability to accept fundamental change.
In the investing world, successful money managers - be it in private or public companies - must understand and adapt to change. Those who don’t will miss on the trends that change the landscape.
Ultimately, the “institutional imperative” leads to poor capital management and poor “decisions on the allocation of capital. The biggest reason for the institutional imperative though is just mindless imitation of other companies.”
If you disagree with what I am about to say, don’t attack me, go take it up with Warren Buffett, the single greatest investor of the 20th century, and once the me-too dot com investing euphoria subsided, the most successful investor of all time.
- Risk vs. Return
A fundamental balancing act in finance and investments is the relationship between risk and return. This is called an investor’s risk profile. The more risk I undertake, the greater the return I expect. It’s a very simple relationship. In pop culture, we simply this as the greed vs. fear conundrum.
An entrepreneur, by nature, is a risk-taker. But, the single driving force amongst entrepreneurs is not money, but the pursuit of success and happiness. Happiness and success are very subjective, and these can include money, but money in of itself is not the end goal. It is a manifestation of the achievements that an entrepreneur has accomplished.
A venture capitalist, by nature, is a risk-taker too. But unlike an entrepreneur who pursues an area they are passionate about, a VC is an investor who invests other people’s money and allocates resources (time and money, in essence) to maximize profit. After all, a financial manager’s objective is to maximize profit. That too, is something I learned if business school.
- Know Your Role
At the very core of this entrepreneur/venture capitalist relationship is this dynamic: an entrepreneur chases a passion, a venture capitalist chases profit. Together, they combine resources, expertise, experience, networks etc. and create value.
In other words, to the entrepreneur, the truth is that a venture capitalist’s money is a necessary evil, a means to an end. Conversely, to a venture capitalist, without the entrepreneur there is no business. Perhaps this is why rock-star VC Fred Wilson calls entrepreneurs a venture capitalist’s clients. He is right, without clients, there is no business, no revenues, no profits.
- Welcome to the Boys Club
There’s a lot of merit to the argument that the VC landscape is a private boys club. Paul Kedrosky yesterday pointed to Sequoia’s website, which does not even allow for business plans to be submitted. But, the flip side is that if you have something of value that can return investors 3, 5, 10 times their money in a relatively short time period, you will be able to get their attention.
- Time Horizon
An investor’s risk profile is intricately related to one’s time horizon. This naturally has to do with the time value of money concept, which is basically where the “time is money cliche” comes along.
The longer you forego your investment, the higher the return you expect, all things being equal.
Of course, the risker the investment, the higher the return you expect. A safer investment over a longer timeline might require a lesser return than a risky investment over a short time period. But, we digress.
The point is, rarely do entrepreneurs find financing backers from the get-go. Sure, many do. But for most entrepreneurs, they will dream up a concept, plan its launch, build the company and subsequently raise money. The time gap between the idea is hatched - when the entrepreneur incurs an opportunity cost, basically - and the financial partner comes along is usually months, if not years.
As such, when a VC comes aboard, the time elapsed can be 1 or 2 years. In other words, all factors being equal, an entrepreneur and a VC do not share the same time horizon, and this is problematic. What exasperates this problem is that while the entrepreneur was building his or her company, there was an accruing opportunity cost, which means that the entrepreneur’s risk profile is decreasing (willing to take less risk), one would imagine.
- Aligning Interests
One of the major cliches in the investing game is that entrepreneurs, employees and investors need to have their interests aligned. Once investors come on board, they invest in a company and own equity. The theory is that investors and founders have aligned their objectives.
Nothing could be further from the truth, and this is where both entrepreneurs and venture capitalists make a cardinal sin, usually one that leads a billion dollar idea to become a million dollar one.
- Case Studies
In my humble opinion, Delicious sold too soon. So did Feedburner. I can name many other companies. One company that did not sell too soon was Facebook. Mind you, hindsight is always 20/20. One more thing about Facebook, the investors got that right. There is only one Google, there is only Facebook, but if more entrepreneurs and investors take a cue from Facebook’s financing history, then more companies will end up like it.
The biggest mistake VCs and Entrepreneurs make is not encourage entrepreneurs from taking some money off the table as to
a) bolster the entrepreneur’s treshold for risk,
b) extend his time horizon and
c) match his target exit price with that of the investor.
Naturally, the mere notion that entrepreneurs should be allowed to take money off the table has drawn criticism. The truth is, it should be encouraged.
Two very common objections are the following gems:
- VC cliche #1: “the VC wants you to put all of the money in the company.”
Let me get this straight, you are going to plunk down $1M, $5M, $10M etc. in a company whose business plan will change more often than you can count, but you are going to lose your interest in said company because the entrepreneur wants a fraction of that to cover some of the opportunity costs he’s incurred over the years?
Don’t you think that paying off debts and loans and having a safety net going forward is a better use of funds for the entrepreneur? Does that not better align the investor’s target return with that of the entrepreneur?
- VC cliche #2: “Why would you take any money off the table? Are you not as bullish in the company’s prospects as you say you are? ”
Oh that’s precious. Your answer to that should be: “Bulls make money, Bears money, but Hogs get slaughtered.”
When I am sitting on a fat, juicy capital gain on a stock, every single theory of investment urges me to sell a portion and demonstrate some fiscal prudence. If you have a bird in hand (an offer to sell 100%) and a VC is offering you two in the bush (selling a portion and raising financing) you have to take a bit of money off the table.
No one is talking about entrepreneurs getting back multiples of your “sweat equity” or your actual investment, we’re talking up to an index of 1 (in cases where no investment has been made and the company is generating cash flow, then sure, the entrepreneurs who are diluting and sharing in the wealth should certainly get some money off the table and it can be multiples of revenues or profits, but as Buffett would suggest, these opportunities should be treated on a case-by-case opportunity).
- Really Understanding What Drives Entrepreneurs
Do you think the entrepreneur, who has sacrificed everything, put up with ridicule etc., is suddenly going to become risk-averse or less hungry because he takes a sliver of pie off the table? Of course not, it reinvigorates the entrepreneur and increases their threshold for risk, something that in fact aligns the investor’s interests and objectives to that of the entrepreneur.
- Giving Investor’s a Bigger Piece of the Pie
In fact, in today’s climate where VCs face competition from angels, corporations and private equity firms… and where open software, cheap hardware and freely available APIs contain startup costs, investors have a simple choice: adapt or lose on some deals. The flip side is not even losing deals to other investors, it’s entrepreneurs settling for a sale to a company, usually companies that today compete with VCs by investing in startups, too.
The leverage that VCs have has gone down, perhaps not enough entrepreneurs recognize this so they will accept the conventional wisdom and myth that entrepreneurs who take money off the table lose their drive. Ultimately, many VCs are allowing for liquidity founder clauses, these include Lightspeed Ventures and Founder’s Fund.
- The Entrepreneur’s Dilemma
Entrepreneurs always want to go long, we want to go big, we want to go deep. When we start a company, the smart ones build their businesses on the strength of a series of short, safe, but ultimately effective plays. At some point, we realize there is a large, gaping hole in the field. So we recruit and draft, we scout and trade for more firepower. Sometimes this firepower comes by way and in the form of a round of venture capital financing.
VCs have wretched reputations, some of it deserved, some of it not.
But ultimately, I don’t care what people say, the conventional wisdom and institutional imperative has basically led to a destructive, short-sighted, me-too thinking by investors and a capitulation of going for the major victory by entrepreneurs.
Last year, Fred Wilson and I disagreed on some of the factors that lead to entrepreneurs selling too soon. I stated my opinion, he disagreed. Ultimately, entrepreneurs would demonstrate a greater long term approach if they had some safety net. Think Mark Zuckerberg… Rumor has it that Zuckerberg was allowed to proverbially speaking, take some money off the table.
Jeremy Liew of Lightspeed discusses this practice some more on his blog. I’ve talked about it here, in response to uber-angel investor Ron Conway’s criticism of the trend. Mr. Conway knows more about angel investing in his toe than I do in my brain, but on this one, Mr. Conway is wrong. I am the client as an entrepreneur, after all, and it does not matter what Mr. Conway says or feels. For him to call Peter Thiel a “third rate VC” for doing so is laughable.
- Executive Hours, Executive Pay?
It’s important to note than when an entrepreneur sells a stake in his company to a VC, he does not have any illusions that his company has become a money-gushing corporation that will pay him executive pay, offer his executive perks and where he can work executive hours.
Any sane and smart entrepreneur understands that VCs are going to expect the company to skyrocket in terms of growth and to do that, it requires more work and more sacrifice. But to do that, the expectation that an entrepreneur must remain hungry and driven is one of the more laughable things ever, because the least driven and hungry entrepreneur is probably more driven that the most ambitious VC. That’s not a knock to VCs, in fact, since most VCs were one-time entrepreneurs, I’d bet many would agree.
- Options
An entrepreneur has four options to manage growth. Two of the main ones are M&A or VC.
Let me get this straight, say an entrepreneur owns 100% of a company and can:
- sell his company for $1M, OR
- sell 25% of his company to a VC for an investment of $250,000, valuing his company at $750,000 for a post-money valuation of $1M.
By doing so, he loses power via liquidation preferences. He also can’t sell his company so long as the value rises to 3, 4, 5, 10x the valuation that the VCs entered at.
If an entrepreneur is willing to embrace this uncertainty and loss of control, then clearly it’s not about money, it’s about the task at hand, right?
But since the entrepreneur could take the easier, safer road but opts not to, should he or she not be rewarded? Not rewarded as in you are special, rewarded as in what is expected when one takes on risk.
I understand why VCs throw out cliches, they are investing their money and reputations on young entrepreneurs who need to remain committed to the company. That’s where due diligence should come in, one would think.
But by raising money, you create uncertainty in terms of partnership risk (the discrepancy between your time horizon and target exit price and the investor’s).
Yet if uncertainty equals risk, why is it that only VCs should be compensated for risk, why shouldn’t entrepreneurs. It’s much easier, all factors being equal, for a would-be investor to run background checks, yet for me to run a background check on an investor, it’s less obvious, and potentially, less diplomatic.
Ultimately, if the entrepreneur is the client, why should the client be negotiating from a position of weakness? Sure, it boils down to demand vs. supply, but in that context, then it’s time for this institutional imperative to fall on deaf ears to encourage more entrepreneurs from going big, and going deep.
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September 6th, 2007 at 12:28 pm
Ashkan,
Agreed - An entrepreneur taking a few chips off the table has no direct correlation to their interest in the long-term success of their venture. The entrepreneur is still very emotionally and financially tied to the company. VC’s use this as a way of leveraging full control. An entrepreneur should be able to participate in the mitigation of risk.
Steven
July 19th, 2008 at 8:19 am
[…] - VCs want to see an entrepreneur put his money where his mouth his, but if you have done that in the past, then they don’t want to account for it, they want to wipe the slate clean… which I think is lunacy… and usually where talks with VCs end. For more on my belief why this is one of the biggest mistakes VCs make, read: “The Biggest Mistake VCs and Entrepreneurs Make: Bulls make money, Bears money, but Hogs get slaughte…“. […]
August 27th, 2008 at 3:51 pm
[…] - Why do Entrepreneurs Accept Draconian VC Terms? - Biggest Mistakes VCs Make. […]