Why Entrepreneurs and Venture Capitalists Often Clash

When I started into business, I had some feel for how to handle customers, suppliers, employees and competitors. But when I got to the point of going after big money, I found I didn’t understand venture capitalists. And that’s a serious handicap if you want to get your company on the New York Stock Exchange, as I did.

By:
Jack Roseman
Pittsburgh Post-Gazette

http://www.nasvf.org/web/allpress.nsf/pages/9300

None of what I’m about to tell you is from a book. It’s based on my personal experience running three companies. So you could argue that it is just my experience and not universal. And that may be. I happen to think it’s universal.

The reason venture capitalists are so hard for entrepreneurs to understand is that there is a fundamental disconnect in intention. Take, for example, On-Line Systems. We felt we were the greatest at what we did or we never would have started it. We wouldn’t have put years into this thing if we weren’t really sold on the value proposition, on the service we were performing. We lived it 24 hours a day — it was our baby.

Studies have shown that most entrepreneurs start companies for the challenge of building them, not for the money they might make. Money is the scorecard. And there is an underlying belief that what we do in our companies — the way we live it, breathe it, cry over it, bleed for it, worry about it, etc. is because it’s ours. And if we do it right, one day, as a by-product, we assume there will be money. We do not accept failure too easily.

When I first approached a venture capitalist, I was full of, "Isn’t this a wonderful service? Isn’t this a wonderful feature of our service? Isn’t this a wonderful this and a wonderful that?"

At first, I couldn’t understand his lack of enthusiasm. Eventually it dawned on me that guy was only interested in one thing: how much money could he make. He couldn’t care less about our baby. He wanted to know things like: "How big is your market and how fast is it growing? What is your unfair advantage?" All he cared about were the things that would increase the probability of a large, quick return on his investment.

I always say that if a company doesn’t serve society in some way, it doesn’t deserve to exist, nor will it continue to exist over the long run. The venture capitalist is only interested in how much money he will make, and the rest of the data is just to evaluate the risk he’s taking.

Now if you think I’m exaggerating, let me tell you how one time I needed some big money, so I went to New York to meet with the president of one of the oldest investment banking firms on Wall Street.

He and I never saw eye to eye on things. I considered him in some ways a scoundrel, but an honest scoundrel. By that I mean, I didn’t always agree with what he did, but he always told you just where he stood. So I remember during that conversation he said: "Jack, I don’t fall in love with my investments. I may invest money in a company today, but if tomorrow I find a better investment, adios."

So here I am, working 24/7 morning afternoon and night; I’m totally committed to my baby. And this guy says, "Wait a minute, if I find a better company tomorrow, adios, baby." That brought home to me the mentality of investors.

And if I were they, maybe I’d feel the same way. But I’m not. I’m an entrepreneur. I don’t start companies for money. I do it for love. I think I’m bringing something of value to society. I don’t first and foremost think how much of that lands in my pocket.

So if you want to get money out of VCs, investment banking firms, or sophisticated investors — don’t talk about how wonderful your product is. They care, but only to the point of estimating their return on investment.

One time I was at PNC and I was talking up Actronics. The investment banker listened to my pitch, and then he said he was not making an investment. So I said: "Let me tell you something. When everybody cashes in and makes a bundle on their investment, you’ll be sorry."

And then he gave me another insight into venture capitalists. He said: "Jack, the only time I can be sorry is when I do make an investment. My boss never yells at me when I don’t make an investment. When I make an investment and they don’t get the return they were looking for, that’s when I get yelled at. So I can never be sorry by saying, ‘No.’ "

The other thing I didn’t understand in those early days of seeking big money came up when I was dealing with a major venture capital firm in New York, an offshoot of Citicorp. They have billions in their treasury now, but I was approaching them when they had much less. I talked to four of the partners, but the fifth partner couldn’t make it. And they said: "Don’t look anywhere else. You’ve made a sale. We’re going to invest. However, we can’t commit today because our fifth partner isn’t here. And if one partner gives a thumbs down, the answer is ‘no.’ " That’s true to this day.

So it turns out, the guy comes to visit us, and for whatever reason, either we did a lousy demo or he had an off day or we had an off day, but he goes back to New York and says he’s not convinced. So four out of five people saying "yes" doesn’t mean you have made a sale.

So what does matter to venture capitalists? How to get a high rate of return on their investment. And to do that you have to know who your competitors are, your unfair advantage, the size of your market and how fast it’s growing. The management team is what matters. Incidentally, all of these issues are obviously important to the entrepreneur also.

Another thing first time entrepreneurs don’t appreciate is the golden rule: He who has the gold rules. You think you can accept a large investment and stay in control. But when a venture capitalist finishes with the term sheet, you will not have control.

Understand that a VC on the board is inherently in a conflict of interest. And I don’t know why that hasn’t been addressed to this day. Most times there isn’t a conflict. As the investor, I want you to make a lot of money so I make a lot of money. We’re buddy buddy and partners. But the investor/director can get into a conflict when you go for more money. As the entrepreneur, when you go for more money, you want the valuation to be high because you want as little dilution as you can get. The investors would rather have the valuation low if they are going to participate in that round. So there is that conflict.

When you are on the board, you’re supposed to have only one fiduciary responsibility: What’s in the best interests of the company. When a VC is on the board, he really has two responsibilities in his mind: What’s in the best interests of the company, and what’s in the best interest of his fund. And one can be in conflict with the other. When they are in conflict, trust me, the investors usually win and you lose.

So what is an entrepreneur to do? All I can say is forewarned is forearmed. When you go out for big money, recognize that you are swimming in shark infested waters and they’re hungry. If you were the VC you’d feel the same way. They are in business solely for return on investment. The entrepreneurs who want their money, on the other hand, are usually in business primarily to nurture their baby and see it thrive.