The title of this article is how one Silicon Valley CEO described to me his colleagues in startups who submit to venture capital arbitrage today.
Slaves To Subprime
This alternatively funded CEO describes other CEO’s that seek VC funding as idiots – with a 1 in a 1000 shot at a lousy valuation (52% Round A, 25% Round B and 15% Round C). He continues that many of the serial entrepreneurs trumpeted by VC’s have no money themselves despite “successful” previous exits.
He is not alone in the ineffectiveness of Venture Capital. I frequently hear from other successful entrepreneurs about it. And the situation may get worse before it gets any better. The economy is offering VCs even more excuses to turn the screws, and control of companies happens in more ways than a simple equity stake.
I believe technology investing today is mostly a subprime asset class as described in a plethora of articles referencing subprime VC in this blog, and find many entrepreneurs discouraged by both the process as well as the outcome of fundraising, even when that yielded a round of funding.
Because of the ineffectiveness of VC and the rampant false positives and false negatives, I refuse to believe VCs (and the NVCA collectively), who suggest that the sum of Venture Capital equals the amount of technology innovation. We see great entrepreneurs actively pursuing more creative investment vehicles (high-net-worth individuals, private equity firms, investment bankers, sovereign funds, anyone with money), and rightfully so.
In the meantime, oblivious to recognize their flaws, VCs are further descending the subprime spiral by restricting investments to compliant entrepreneurs, evidence that they remain clueless about the fundamental risk management of high yield returns.
Smart CEOs should refuse to work with many technology investors for the following reasons:
– Exorbitant loss of upside
Great entrepreneurs are known for their passion for pursuing their dreams at virtually any cost, and subprime VCs smell their blood and desperation. Those companies become owned by VCs quickly and because of the investors’ lack of relevant operating experience yields a further deflation of the valuation of the company. We’ve seen many companies with end-game founder stock way below 5%, which is unlikely to become life-changing. So, why would you take the scrutiny of the CEO job with that outcome in mind?
– Indirect loss of control
Voting rights, as well as other fine print in the term-sheet, severely impact your ability as a CEO to disrupt a market. While in the beginning, the founders may still own the majority of the shares, the dependence on further runway support gives VCs the ammo to press their preferred operational trajectory and leaves operational decisions at the mercy of its first investors.
– Restrictive expenditures
Clauses further restrict the powers of the CEO on expenditures in either the articles of incorporation, term-sheets, voting rights, or other legal documents. We’ve seen restrictions requiring board approval for spending as little as $5,000. That means a CEO can’t make important decisions until a next board meeting or when there is an ability to call an impromptu session. These restrictions are further evidence that a CEO does not have the trust of the board.
– Insufficient ecosystem control
Investors typify investments in technology waves (witnessed by their mindless herding at technology-focused events) and blindly allocate certain expenditure expectations to R&D, marketing, business development, and sales divisions. But the ecosystem of every company, regardless of segment, is unique to that company. CEOs who let VCs determine or validate the ecosystem expenditures will spend the subsequent board meetings explaining why they deviated from that, a waste of precious time.
– Deal with undeserved authority
Many VCs do not have the credentials and relevant operating experience to lead an experienced CEO. It behooves the CEO to listen to the quirks of the VC for them to endorse a CEO’s leadership. Nothing is worse for a company’s future than having to wait for the investor to validate every step along the way.
– Micro-economically sandwiched
Technology founders and VCs often focus on building technology, very few investors pay close attention to the macroeconomic differentiation (and valuation), leaving intelligent CEO left to drive a more sustainable big-picture strategy with a limited board and back-end support.
– Forced syndicates
Investors with early shareholder stakes can essentially force the company to engage with other VCs in subsequent rounds that favor the initial investor, rather than the entrepreneur. Many VCs huddle together in like-minded “vulture” strategies in the hopes of maximizing their often ill-performing portfolio.
– Damaging to reputation
The valley is so small, and deliberately ignoring the advice of an investor can have a detrimental effect on a CEO’s future career. The “you will never work in this town again” syndrome is not unique to Hollywood; it is alive and well in Silicon Valley. The word spreads quickly when you challenge VCs and don’t accept their terms, a reason why they tell you not to shop valuations around – it will hurt you.
– Sticky lawyers
We’ve inherited bad lawyers in companies we ran and found some good ones. But in many cases, lawyers in Silicon Valley pretend they created the companies, just because they filed their incorporation paperwork or attended board meetings. They mingle with the money sources and make the introduction to VCs that secure their billing runway. They end up getting cozy with the major shareholders and tilting the balance even further away from the CEO who signs their checks. Another entity to keep in check as a CEO.
– Low salary
Opportunity rather than salary is top of mind to entrepreneurs, but that mindset changes rapidly when they struggle to support their families and pay mortgages. $175K is not a salary that leaves much on the table, especially not when you live in the expensive area around Sandhill Road. And VCs are challenging those salaries even more while they are raking in astronomical fees associated with their substantial funds and sitting pretty for the next ten years. The risk/reward equation between VC and entrepreneur is entirely out of whack.
– Poor severance
Board-run companies leave CEOs in a vulnerable state once its collective wisdom does not pan out. The blame for that failure is usually generously applied to the CEO, while the decision-making power was not. An early-stage CEO should consider himself lucky if the company can still honor its pre-negotiated severance obligation.
Pimps and Hoes
The current venture climate reminds me of the fascinating HBO documentary Pimps Up, Hoes Down in which the undeserved authority of Pimps is applied to the Hoes who do all the (dirty) work.
No self-respecting CEO should accept the constriction deployed by subprime Venture Capital as described above. The outcome of the current entrepreneurial restrictions is not only highly predictable but has thankfully reached the balance sheets of fund-managers and Limited Partners, who fund the VCs and are starting to question the role of the VC as the intermediary.
The downturn in the economy masks the unrelated impending implosion of Venture Capital. No VC should use the economy as the excuse for the restrictions above and as a CEO, you should read its deployment for what it is; a diminished faith in you and the company.
So, unless you can reach a great VC independently or with help from others quickly, my suggestion is to wait for testing your CEO skills until Venture Capital, not the economy recovers, if you can.
In the meantime, I’ll do my best to help fund-managers revive Venture Capital. It is about time the fund-managers hear the entrepreneur’s point of view. That has become my new mission.
