Take the Money and Run: An Insider’s Guide to Venture Capital

[Editor's note: Gerry Langeler of OVP Venture Partners shares an excerpt from his new book "Take the Money and Run: An Insider's Guide to Venture Capital."]

How to Avoid a “No” from a VC: People

The old saying in the VC business is investors invest in three things: people, people and people. There’s more than a little truth to that. We’ve seen great teams dig themselves out of some deep holes, and weak teams dig themselves into the ground.

But how do you know you have a great team, at least in the eye of the beholder (us)?

First, ask yourself this question: “What is the probability that there is a team with more domain expertise, more horsepower, and more high-level industry connections located somewhere along the Silicon Valley, Seattle, Austin, Boston, London, Zurich, Haifa, Mumbai, Shenzhen, Tokyo, Seoul corridor?” Really – ask yourself that! Because we are asking ourselves that as you speak.

We know all too well that in this global, internet-savvy world, unique ideas are fleeting. But, unique teams are precious.

If you can’t answer the question above with a solid “yes,” then ask yourself if you CAN gather such a team. We understand that early-stage startups often start with less than fleshed-out teams.

Gerry Langeler

So, know where you are weak or missing talent. Know what you don’t know, but know you need to know. And know that if you share that level of introspection with us, we will be much more impressed than if you try to blow by us with a patched together personnel story – or worse a bunch of B or C players plugged in to fill holes on an organization chart.

We VCs are very used to building teams and used to working through team transitions as companies grow. But we’d like to fully understand where that help will be needed before we begin, not after the first key milestones are missed. And we’ll be evaluating how much heavy lifting is reasonable and still expect you to succeed.

Next, beat me to the punch. I have a set of questions I love to spring on unsuspecting entrepreneurs (I guess this ends that opportunity). I go around the room and ask each member of the founding team to describe who they are, their background, and their role.

• Now, I’m looking at you, “Bob, what’s your role?”
• and you say… “I’m the CEO!”
• and I say… “Why?” (this is usually the first time anyone has asked you that question)
• and you pause for a moment and then say… “Because I’m the founder.”
• and I say… “So?” (long pause…) “What do you think a start-up CEO has to be good at? Are you good at those things?”

You’d be amazed how many times I’ve done this and how many deer in the headlights moments it has engendered. Let me be clear, I’m not doing this to be mean. I’m doing this both to make a point, and to get at some very important information. You wouldn’t hire a VP of R&D unless they had proven they had the right skills and experience to do that job, nor a VP of Sales, nor a CFO.

But founder after founder thinks that being a founder is all it takes to be a good CEO. We have ample evidence to the contrary.

Actually, being a founder shows you do have one key attribute of successful startup CEO’s – the ability to craft a compelling vision of the future direction of the enterprise and then get people to follow that vision. But, vision buys you the first couple of months. After that, only steely-eyed execution matters.

And the fact that I put entrepreneurs on the spot doesn’t mean they can’t be CEO. It means they need to understand that from the day they take our money it’s no longer about them, or about us. It’s about the enterprise and what’s good for it.

If that means you are a one-in-a-million like a Bill Gates, Michael Dell or Steve Jobs and can take the company from day one to billions in sales – terrific! If it means you need to step into another role in six months – terrific! What we all need to be working on is building a powerful, lasting, valuable enterprise – with whomever we need in whatever roles need filling.

My final ploy on this topic is to ask a simple question, “Do you want to be the boss, or do you want to be rich?”

There is only one right answer.

Again, it doesn’t mean you can’t be both. But it means if it becomes clear someone else is needed to help the company reach its potential, you are not confused about our shared need for economic success. By the way, there is absolutely nothing wrong with answering that question, “the boss.” It just means you are not right for institutional venture capital – and as I said earlier, there’s nothing wrong with that, either.

In the end, we look at the team and say to ourselves. “Are these guys and gals likely to go toe to toe with those phantom start-ups around the world that are somewhere between six months behind and six months ahead – and win?” If we think you are, then we start thinking seriously about the next three risk areas.

Dilution and Ownership

Did you hear about the guy who died from dilution?

One of the toughest issues we deal with in early stage investing is overcoming the founding team’s fear of dilution. That fear is perfectly natural, normal, and completely misguided. It turns out most of the pushing and shoving on this issue, particularly at the first round Series A stage, gets lost in reality as the company grows and requires additional rounds of capital.

Let’s consider the following case:

Most substantial early-stage venture capital firms require 20%-30% of a company to make their economics work. Most also invest in syndicates with at least one other firm. So, no matter what other valuation and discussions go on, after the Series A, the VCs will own 40%-60% of the company. Of course, the business plan usually says this is all the money that will ever be needed. But, reality says that is nonsense. The overwhelming majority of firms need two or more likely three rounds to reach cash flow positive.

So, if the VCs pony up the money for round 2, regardless of the progress made, one should expect that financing may consume half the previous one, or about 20%-30% of the company. Round 3, again even with nice progress will require half of that or 10%-15%. So, do the math. At the low end: 40% + 20% +10% = 70% of the company to the investors. The management team owns 30% in the best case. At the other extreme, the investors own 105% (60+30+15), which is clearly not possible.

That brings in the reality of a reasonable floor. We tell all young management teams that the good news is we may be greedy, but we are not crazy. If they don’t have enough incentive to put in the 100 hour weeks, we don’t get paid.

In our judgment, that floor is around 20% of the company. If financing events take them below that, we dilute ourselves to refresh management’s incentive. So, in the end, all the fuss and bother about valuation and dilution is about a maximum possible spread between a 20% floor and a 30% ceiling on management ownership at the end of the fund raising process.

The same can hold true on preference stacks.  If after a number of rounds of financing those grow too large to leave management any hope of a payday, investors will usually either reset them to a lower level, or put a “carve out” in place to ensure management is properly motivated.

This is why we say, over and over again, “No company ever died from dilution. The ONLY thing companies die from is lack of cash. Optimize for cash – not dilution.” Sometimes the entrepreneurs hear us, sometimes they do not.

Gerry Langeler is a partner at OVP Venture Partners, a Kirkland venture capital firm. Take the Money and Run is available for download here.

  • http://blog.CascadeSoft.net @CascadeRam

    >>This is why we say, over and over again, “No company ever died from dilution. The ONLY thing companies die from is lack of cash. Optimize for cash – not dilution.” Sometimes the entrepreneurs hear us, sometimes they do not.

    “lack of cash” is the end-result of startup failures, but I wouldn’t describe it as the cause.

    Startups (or companies in general) fail because their products don’t match market needs.

  • Sarcastic

    Based on author it is clear now why OVP is a dinosaur in these days and may soon become not relevant. You are betting on entrepreneurs that don’t want to risk their pay check and falling into same trap when calculating how much to give entrepreneurs and build a financial model for an early stage company. You are trying to make the guy to lose his confidence and make rely on your judgement how much he will get from you at the end. He will stop being entrepreneur and will become your employee after getting your money – how pity. As a result, if he agrees you will get a second tier guy because of the greed you have expressed. Not surprised OVP has become a 3rd tier of VC firms. 

  • http://twitter.com/GerryLangeler Gerry Langeler

    OK – while it is always perilous to engage in these affairs, the two comments warrant some response. 

    CascadeRam, you are right, of course.  However, the vast majority of start-ups don’t exactly hit the market need/fit bulls-eye on the first try.  Cash, then, buys them both time and resources to adjust and get it right. As long as they have cash, they can keep trying.

    Sarcastic, I can only say “lighten up a bit.”  To be fair, I chose the excerpts to be provocative. That’s what gets people thinking and talking – although it got more of an emotional response in your case than I anticipated. The whole book is not like that.

    Then again, it seems to me you are missing a key point.  Building a major enterprise from scratch is very, very hard.  Most companies fail, no matter how well-constituted and funded. 

    So, the last thing an entrepreneur needs from their VC is happy talk about how wonderful they are and how we really don’t need to own any material part of the company to make our businesses successful.  Entrepreneurs need the truth about VCs, about their company’s strengths & weaknesses and their own.  I don’t know about you, but the most useful and memorable teachers and coaches I had found that magic balance between building my confidence but also letting me know in no uncertain terms where I had to improve to be successful.  That built REAL confidence, not T-ball false confidence (everyone gets a trophy).

    As to OVP being a dinosaur or a second tier firm, we can agree to disagree on that.  As I look at our most recent fund (OVP VII) and Seattle companies like DataSphere in IT, EnerG2 in Clean tech and Fate Therapeutics in Biotech (yes, they moved to San Diego), I feel we have arguably the top three locally-generated recent start-ups in our chosen domains. And there’s a longer list behind that I won’t bore you with.

    Finally, let me share a story about another OVP VII company, about to be acquired so I can’t use its name.  That CEO probably was one of the ones who would have been less prepared for my first provocative question, although fully prepared for the second (he wants to be rich).  He’s about to be.  He and we both figured out that he probably was not the guy to take the company to $100M in sales.  But, he was absolutely the guy to take it to single digit millions with a product that he and his team designed to become strategic to a couple of large potential corporate buyers.  So, when it became time to find the company a home, we worked with him to get a bidding war going.  Both acquirers wanted not only the product, but his team and they really wanted him to lead a large part of their whole R&D effort post merger. He had a clear preference on which firm he wanted to end up working for. 

    So, one of my partners worked the issues and the buyers with the CEO to get the best price and the best company fit. We did. He will make millions, will work for the company he likes, and we’ll do very well for our investors.

    If that makes us dinosaurs, call me Triceratops.