A convenient but uneasy partnership
7 Nov 03

Plenty of entrepreneurs in Europe vow they will never take a penny of start-up venture capital money. Are they right?

One of the less visible results of the fall-out from the late-1990s bubble is that the partnership between venture capitalist and entrepreneur has been severely strained. While many a company founder bemoans the funding drought that followed the bubble-era glut, others take a different view.

Venture capitalists will not even get to see the best opportunities these days, they contend, because the most promising start-ups will choose to boot-strap their way to market in order to avoid the perceived discomforts of having to deal with venture capital.

The big, bad venture capitalist has certainly earned his place in the entrepreneur's demonology. In the downturn of the past three years, investment agreements have sprung up with punitive terms that often meant the founding management stood no chance of seeing any financial gain unless the company was sold for an unrealistically large sum. Companies have been strung along by prevaricating investors until they were within an ace of running out of money - and forced to agree to crushing terms to secure financing. Some venture firms themselves ran out of cash, having spent it too fast in the bubble, and set aside too little to support their existing portfolio.

At the same time, entrepreneurs (and not just the evanescent dotcom crowd) have been naive about the venture process too, failing properly to understand the motivations and pressures of the venture investors themselves, and the dynamics of the overall relationship.

Even in a benign environment, the relationship between entrepreneur and venture capitalist is an uneasy one. From the entrepreneur's point of view, if a venture-backed company succeeds, he did it all, and gave up far too much equity to the greedy venture capitalist along the way. If it fails, it's because the VC did not understand the business.

In the latest downturn, the relationship soured rapidly, as a cocktail of inexperienced investors and collapsing markets took hold. Pat McGovern, chairman of IDG, the media group, observes: "Young VCs are all intellectual analysts but have no experience of dealing with people. They say, 'Ah, you've not thought of that'. What they are really saying is, 'I'm smarter than you'. This is inducing failure."

Horror stories abound. Squabbling investor syndicates have, for example, jeopardised follow-on funding rounds, with early investors unable or unwilling to advance more cash and apparently willing to let the investee company go under rather than see their interest diluted - either in exercises of brinkmanship or displays of raw ego (or both).

The readiness with which some venture investors have fired managements is another battleground. In many cases they may have been justified, but there is also the case of the country head of a pan-European venture capitalist who pointed to the CEOs and CFOs he had fired in recent months as evidence of progress.

However, if company founders better understood how venture capitalists worked, and did a fraction of the due diligence on prospective investors that the venture capitalists did on companies, they could forestall at least some problems.

It comes down to some surprisingly basic issues. Who, for example, is the client in this relationship? It is the institutional investor who puts money into the venture capital fund, not the founder of the investee company. Understanding that helps explain some standard VC behaviour.

Unscrupulous and incompetent VCs would have a far shorter life expectancy if entrepreneurs did proper due diligence on them. Yet many do very little. "Some people are too meek to do proper due diligence. They are on their knees to these people with a tin cup," says one chief executive unburdened by such hang-ups.

When negotiating the initial agreement, founders can mitigate the asymmetry of the relationship (the VC has negotiated multiple agreements, for the first-time entrepreneur everything is new and opaque) by finding out everything they can about the funding market - how much VCs are paying for companies, what are the awkward terms of the moment).

Why do venture capitalists run out of money? Entrepreneurs need to gain a better grasp of the quirks of the VC's own fundraising process, in order to furnish themselves with some pertinent questions to ask a prospective funder.

Entrepreneurs often look for the wrong thing in the first place - "dumb" money in preference to "smart" money, shorthand for lack of interference in the business. Dumb money may well keep out of the company founder's hair when things are going smoothly but it will soon reappear when difficulties emerge, and will more than live up to its name in the ensuing crisis.

Venture capital only works when it is a proper partnership - something that applied in the pre-bubble US, but was forgotten in the frenzy of the late 1990s. As Charles Waite, founder of Greylock, one of the oldest US venture firms, is quoted as saying in a recent book: "We try to hire mannerly, personable people with a good education who honestly want to make a contribution to the companies they are involved in. Most firms say they do but in my experience many don't. They'll hire the smartest people they can get, but [who] are often devoid of people skills and the ability to help entrepreneurs."

The onus is on company founders as well as the venture capitalists to get sharper, because savvier first-time entrepreneurs are a crucial part of professionalising the process of venture creation in Europe.

The writer of this article is the author of Smarter Ventures - a Guide to Venture Capital. For more information about this title or to purchase directly from Pearson Education click here.

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