Not All VCs Are Created Equal

Raising capital for new ventures may have suffered a setback when the dot-com bubble burst, but that has not impeded the flow of bright ideas that cry out for funding. A panel of venture-capital experts recently met at MIT — arguably innovation headquarters of the world — to discuss venture capital today and to answer questions from an audience of inventors, entrepreneurs and others. The panel discussion, appearing here in edited form, offers practical insights not only into what entrepreneurs should look for in a VC firm, but also what venture capitalists seek from startups.

Howard Anderson: What do entrepreneurs want from a venture-capital partner? Money, right? Is your money different?

Vernon Lobo: Money is money. Entrepreneurs need someone who’ll help build the company, who has knowledge about the market space and access to similar companies, who understands financing.

Craig London: Our network of 300 companies helps young companies get customers and revenue faster. Startups that make “warm” calls instead of cold calls can get launched quicker.

Scott Lawin: Entrepreneurs need well-connected, experienced people dedicated to building the company. GSVentures wants to partner, not just invest. Look for value beyond cash.

Russell Siegelman: Kleiner Perkins offers operational experience. Any venture capitalist can write a check.

Howard Anderson: Sitting on startups’ boards, maybe you get to one company’s meetings six days a year. Is that what you offer?

Vernon Lobo: The question is: How much work do VCs do? Entrepreneurs should check references — even talk to portfolio companies that aren’t stars and see how they’re treated.

Craig London: The first criterion for choosing a VC is chemistry with your company — between the person you’ll work with and your management team. Second is how the VC’s technology fits your goals. Third is a network you can tap.

Scott Lawin: Add “alignment of interest.” Does the VC want to enrich you, not just itself?

Audience member: Is it better to take the money or wait for the right partner?

Vernon Lobo: Wait. The wrong partner will cost more. Although if you’re running out of cash, you have no choice.

Russell Siegelman: Don’t wait forever. Deals can go dry. I’m wary of deals that have been marketed for six weeks. Take the best deal out of the first three weeks and move on.

Howard Anderson: Where can entrepreneurs get advice on the arcane aspects of proposals?

Vernon Lobo: A lawyer.

Russell Siegelman: Insist that you don’t want something complex. The VC should be able to explain the term sheet in plain language.

Howard Anderson: Suppose the entrepreneur needs help filling the management team.

Craig London: Often the best managers are found through word of mouth. It’s not necessarily value-added to have a VC do recruiting — unless it’s for a CEO.

Russell Siegelman: Ask VCs if they have names that might be a good fit. Good venture people are always meeting people just to meet them. I think having VCs help recruit is value-added.

Scott Lawin: During the interview process, ask VCs, “What domain expertise do your partners have? Can they help find managers?”

Howard Anderson: Now, what do you want from startups? Before investing, how do VCs assess synergy with the startup’s management team?

Russell Siegelman: I probe to find out how people got together. Is there a shared vision and culture? Some people may have strong technical dreams, and others may be completely different — a warning signal.

Craig London: Be sure you don’t have two camps within the company. I even go to their offices and talk to the clerks.

Howard Anderson: What do you do about the B players on the management team?

Vernon Lobo: If we want to work with the company, we talk to the A-team players about the B players. When people have worked together before, the A team will have an informed perspective. We ask what they would do if the problems we anticipate materialize.

Vernon Lobo: I’d present a hypothetical problem to the A team. They might say, “He’s never leaving; what we are doing is about more than building a company.” Or they might say, “We’ll do what’s right for the company.”

Scott Lawin: Entrepreneurs who are reasonable business people understand the difference between working with your friends and building a successful company. We try to be frank upfront.

Audience member: How much operating control would your VC take on?

Craig London: We need at least 25% of the company. Most VCs take control of areas where they can add value.

Howard Anderson: OK. Now suppose an Internet grocer wants to build 10 warehouses for $1 billion. Would you try to change management’s mind?

Russell Siegelman: I don’t think VCs should have any political operating role. We’re investors. We’re betting on management to make operating decisions. However, if management is not making plan, that’s different. A venture capitalist makes three decisions. First, to invest and how much. Second and third, with the rest of the board, to hire or fire a CEO. Everything else is cajoling, persuading, presenting evidence. Watch out for investors who want a significant role in operations.

Howard Anderson: And if the startup isn’t meeting the business plan?

Scott Lawin: Cajole strongly without trying to run the company.

Russell Siegelman: If startups don’t make plan, VCs have to do something. That’s different from unilaterally making decisions.

Audience member: Do most VCs want control of the board?

Scott Lawin: If we have majority ownership, we want comparable board seats.

Vernon Lobo: Usually our board representation is minority, like our investment. But the shareholder agreement gives us a say in large capital investments — and if there are changes in the business, the CEO or compensation.

Howard Anderson: As VCs, do you put money in, then tell people they don’t own their stock anymore?

Craig London: They’d keep most of it. It depends on how good they are at negotiating.

Vernon Lobo: In the early stages, the equity holders should be people who are building the company. If a founder with 25% of the company leaves after six months, his replacement needs some equity. With reverse vesting, the remaining founders have a greater stake.

Russell Siegelman: Founders should think twice about splitting equity 50-50. One person may have the ability to add long-term value; the other may not. We tell companies we won’t invest under that scenario. They rejigger the split or we walk. Face facts upfront. Once somebody’s stock is vested, it’s nearly impossible to rip it away. The idea and the reality of starting a company are different. First-time entrepreneurs think, Wow, somebody’s giving us money to do this great thing. Two years later, some partners bail. How much equity should they take?

Howard Anderson: I like to point out in the New Enterprise course I teach at MIT, that an unprofitable company is in disequilibrium. Something will go wrong: The business plan won’t work; the product will be late, or it will be the wrong product; a crucial customer will make impossible demands. Some team members are used to large staffs to help with pricing models or whatever. There’s a 75% probability the team won’t be together in three years.

Audience member: If a VC wants to turn our stock into an incentive stock-option agreement, how can we limit loss of stock?

Howard Anderson: Make the business plan. If you get in trouble, let your board know early and propose a solution.

Vernon Lobo: Do due diligence on what kind of people the VC partners are. Do they take unfair advantage of entrepreneurs when the going gets tough?

Audience member: Should we choose a strategic investor or VC?

Craig London: Both. Strategic investors may become customers — even acquirers. Having a strategic investor validates your model. From an operations perspective, it might be better to go that route first.

Howard Anderson: Be careful, though. Strategic investors sometimes have hidden agendas. Intel might demand things a financial investor wouldn’t. And if you deal first with a strategic investor who’ll become a customer, other customers may avoid you.

Russell Siegelman: Get pure financial players first. Then the outside strategic investor will know it can’t twist your arm. Also, the strategic investor’s agenda may make it hard for VCs to come in later. Use a VC, then raise money from a strategic investor later at a higher valuation.

Vernon Lobo: Strategic investors make you jump through more hoops.

Russell Siegelman: If you think VCs’ term sheets are complicated, try Intel’s.

Howard Anderson: The experienced VC is used to problems and knows how to stick by companies. The strategic guy says, “Oh, problems? Time to run.” The same with angel investors. On another topic, Scott, suppose Goldman Sachs has a strategic relationship with your startup and wants it to standardize its software. Would you be happy?

Scott Lawin: No. I’d want the entrepreneur to do many things with the software. Goldman Sachs wants a financial-service product, and that’s it.

Russell Siegelman: Strategic players help with channel share, customers or even technology. But first, entrepreneurs should negotiate an operating agreement. Be sure that interests are aligned before you let the strategic guys invest.

Audience member: What are the pros and cons of VCs who have invested in companies that could become your strategic partners and customers?

Vernon Lobo: That’s a criterion. Investigate. If the VC has such contacts, you can say, “Here are ways you could get synergy between our company and your other companies.”

Audience member: What about building an investment syndicate: VC firms working with other VC firms?

Russell Siegelman: For you, there’s value, but the venture guys might balk. Syndication makes it harder for us to get the right percentage of ownership. We’ll join only if you’re willing to sell 40% or 50% of your company.

Scott Lawin: In a syndicated deal, you need at least one VC who is committed to working with you when problems arise. Cut it up too fine, and the law of diminishing returns takes over.

Audience member: If we gave up 50% of our company to syndicate with two good VC firms, would one get passive after a while? Would we be better off having just one VC?

Russell Siegelman: It depends. I’ve been on a board with Benchmark Capital for several years. We work equally hard. Frankly, if any board member isn’t delivering, ask that person to leave.

Howard Anderson: Oh, the hardest thing is to get rid of VC board members. They stick around until they smell like last year’s cheese.

Audience member: Do VC firms ever have competing investments managed by different partners?

Russell Siegelman: We try not to. Sometimes we invest in a company that changes its business plan and ends up competing, but we wouldn’t allow it going in. Life’s too short.

Scott Lawin: Our pockets of investment dollars vary. Some are 100% Goldman Sachs money, some are less. We would not intentionally have 5% in one company and a big investment in an early-stage competitor, but we can live with it.

Howard Anderson: Do you sign nondisclosure agreements?

Scott Lawin: Later on in the process.

Howard Anderson: VCs do want to see that business plan first — the secret recipe.

Audience member: Why should a soft market lower our valuation?

Russell Siegelman: Same reason a bull market raises valuations.

Howard Anderson: VCs look at what’s comparable in the market. A soft market means it will take longer to get liquidity. Let me ask the panel, what was your internal rate of return on investment in 1999?

Russell Siegelman: Ours was incredible. We had Juniper Networks.

Howard Anderson: 600%? You have to report it to your limited partners.

Russell Siegelman: You’re not my limited, Howard.

Howard Anderson: Will your late ’98 and early ’99 investments have lower IRRs when they’re liquid?

Russell Siegelman: Absolutely. Look how many companies trade below their IPO prices.

Audience member: What is Safeguard’s incubation strategy?

Craig London: Young companies need operations assistance. They have trouble getting and keeping qualified engineers. The Safeguard family has more than 40 “captive” engineers for software and hardware design. The value of incubating is not in providing shared T-1 services. That’s ridiculous. The value is in captive resources and advice.

Howard Anderson: Don’t discount angel investors. They’re not as demanding as VCs, often have time to help and can tap their relationships.

Russell Siegelman: It’s a detriment that angels “are not as demanding.” I won’t invest where angels have invested at a high valuation and done nothing.

Scott Lawin: It can get ugly when you’re negotiating a VC round and angels demand a voice.

Howard Anderson: Some angels run away in tough times. VCs charge a little more, but they are long-term investors. If you need multiple rounds of financing, having a credible VC on your side carries clout.

Audience member: Many VCs focus on minimizing their portfolio’s downside. Shouldn’t they be maximizing the upside?

Russell Siegelman: Yes. If VCs wanted mainly short-term dollars, we’d resign from underperformers’ boards. We don’t. Why? First, we’re working with people we want to work with again. Second, we’ve seen $7 million write-offs that later gave us 300% returns.

Howard Anderson: We also have an emotional investment.

Vernon Lobo: And a reputation to uphold. If something goes awry, we blame ourselves, too, and want to help fix it.

Russell Siegelman: VCs shouldn’t let underperforming companies suck up all their time, but we generally err on the side of staying involved.

Audience member: Do you prefer entrepreneurs whose family and friends have already shown trust by investing?

Howard Anderson: Yes, it shows Mommy loves you. Seriously, people have to get started somehow. You may not be able to take a second mortgage or to go without salary temporarily. But avoid VCs that are spread too thin. As the economy gets worse and liquidity becomes more difficult, VCs will spend more time and money on current portfolios. You might prefer a new fund. You need VCs with bandwidth and time.

Now it’s time to thank the panel. Thanks for not just talking about how your money is better. Thanks for getting to substantive issues that really can help entrepreneurs.