Tuesday, September 25, 2012

Driving Forces Behind Startups

Not all VCs are created equal, however….

It turns out my gut feeling was probably correct. A newly released research by Shikhar Ghosh, a senior lecturer at Harvard Business School, shows that almost 75%-95% of VC backed startups fail. VCs would normally say that only 30% fail and the rest simply did not bring the expected results – big difference.

I founded few VC backed companies, and although my sample group is relatively small for any statistical relevance, I have been interacting with many other entrepreneurs over the years and kept hearing the same mantra, which is “VCs suck the life of companies”.

VCs typically (in spite whatever you think when you are funded or been told) work against the company instead of what seems logical to assume. The problem is they pull in different directions so the sum of all forces zeros out, in many cases they talk about extending runway on one hand and what they mean is for the founders to work for less, while they keep sending invoices for first class flights to board meetings (true story).

There is a whole ritual in the VC process, where initially VC and founders fall in love. Later if success is slow to come, they try to force changes. If success comes too fast, they get greedy and may block an exit, or even worse, try to take over bigger parts f the company by blocking next round depleting the company cash reserves only so they can offer a bailout bridge loan in bad terms for everyone but them. This triggers a whole company-VC hate cycle, where VCs try to replace the Founder/CEO and founders try to bring other VCs to reduce the power of exiting VCs, and the cycle repeats.

However, I think the problem lies at a deeper level than that. I recently raised my hand at an event to ask a panel of investors if they can envision a scenario where they invest with no preferences, I.e. everyone in the company, founders and investors alike, will have common shares. I did not have to wait a second; all of them, without any hesitation said NO, Never. They could not even envision something like that.

[As a side note: The preferred stock held by investors has more rights and privileges than the common stock issued to Founders. The most important rights that affect badly the founder up-side, is the right of the VC (preferred shareholders) to get paid before the common stock holders. If the company is acquired, the preferred stock holders will be paid first. Then, if any money is left over, the common stock stockholders will be paid in a prorated fashion, (i.e VCs get yet another dip).

As usually defined, the amount paid to the preferred stock holders is usually a multiple of the amount invested. For example, if Series A stock is sold to first-round investors for $1/share, the preference amount for that stock is sometimes a 4X multiple of the share purchase price.

Common stockholders should care about the preference, because that preference is "ahead" of the commons in any acquisition outcome. For example, let’s assume that the company raises $5m dollars by selling 5,000,000 shares of Series A preferred stock with a 4X multiple. That means that if the company is acquired for $20m (or less), the preferred stock holders get all of the proceeds and the common stock holders get nothing. In other words no upside to the Founders for exit of less than $20M even if they own 75% of the company]

Since in my past, I happened to be a co-founder of a company that was organized with common shares (and eventually went public at NASDAQ), I can tell you that the same love-hate cycle existed even when everyone had common shares, however the fact that parties had relatively equal “power” created a balancing force. It did two things, first it enabled the founders more maneuvering space to succeed in spite the investors greed, and second it protected the one common success factor everyone forget about, and that is the Founders’ upside.

Taking the upside from the Founder strips the company from its main driving force and converts the company from a potential success to a company with large chance to fail. I believe that this survey reflects that.

I believe investors should re-examine the assumption that they must have preferred shares, and start testing scenarios where everyone has common shares and where the founders are so motivated to make thing work that they increase the chances to succeed tenfold.

If VCs will see more success, they will become less greedy, interests will start to better align between Founders and VCs and with everyone pulling in the same direction chances are that more startups will succeed. The question is now which VC will be the first to create and lead that trend.

VCs often say that like horse track gamblers, they bet on the jockey not on the horse. If I to continue that analogy, I guess placing a nice juicy carrot in front of the jokey can dramatically improve the odds of winning the race.

What do you think?