Lessons from the Dark Side (of Venture Capital)

Next Friday I get to give the keynote/commencement speech for a group of European entrepreneurs who have come to America for Startup School. They are attending a program called Mind the Bridge, under the leadership of an old friend and colleague of mine, Charles Versaggi. Charles and I both worked for Regis McKenna Inc. once upon a time before the advent of electricity. It’s great to keep up with old friends, and fun when your work gives you a chance to reconnect. Plus I love teaching so it’s great to have this opportunity

Charles specifically asked me to give his class a talk that fits this title: Lessons from the Dark Side: Secrets of a Venture Capitalist. He gave me explicit instructions to work Darth Vader into the picture. I had to laugh because I actually own the original painting of this graphic to the right, a prized possession which hangs prominently in my house.

I thought I’d summarize here what I came up with for this talk because I know my audience includes many entrepreneurs who may find it interesting. And I know my audience also includes some venture capitalists who may find it rude. Or vice versa. In any event, here it is: mythbusters, Valkyrie style

I think it’s worth starting out with a clear statement of the venture capitalist’s job description. It’s quite simple. Our job is get money from some people, invest it in things that look like good ideas, and thereby return more money to those earlier-noted people than they started with. That’s pretty much it. While we like to think it’s our job to make the world a better place (lordy!), and we may actually contribute to that occasionally, it’s a byproduct, not the target. We may be associated with an organization that has a particular mission, and that may color the lens through which we choose our deals. But in the end it’s pretty simple: go to the office to turn small piles of money into large piles of money. Except you don’t get three wishes.

I think it’s important for entrepreneurs to be clear on that when they think about venture capitalists (VCs). There are lots of conventionally held beliefs about VCs and some of them are all too true. But some of them really are myths. I think that if the average entrepreneur were asked to describe venture capitalists they would say:

On the bright side:

• VCs have more market insight than average
• VCs are looking for the most disruptive ideas
• VCs can make money appear as if by magic
• VCs can turn straw into gold (or unicorns)

On the dark side:

• Despite striving for disruption, VCs often default to pattern recognition/repetition
• VCs are a club that has each other’s backs, not the entrepreneur’s
• VCs can be heartless, arrogant and uncaring
• VCs are generally just driving their Tesla’s around until the returns pour in, leaving the hard work to the entrepreneurs

So here’s the cold hard truth.

Yes, it’s true that many VCs are insightful; in the best case they have a lot of deep market knowledge they have gained over years of work; in the worst case they rely on guessing and/or the smartness of others. As one of my old bosses used to say, “In any group of people in every profession, half of them are worse than average.” Good news: that means half are better than average. Make sure to work with the right ones.

On the disruption front, it’s also a mixed bag. Some VCs are truly bold; they back ideas that others say are impossible. Like firemen, when everybody runs away, they run towards. They make big bets and stay all-in even when times get tough. These are the good ones. On the other hand, a very hard lesson we learn in my field is this: sometimes it’s just as bad to be too early to market as to be too late. Figuring out that balance and getting it right more often than chance is a tough game and takes ovaries of steel, as my buddy Charles pointed out. One of my favorite quotes is this one from Bill Gates, “We always overestimate the change that will occur in the next 2 years and underestimate the change that will occur in the next 10.” So true.

Because of that, many VCs are a little (or a lot) more lemming-like. They like to back the 2nd or 3rd version of the new, new thing. They may run into the fire, but they are not first through the door. As anyone who hikes will tell you, you only have to run faster than your hiking buddy, not the bear. This has proven to be an effective money-making strategy sometimes, even though it frustrates entrepreneurs.

On the other hand, being the last investor to a party can be a mess when all the potential dance partners are already taken (e.g., all the potential buyers have found their dream acquisition). It’s important to know that the whole concept of due diligence is about minimizing risk, or at least understanding it. While frustrating to entrepreneurs, you just have to get used to it. Anyone who gets married after the first date is bound to end up in line behind Brittney Spears at the divorce attorney’s office. Or perhaps I should say Kim Davis to be current.

Yes, it’s true that VCs are prone to pattern repetition. As the saying goes, if it ain’t broke, don’t fix it. This is why VCs back the same CEO over and over again, or deals that have common ingredients (welcome to the sharing economy!). Sometimes this is a good idea; trusted executives, successful business models, clearly understood sectors are all a plus. Sometimes it leads to bad behavior, such as failure to recognize a big new thing when you see it or a total inability to value diversity. Backing another 25-year-old white engineering major from Stanford who happens to have a tan and a pink shirt is not a diversity program. For those entrepreneurs who are different or who are bringing a truly out-of-the box deal, this means that the burden is on you to tell a particularly compelling story. Don’t forget to bring it when you get the spotlight.

That golden halo effect is sometimes very real. Some VCs appear to have money simply thrown at them by others, desperate to bathe in the light of their ability to turn straw into gold. But truthfully, most VCs work very hard for the money (I know you’re thinking it: so hard for it honey!). Raising a fund is no different than raising capital for a company. It involves lots of begging, proving, cajoling, story-telling, praying. Our investors measure us constantly, just as those who back entrepreneurs measure them, or should anyway. Our funds are generally pretty insecure entities—prove value before the next fund has to be raised or step aside. This happens every 4 years or so. It can, and should, make for pretty decisive behavior.

And frankly, we are entirely dependent on entrepreneurs to make us successful. Yes we can help and the best VCs help a lot. But when management fails, it’s very hard to recover and a bad business model rapidly leads to a failed investment. It’s true that investors can screw up a company, but usually that’s not who screws it up first.

But to that point, and while it is a very clubby brotherhood (or Bro-hood in modern parlance), it is a pretty dog eat dog world. VCs who invest together are friends til the end, until their own respective funds get tragically misaligned. Circumstances can change and VCs can start acting in the interests of their funds and not the company in which they have invested, even when their Board Member job description reads differently. This is how VCs can kill a company—when they get too wrapped up in their own limited lens. It can turn back-slappers into back-stabbers when the opportunity appears to make a buck at the other investors’ expense. And since it is a VC’s fiduciary duty to make money when they can, this can be a slippery slope (refer to prior job description which does not mention bringing your friends along with you). It is essential for entrepreneurs to really understand the status, funding, alignments and misalignments of their investment syndicate. Those dynamics play out in the Board room and they can be wonderful, weird or wack. Be prepared like a Cub Scout.

OK, it’s hard to argue against the charge that VCs can be arrogant. Lord knows I am probably guilty myself at times. But many of us were just like you at one time: entrepreneurs trying to get our companies built. It’s good to understand the background of the investors you align with; those with operational experience are a real plus most of the time because they can empathize with your plight.

And because of that, we are rarely heartless. VCs may walk around talking tough like the Tin Man but it is more common for them to fall in love with the companies and CEOs they back and, in the case of the latter, fire them too late when things go wrong. VCs often invest good money after bad because they are so enamored of the idea they long ago picked that they can’t see when it has grown old, fat and lazy. They follow these damaged companies right down the drain while wearing rose-colored glasses. Unless they can find their way to that Darth Vader mask, remove the emotion, and whip out the light saber before it’s too late. Sometimes you gotta be the bad guy. The startup economy is hard; bring your helmet.

I think the most interesting myth is the one that VCs back companies then sit around filing their nails (oh wait, that would be rare…) or gunning their silent Teslas waiting for the cash to come rolling in. They drive by board meetings like gang members in the night and don’t really know what’s going on at the companies. This myth is interesting because it is sometimes true and sometimes false.

If you’re an entrepreneur, you want the VCs who are up all night biting, not filing, their nails. You want the ones that boldly demand information from you (quel horror!) and are asking you annoying questions about why things aren’t going as planned; the ones that are constantly offering to make introductions and help you think about new strategies. Trust me, this is better in the long run. As my prior business partner once told me, the VC’s mantra should be “you expect what you inspect.” If you never inspect, you never cash a check. Your investors should be in the swamp with you when the going gets tough, not standing on the side in a cabana. Before you take someone’s money, talk to a few of the CEO’s they have backed before and make sure that they are going to war with you, not sitting in the foxhole while you take the all the bullets.

And for those entrepreneurs still reading, here is what your investors want from you:

• A great business, not just a great product
• Great leadership at the top
• A CEO who is a master storyteller, especially to customers
• The will to build a great team
• Truth and transparency
• Strong financial acumen
• An ability to ask for help and use it
• A murderous drive to succeed at the expense of all else
• An overwhelming desire to be rich, not famous
• Results that produce ROI

Class dismissed.