Venture Capital funding produces sub-optimal outcomes for the majority of companies that sip from the chalice, but why? Well in part it’s down to some inherent conflicts of interest.
Readers of our posts might assume that we have an issue with VCs. That’s not true. Many VCs are incredibly talented and work tirelessly on behalf of their portfolio companies. They have helped fund and support companies creating breakthrough technologies like the semiconductor, personal computing and software. More recently the VC industry has given us squashable juice pouches and robotic pizza slicing (sorry, couldn’t resist).
The conflict in venture funding doesn’t come from bad intentions – its an issue of poor incentives.
Every partner in a fund has a finite amount of time and therefore a limit on the number of portfolio companies they can sustainably support. A partner in a venture fund tends to sit on the Board of up to 10 companies (more in some rare cases). So, it follows that for every portfolio company there’s an opportunity cost – a reduction in a partner’s ability to make another investment and sit on n+1 Boards.
The average life of a venture fund is 10 years, but VC’s are usually busy raising a fund every 2-4 years. In order to raise that next fund, VC’s are under pressure to produce returns (usually paper mark-ups) in a short space of time to be able to raise their next fund. This is important because for many funds, management fees not carry are the major component of their income.
These twin incentives mean that VC’s would like to see indications of success or failure as fast as possible. If the business is successful, the valuation mark-up will help raise the next fund. If it’s not, well that’s a bad outcome, but at least it frees up partner time. The worst-case outcome is a company sort of muddling through – not doing enough to ever achieve a ‘venture scale’ exit but consuming follow-on capital (bridge rounds, possibly down rounds etc.) and partner time.
The challenge with these incentives and the pressures they produce, is that they are totally removed from what is best for the businesses these VCs are backing. Many ‘hot’ start-ups receive more money than they need, which usually ends up eroding discipline around costs. Others find themselves pushed into selling hard too early – burning through capital on marketing when they would be better served spending more time iterating for proper product market fit. Some find that the culture they strived to create has been sacrificed on the altar of growth at all costs.
Jason Fried, CEO of Basecamp, nailed it when he compared a start-up to a seed: “you plant a seed, it needs some water, but if you just pour a whole fucking bucket of water on it’s going to kill it.”
So, what to do? Well, as a founder you get to choose the game you’re playing. Awareness is half the battle here. Don’t blindly pursue VC funding because it’s the zeitgeist. Think about what your objectives are as a founder, what matters to you and what you’re prepared to compromise on. Your choice of financing structure should support your plans, not dictate them.