Monday, January 25, 2010

Institutional vs. "Friends & Family" Investors

Part 3 of a 3 part series on surviving the funding transition

In this final post of the series, we discuss the difference between a friends and family ("F&F") vs. an institutional* (i.e. VC) investor and what this means for a founder/CEO.  We'll start by looking at what the startup world looks like from the VC's side.

How Venture Capital Firms Work
Venture capital firms are usually structured as limited liability partnerships.  The VC firm raises money from limited partners (i.e. wealthy individuals, pension funds, etc. who put in money but are  not actively involved in the firm's management) which are collected into a fund.  The proceeds of the fund are then invested by the general partners in a portfolio of startup companies for typically 5-7 years.

During this time it is expected that some of the startups will have some liquidity event like an IPO (initial public offering) or a strategic sale (i.e. company gets sold to a corporate buyer) while others will fail.  Ideally, the proceeds from the successful liquidity events will exceed the losses from the failures and the VCs will be able to return the invested capital plus gains back to the limited partners at the end of the fund's life.  This means:
  • VCs have a fiduciary duty to protect the interests of their limited partners - This means that they are legal caretakers of their investor's money and must take all reasonable care to protect it.  They must perform due diligence on prospective portfolio companies, negotiate hard for the most favorable terms for their investors, and will use 3rd party experts to provide independent opinions to support the firm's investment decisions.  If they sit on your board, while they will have a director's duty to do what's best for the company, it will be with respect to what's best for the shareholders (not management, employees, or any other stakeholder).
  • VCs are professionals - They have the resources to conduct sophisticated financial, strategic, and legal due diligence of the business.  Unlike F&F investors, they will read the operating agreements, contracts, analyze the financials, cross-check market assumptions, and attempt to ferret out any non-compliance issues that could come back and bite the company and - more importantly - them.  They will require portfolio companies to have financial controls, insurances, and legal compliance procedures.  They will be sensitive to the fact that if one of their portfolio companies gets embroiled in a lawsuit, they are the deep pockets that a plaintiff will pursue.
  • VCs must exit their investment within a fixed time frame - VCs will expect their portfolio companies to make active progress towards a liquidity event.  Their money is not meant to be in forever.
  • Most VCs are not operational - Therefore, they will seek to maintain leverage by ensuring alignment of management incentives with those of shareholders.  They will look askance at any attempt by management and employees to reap returns before the investors (e.g. cash bonuses before the company is cash break even).  They will look favorably at anything that shows management  has "skin in the game" which to a VC means your heart and soul.
Implications for Founder/CEOs
So what does this mean for a founder/CEO?
  • First impressions start in due diligence - The first time a VC will see you in action will be during due diligence.  A smooth process will leave a favorable impression of your team's ability to execute (always a concern for an investor); a rocky process just the opposite.  Prior to seeking funding, it is a good idea to get your house in order, particularly with respect to legal compliance issues.  It's one thing not to have general liability insurance because you were preserving cash.  It's quite another not to have filed your tax returns for the past three years.
  • Your board will (likely) be professionalized - VCs are likely to insist on one or two board seats as a condition of their investment and want the board to be structured in accordance with good corporate governance practices.  This likely means a VC director, one or two independent directors (often recommended by the VC), and limiting management directors to just the CEO.  F&F directors, unless they possess some unique skill set (i.e. your cousin on your board is Marc Andreesen) will likely be dropped.
  • You are now a fiduciary - Actually if you have F&F investors, you already are.  But your F&F board probably wasn't in the habit of reminding you of your duty to shareholders at every meeting (if you even had live board meetings).  Your VC directors will.  It is a good idea to agree on and establish upfront a regular mechanism for keeping your board informed.
  • Your relationship with your board is based solely on your future expected performance - You continued tenure at the company is not based on what you've done for the company in the past or even on how you are performing now.  The only thing that matters is how you're expected to perform in the future. And expect tolerance for under performance to drop significantly about 18-24 months before the targeted exit date.  For an excellent elaboration on this point, read this post by Steve Blank.
  • Assume that any advice from your VC board member is skewed towards the interest of shareholders - And as discussed in the last post, this is not always the same as what's best for the company.  You are the pivot point for balancing off the various stakeholder's interests for the good of the company.  While your VC board members will be clear about the tangible, short term, measurables of your business, only you can factor in the intangible, long term, unmeasurables.
  • Learn to distinguish between advice, demands, and decisions - Advice and demands are opinions.  They are not decisions.  This fact often gets lost in debate, particularly when consensus is reached.  Consensus is also not necessarily a decision.  Board decisions should be confirmed by formal vote and resolution.  If in doubt, explicitly ask if a consensus opinion board is really meant to be a decision requiring a formal vote.
Overall, the toughest part of the transition for a founder/CEO is going from being the final decision maker answerable to no one to having a boss again - the board.  It may no longer be clear where the line is as to when you should continue to just make the decision and move forward vs. when you should seek board consent.

The best way to strike this balance is to view your shareholders as co-owners, which they in fact are.  While the board is technically your boss, as founder/CEO and a shareholder in your own right, you cannot act as an employee manager.  Not even your board wants this.  The VCs invested in your company because of what you and your team created under your leadership.  They still want and need you to lead.

* Throughout this post, I use "VC" as synonomous with "institutional investor."  In reality, institutional investors can also be private equity or angel funds.  I use venture capitalists as representative of institutional investors because they are the ones most likely to be engaged with early stage startups.

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