Don’t Take Money from VCs Until You’ve Asked 4 Questions

Don’t Take Money from VCs Until You’ve Asked 4 Questions



In the race to get the check in hand, most entrepreneurs don’t do in-depth due diligence — or any due diligence — on the venture capital (VC) firms they pitch. Founding teams eager to raise capital to grow their companies enter into long-term partnerships with VC firms they don’t know well. It’s a risky strategy that can leave startup CEOs in mis-aligned partnerships with unrealistic expectations.

To better understand their investors, entrepreneurs should start by asking these four questions:

What is the VC’s track record?

Most entrepreneurs, if they had full visibility into the performance of each VC firm, would choose to partner with a top performer. After all, the best performing VC firms, by definition, have experience identifying and working with high-performing teams, helping startup companies grow rapidly, and guiding them through successful exits.

VC firms with poor or unrealized performance are riskier partners for entrepreneurs. They are at higher risk of losing investment partners — including, potentially, the one that championed your company — due to unattractive fund economics, such as low levels of carry. Underperforming VCs are likely to have more trouble raising subsequent funds, which means significant partner time and energy devoted to fundraising instead of to portfolio companies. They can also run into trouble syndicating later rounds of financing if other VC firms see that they are losing partners, or suspect that they are a “zombie” firm, unable to raise a subsequent fund. VCs understand these dynamics, and work hard to keep their performance numbers confidential.

Instead of looking at fund returns to judge VCs, many entrepreneurs treat a firm’s brand or logos as a proxy for performance. The narrative of this approach is that the best entrepreneurs will seek capital from brand VC firms, which will be able to invest in the best companies, and ultimately, generate the best returns. It’s an interesting hypothesis, but is not supported by actual returns data. Investors in VC funds see returns data from a wide range of firms, and those performance figures make it clear that many well-known “brand” VC funds consistently fail to generate minimum venture rates of return.

The minimum “venture rate of return” investors expect to receive from a VC fund is twice the money they invested, net of fees and carry. Entrepreneurs should remember that VC firms exist solely to generate great returns for their investors, which means significantly outperforming the public equity markets by at least 300-500 basis points annually. Most VC funds fail, by a wide margin, to deliver those minimum returns.

To evaluate a VC firm’s track record, entrepreneurs can ask about actual performance. Many VCs will be open with entrepreneurs who ask about their firm’s returns. Beware those who won’t offer visibility, or focus on anecdotes of a few good exits without addressing the fund’s overall performance. Good returns from one or two exits don’t mean great returns for the fund, and one or two “logo investments” — where VCs invest in hot companies just to add their logos to the portfolio — don’t mean anything unless you understand the amount and timing of the investment, and the valuation.

Another way to ask about performance is to determine the timing and size of the last fundraise. Firms that haven’t raised a fund in more than four years, or who are raising smaller and smaller sized funds, could have performance issues. Entrepreneurs can also find a surprising amount of VC firm performance data through public investors such as pension funds like CALSTRS, and universities like the University of Texas. These public investors are generally required to disclose the performance of the individual venture capital funds in which they invest. Rules vary by state, but if the portfolio results aren’t available online (and many are), submitting a simple online Freedom of Information Act request will allow you to obtain it. The data isn’t perfect, and it’s time lagged, but it’s better information than none.

How much money is the VC personally investing?

Entrepreneurs go all in financially when they start a company – taking relatively low salaries in the hope of big upside if the company succeeds. As a result, entrepreneurs are fully committed to the economic performance of their company. Most VCs don’t take anywhere near that level of financial risk because they don’t invest significant personal capital into their own funds and portfolio companies.

The industry standard has long been that a mere 1% of a VC fund is raised from the partners themselves, as opposed to outside investors. This lack of “skin in the game” financially insulates VCs from any fund underperformance. It also creates a misalignment of economic incentives between the entrepreneur and VC that can lead to disagreements around company strategy, fundraising, and exit timelines.

Many VCs are increasing the amounts they invest in their funds in order to signal a strong sense of personal conviction and confidence in their own performance, and create better alignment with their investors and their portfolio companies. Entrepreneurs should ask VCs how much they’ve invested personally in their fund, and run, not walk, away from funds in which the VC hasn’t enthusiastically committed a meaningful amount of personal capital.

How big is the VC fund?

Fund size also impacts the economic alignment between the VC and entrepreneur. VCs are compensated through a ‘2 and 20’ structure that gives them a fixed annual management fee of 2% of committed capital, and a 20% carry on investment profits (if there are any). VC partners at smaller funds rely on carry for most of their compensation since the management fee stream isn’t large enough to give them outsized salaries. Their compensation is closely tied to the performance of their portfolio, so they are most aligned with the entrepreneurs in whom they invest. At larger VC funds, partners lock in high salaries from fixed management fees, regardless of their investment performance.

Do you have a list of portfolio company CEOs?

Entrepreneurs should reference check any VC they are considering as an investor. Talk to at least three to five other CEOs the VC has invested in – both on and off the list of references they provide – and ask about the VC’s level of involvement, contribution to Board of Director dynamics, and where they’ve been helpful (or not) to the company’s growth, and to the CEO. Make sure to talk to founders whose companies have done well, as well as ones that have struggled. Most VCs support entrepreneur due diligence and will actively encourage you to talk to their portfolio company teams. If a VC resists the process, it’s a red flag.

These four questions offer a starting point for entrepreneur due diligence on potential investors. It’s worth paying attention to both the attitude and answers from the VC when asked these questions. If the VC you’re considering won’t openly and quickly provide answers, it might be time to ask yourself whether that VC is the right investor and partner for your company.

Diane Mulcahy is a Senior Fellow at the Ewing Marion Kauffman Foundation and an Adjunct Lecturer in the MBA program at Babson College. She speaks and writes frequently about the VC industry. Follow her on twitter at @dianemulcahy.


[Harvard Business Review]

April 8, 2016 / by / in , ,

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