Tech's Smart Money, Dumb Money and Worst of All: Malignant Money
Entrepreneurs raising funds from angels or venture capitalists often focus on the difference between "smart money" and "dumb money." Founders go after "smart money," that is, investors who can provide strategic guidance and assist with introductions. They avoid "dumb money" investors who offer a check with no additional value.
While that's a reasonable goal, it's far less important than seeking out "benign money" and avoiding the curse of "malignant money."
Entrepreneurs tie themselves with alarming frequency to investors who are actively harmful to their company. Just as the body can have a malignant tumor, companies can have malignant lines on their cap table. Start-up investors typically have tremendous power over their portfolio companies, generally over a period of many years.
There are many ways investors can damage entrepreneurs, but here are some of the most common.
1. Wasting the entrepreneur's time
Investors often demand huge amounts of time from a management team, especially right before, during and after a board meeting. Entrepreneurs often spend one to two days per quarter preparing board material -- much of that time spent making PowerPoint presentations look pretty. Investors will often ask entrepreneurs to undertake extensive market analysis or scenario planning exercises that management knows are worthless.
2. Misaligned Financing Plans
It's fairly common for venture funds to push more money on a company than they might like to accept. Venture capitalists may have ownership targets that they've promised their limited partners, or they may need to deploy a certain amount of money per investment to match the size of their fund. Overcapitalization can lead to undue dilution for founders, or spending too much too fast without sufficient thought or oversight. Overspending forces entrepreneurs to return to their existing investors, hat in hand, giving the source of malign capital even more ownership and control over the company. While less common, sometimes malignant investors will prevent a company from raising sufficient capital, for fear they might be diluted.
3. Misguided demands for top line growth
Since many companies are sold for a multiple of revenue, it's common for investors to judge the success of a company based almost exclusively on top line growth. Investors often push companies to beef up sales operations before product-market fit. Frequently they push entrepreneurs into new markets that might be inadequately understood, overly competitive, or even conflicting with their existing customer set.
4. Poor timing of liquidity event
Venture funds typically have 10 to 12 year lifetimes. That means they are sometimes obligated to exit their portfolio companies before those companies are truly ready for a liquidity event. Hopefully over time secondary markets will become more robust, allowing funds to have a liquidity event for themselves without forcing the company overall to sell or IPO. But until those secondary markets mature, it will be a relatively frequent occurrence that venture funds force a company to sell itself even when the time is not right.
5. Wrong board member
The best board members have the experience, wisdom, network and time to provide tremendous value to the company on the board they serve. Often the ideal board member is out there somewhere, but he or she is rarely serving on the company's board. That's partially because a large number of board seats are occupied by whichever partner at the venture fund drove the investment.
So why do VCs insist on occupying board seats? They're generally not stupid people. They know there are better potential board members out there. The reason they occupy these seats is precisely because they know that the interests of venture firms and the companies they fund often diverge -- and they want to have a seat at the table to represent their firm at precisely those moments.
Many venture firms style themselves as entrepreneur-friendly. Some truly are. But too often they act as though their real allegiance is elsewhere -- their limited partners, their desire to be associated with the next Facebook, the hope to look smart in front of other venture capitalists. It's regrettable that TheFunded, a Yelp for venture firms, has receded in the last few years. Hopefully we'll find new mechanisms to call malignant investors to account.
In the meantime, entrepreneurs must beware of malignant capital. It can come with brand names, high IQs, and great Rolodexes. But unlike passive capital or the dreaded "dumb money," it can severely undermine great companies.
This article was also published on TheStreet.