Finding Genius Page 14
Now, several years later and as an investor on the other side of the table, Martin says he has empathy for investors because they are often transparent about their goals at the beginning of a funding relationship. Entrepreneurs, at times, can have tunnel vision when raising money and often accept capital even if it may not be the best for the company in the long run. Brett says:
“The reality is that VCs and entrepreneurs are simply structurally misaligned: VCs have a portfolio strategy whereas entrepreneurs are ‘all in.’ Different strategies create different incentives. My point is that everyone should be aware of and acknowledge these fundamental differences. Doing so will make it easier to understand the other sides perspective and actions. Alignment is not just having a good rapport with your investors but understanding how they are set up structurally. Being misaligned is catastrophic. If they’re partners in your business, operational or financial, having them misaligned with you will make your life hell and be a distraction/annoyance at the least, and rip your company apart at the worst. As an entrepreneur, you’ll hear about the portfolio nature of investors. When you’re an entrepreneur, you’re so ‘tunnel vision’ and thinking about your company/business and that’s the center of the universe to you. They’re often not in the same place and the quicker the entrepreneur understands that, the better.”
While in the case of Uber, the stakes were higher than normal and the breaches of trust were largely unethical, it exemplifies a misalignment that may have taken shape in the early days of the venture, with few people willing to challenge Kalanick. With Martin — and founders who have found themselves in his shoes — the misalignment comes from a naivete of how venture capitalists are motivated or incentivized, how decisions are made and what theses drive those decisions, and how venture funds are structurally set up to maximize returns for a group of investors. All of these elements are largely unknown to the founders themselves. For the purpose of transparency, it is important to look at where alignment begins to fall apart and how entrepreneurs can prevent this from happening. How can genius truly thrive and work well with venture capital?
Venture capital in itself has become a sexy asset class that some entrepreneurs believe to be the most important validation of their businesses. This is a complete fallacy. This notion is due in part to the stardom achieved by some VCs and the importance placed on large financing rounds in the popular press. Nicholas Chirls of Notation expands on this:
“…many venture capitalists have turned into mini celebrities. Chris Sacca is on television. Ashton Kutcher, Kevin Durant, Leonardo DiCaprio are now investing in startups. Fred Wilson has become a legend amongst people within the startup ecosystem and beyond. A lot of these people tend to be great people to be involved in a company, but to some degree, there is a perception that if you can raise money from these folks, you’ve somehow made it already. You can talk to any of these same investors, and they’ll tell you that most startups will fail regardless of whether or not they raised venture capital. Venture capital is an expensive and highly dilutive source of capital. There are cheaper forms of capital, but as a founder, those sources of capital are largely unknown because they don’t market themselves the same ways VCs do. Venture capitalists market themselves really well so that they are visible, that they become the first choice of capital, but there’s a huge over-reliance on venture as a capital source.”
Yes, entrepreneurs should be aware of other sources of capital that exist and that venture capitalists, focused on greater valuations, may not be the best partner for a founder who is looking to establish a company with gradual growth. Moreover, it’s time for entrepreneurs to take venture capital and the venture capitalists themselves off the pedestal, as what dictates the success of the startup. In the next chapter, where I cover the future of venture capital and new forms of financing, I elaborate on some of these other capital streams and how venture capital continues to become a commodity.
While I’ve touched on valuations several times throughout this book, it can be difficult to quantify or accurately describe the pressure that comes after raising venture capital, and the impact it has on the psyche of a founder and executive team. I meet with founders who fearfully discuss their takeaways from investor calls and the pressure their investors put on them to spend more money. The venture capital model is built on this model of spending capital quickly in order to fuel growth. Venture capitalists want to hear that the founders they have invested in are taking calculated risks and bets on areas of the company that have shown promise. They want to see the founders spending capital, and not saving it. That is the purpose — that this is a brief, pressurized experiment to see if a business can take off by throwing capital at the problem. Less sophisticated investors will often chastise founders for not spending their capital, even if the metrics of the business are not improving or the founders need to take a step back to reassess where to invest.
I spoke with a founder who recounted this pressure. She felt that she was not being given sage advice from her investors who were pushing her to raise another round of financing, even though she did not need the capital. Many times, this kind of scenario comes down to a valuation, where the investors are looking for the next step-up in a company’s valuation so that they can a) put more of their own capital to work; b) report back to their LPs that their companies are continuing to become more valuable; and c) help the founder realize a greater valuation on the company, even if it is not yet justified. This is an issue I frequently see come to a head, and it often leads to an alignment issue not only with a founder and their investors but also with their early founding team.
Beth Ferreira of FirstMark Capital brings extensive operating experience to her role as an investor. Prior to joining the venture capital community, Ferreira was COO of Fab, an e-commerce company that at its height was valued at over $1 billion, but ultimately was rumored to be valued at $15 million. Ferreira also ran operations at Etsy. Given her experience at both of these venture-backed companies that saw swings in their valuation, Ferreira discusses how venture capital and valuations often become a slippery slope to maintain:
“Companies can fail because of their investment strategy. It’s really hard to get off the fund raising train when you’ve raised your first round of capital ahead of your traction at an outsized size or value. I got to Fab when we had $10 million in invested capital and within six weeks of my arrival, we raised another $50 million. At the time of that financing round, the business was working but when we tried to accelerate that with more capital, it was too early to do that, and things started to break. We had a big valuation, a lot of capital invested, and the conversations internally and externally turned to how the management team is going to live up to that valuation. The company began to make decisions that were premature or a stretch for the business to execute.”
As I learned from these conversations, the founding teams in these situations stop protecting what has been built, and instead begin pushing the envelope and making gambles going forward. Ferreira talked about how this played out at Fab:
“With Fab, we had a business that was 70% optimized in the US with lots of momentum and positive indicators on how we could get to of owning outsized market share in the US. We were doing things right compared to competitors. Then we raised a ton of capital ahead of our traction, and started to look to manufacture growth, expanded into more categories and entered Europe prematurely. This was the result of pressure that management just told everyone the company was going to be a $1 billion company in five years and now need to find a way to get there.”
These are important areas that both venture investors and founders must understand to get aligned early on and identify what outcomes are most important for each side of the equation. Venture capital, in its chase for Uber-like returns, places an expectation on a company to grow at an accelerated pace. In an effort to demonstrate outsized returns for their investors, a venture capitalist has duties that go beyond the founder and will do what it takes to find
those returns.
Founder-Friendly VCs and Establishing a Board of Directors
In 2019, venture capital funds now tout the term ‘founder-friendly’ on their websites to advertise that the terms of their financing and their diligence or management method will be in support of the founder. While this is certainly an ideal, and a goal that venture funds strive towards (as measured by a higher NPS), it is a tough balance: it can be difficult to manage the relationship with a founder and be ‘founder-friendly,’ while also managing the fiduciary duty to the LPs. Rick Heitzmann of FirstMark Capital discusses this dynamic that, in his words, leads to the lack of diligence on an investor’s part and making investments without doing the necessary research:
“In the last cycle where companies were being funded that very clearly should not have been funded, ‘founder-friendly’ was the thing most VCs wanted to be called. These VCs viewed ‘founder-friendly’ as not asking entrepreneurs the tough questions which ended up being a huge disservice to the LPs and the entrepreneurs themselves. Great entrepreneurs want to be tested with the hard questions and want an investor and Board member that it will to challenge them in a constructive way. In addition, entrepreneurs have to understand that my job is to service them and that they’re my customers, but also, I have a fiduciary duty to my LPs who are investing with college endowments, the pensions of policemen and women and driving medial research, because they want to earn a return on this money — often times with a double bottom line impact. They’re not doing this to make friends with entrepreneurs. We have the fiduciary duty to drive high returns and that return is by not only doing good things but also sometimes doing hard things. We want to be known as fair.”
The board of directors of venture-backed companies becomes a founder’s strongest weapon in making strategic decisions. And it’s important that entrepreneurs use this group of experienced individuals as confidantes to move a company forward. Ilya Fushman of Kleiner Perkins believes that like the role of a founder, the role of a board member is continuously evolving as a company scales. Fushman says that he observes where the company is in its lifecycle and in the early days, he sits in the back seat when the founder has strong conviction on product or vision. During this time, he helps founders think critically about what is ahead of them and helps founders add to the team or build processes, but really he just lets the founder drive the company forward. Over time, Fushman thinks the board should help the management team think about what the next level of scale or opportunity requires and begin offering more input. Beth Ferreira expands on this evolving process:
“The relationship between a venture investor and an entrepreneur should be an open conversation and the investor should act as a sounding board for the founder. The founder should be comfortable that this person can operate as a consigliere in the best or worst situations. A founder should be comfortable with it being their first time and can turn to their investment partners to figure out how to be prepared, or how to think about the world and where their product can or should be iterated on. They should have scenarios laid out in front of them by the investors with the upside to each avenue or scenario and what the value proposition is to the founder. If as an investor, I’m not doing that, I’m doing a disservice to the founders.”
In contrast to his roles as an early executive at many of the well-known technology ventures, Keith Rabois discusses how his role evolves as a board member:
“My role as an early employee was very different than it is now that I am a board member. It evolves. Part of it is a bit like playing psychologist where you can give the founders and executive team someone to talk to and to clarify their own thinking and vision. The law school version of this would be a Socratic dialogue. Fundamentally, the role of a board member is about asking the founders and the management team questions that allow the founding team to better understand their own thinking by responding to their questions. It’s a cartoonish mirror: you hold up a mirror to the company to play back what you’re hearing in an exaggerated way, by exaggerating to the founding team what you are hearing — what the team wants, what they don’t want, and what is being lost in translation. It’s a combination of mirror and psychologist, staying out of their way, helping to clarify thoughts and vision, and removing roadblocks to their success where possible.”
The board, according to Ellie Wheeler of Greycroft, is also responsible for helping the company mature at each stage by coaching the founder and bringing in the right talent to support them as the company scales. As many of the investors noted, much of the venture capital business from a board member perspective is a matter of seeing patterns play out repeatedly from one company to the next. Access to talent remains a consistent and evolving challenge. The amazing hire that was brought in to scale the company for the first 180 days may not be the right person for the next 500 days or beyond. Keeping a structural understanding of the business and what the founder needs at each stage is a key area of support board members provide. Wheeler says:
“On the lifecycle side, the team you start with isn’t the one you end with. Typically, as the company scales, something breaks or is in the process of breaking before it’s recognized. As a board, from an experience standpoint, we should recognize problems that may not exist now but are looming in the distance, and help the founder get ahead of those things — through talent acquisition or organizational design. The brute force required to start a seed company worked, but now we need to build an engine to scale. That is a common role for board members in any sector. For example, with SaaS businesses, what gets a company from $0 to $3 million in Annual Recurring Revenue (ARR) will likely be founder-driven sales. The company may have a handful of sales folks and an early VP of sales who had relationships and won deals narrowly. But as you scale, the company needs to get to $20 million or $60 million of ARR, so that machine looks very different. The board should be there to help the founder understand the different phases of the business, what kind of people you need around the team to bolster them, and those are the conversations you’re going to have with any kind of business in any sector.”
As an early-stage investor, Wheeler is also focused on the journey of the early leadership team. She says:
“I always am looking to understand if the leadership team can make the entire journey through the company. I want the original founders to make that journey, but you need to be a different leader in the early days when you know everyone in the organization, are involved in every decision, and are still in charge of every department. The business evolves and to be a part of the business where you don’t know everyone or aren’t involved in those decisions is a big change for some founders and something, they need to be aware of.”
Keith Rabois of Founders Fund, who has been an early employee at multiple successful startups, shares his thoughts about how board members can complement leadership early in a startup’s lifecycle:
“My role has always been the same as the complement to the founder. Different founders have different skills or traits. Some are product-driven founders, some are technical-driven founders, some are sales-driven founders. Some are atrocious managers of people and some are great managers. I’ve learned that my role is to always be the complement to that. I try to figure out what the person likes to do and is good at and provide support in other ways. I worked for Reid Hoffman, Jack Dorsey, Peter Thiel, Vinod Khosla, Max Levchin and they’re all different so they all require a different complement. It’s not so easy. You need to be fairly broad, with a horizontal skillset. You need to be very sharp so you can keep up with these brilliant people. They have no patience and speak succinctly so you have to fill in the dots to accomplish their vision. It has to be a derivative viewpoint about your role. It’s not your vision, it’s theirs. You have to have that humility that you’re working to accomplish their vision. My job is to make sure the vision doesn’t get screwed up because a lot can go wrong, and I want to help deliver the missing pieces. The missing pieces vary from company to company; some un
derstand technology, some do not, some are good recruiters, some are not. To do the role well, you have to block and tackle their vision, identify the gaps from the skillset of the current team and inject yourself in the most acute areas of need. At Square, unlike at LinkedIn, the revenue model was obvious, and we didn’t need someone to conjure up a business model.”
Transparency at the board level is another quality that entrepreneurs should strive for with their boards and their investors. Jonathan Teo, formerly of Binary Capital, made investments in companies such as Snapchat and Grubhub. His approach to investing was to build the relationship and learn about the problems of a venture prior to making an investment. He explains:
“Typical in the venture community, the first board meeting is where all the bad stuff comes out. We want to build a relationship with the founder where we do our diligence and back work and get to know the founder for as long as possible; where they turn to us as a confidante and feel comfortable sharing the problems with us, long before we invest. We want to be deep in the weeds of the company and figure out how to move forward now that we know all the bad stuff and know what to be aware of. Doing it this way, we’ve found much less conflict and that we’re actually more aligned.”
The relationship between an investor and a founder is not always a story of kindred partnership. Yes, those do exist but they’re not the norm. The reality is that, if not aligned properly, this is a partnership that can end in disaster. It can end in legal disputes similar to the ones recently documented around Uber’s founder and CEO, Travis Kalanick, and his investors from Benchmark capital. The high-profile venture-backed startups with an absolute disregard for investor capital culminated with Theranos and its founder, Elizabeth Holmes, who deceived her investors into financing the company to the tune of $900 million against the bold claim that she could revolutionize blood testing. In other and more private anecdotes shared by the venture investors I spoke with, some distanced themselves from companies they knew to be toxic or rampant with fraud or abuse. At times when they were needed the most, investors walked away from companies after making an investment when they felt the company could no longer generate the returns it needed to. Perhaps, in most of these cases, the venture investors themselves were not the trail-wise sidekicks, but instead profiteers watching from safety miles away.