Caution: Bad Partnership Ahead?

22 Jan

Some time ago our friends at PEHub ran a post from contributing blogger Georges van Hoegaerden on the subject of how best to spot inferior venture capitalists. As one would expect, the intended audience was entrepreneurs seeking venture funding. Broadly speaking, there were some good points.

To be sure, the venture community is guilty of many failings when it comes to interacting with entrepreneurs and there are plenty of opportunities for improvement — particularly in the areas of communication around timelines, assessing the level of interest in the entrepreneur’s company, and the funding process itself. I wanted to focus this post, however, on areas where entrepreneurs unwittingly damage their prospects for a capital raise. I consider these tendencies ‘warning signs’ in that once they are exhibited they usually foretell problems to come in other areas of the VC/entrepreneur relationship and many venture investors simply nip such interactions in the bud than continue to invest the time to properly vett the opportunity.

I suspect that every venture capitalist that has been at this game a while has compiled his or her own list of warning signs to look for when first engaging with an entrepreneur. While it may appear somewhat unfair for an entrepreneur to be dismissed unceremoniously early in a funding process for being guilty of one or a couple of these infractions, venture investors are human, pressured for time and bandwidth, and will lean upon their own pattern recognition to avoid problematic relationships.

1. Demanding that investors sign non-disclosure agreements without merit. I covered this subject at length in a piece, A (final?) word on NDAs, a couple years ago so there’s no sense rehashing it here. The usual VC pushback on NDAs is that (1) they expose them to liability should their firm later decide to fund a competitor (or a company that might reasonably be considered a competitor) and that (2) there is often an adverse selection problem inherent in the request itself. In short, if your idea is that easy to steal/replicate/jeopardize simply by your telling me about it, I am probably not interested anyway. Finally, and perhaps most tellingly from my perspective, in the hundreds of times I been asked to sign an NDA before seeing an Executive Summary I can recall only a handful of those occasions when an NDA might have been warranted. It’s a red flag when an entrepreneur does not understand the opportunity well enough to determine whether there is something truly proprietary that could warrant having an NDA. It tells me that the team does not really know what is important and that it might have an inflated view of the value of what they have built or are trying to do.

2. When the level of paranoia becomes an obstacle to communication and information sharing. In a continuation of point #1 above, unfounded paranoia on the part of the founding team is another red flag that comes up early and often. Intel’s Andy Grove famously titled his book ‘Only The Paranoid Survive’ . Many venture investors consider it important that their portfolio companies constantly be in a healthy state of paranoia. However, the key word here is healthy. Start-up teams need to be constantly focused on incumbents and their competitors and need to think many steps ahead lest they miss out on opportunities that might allow a competitor to steal a key customer, outflank them on a partnership deal, or make another move that could doom the company. Where things get problematic is when a founding team turns that paranoia inward and begins to hoard information, distrust its partners, block employees from speaking with investors or other stakeholders, and take other irrational actions.

If early in the fundraising process a entrepeneur appears vague or less than forthcoming about sharing key information, we will usually lose interest in the opportunity. While I don’t suggest that entrepreneurs blizzard VCs with every document in their files, it is usually better to overshare and let the VCs determine what information is most important in their diligence process than to make the VCs feel they need to pull teeth to get basic questions answered and documents provided.

3. Not understanding the fundamentals of the venture business or the firms being approached. First-time entrepreneurs would do well to spend a little time understanding the venture business before formulating a fundraising plan. I am struck by how many teams that approach us have little to no basic understanding of how the VC business works and how deals get funded. Additionally, it’s critical to do some research on the firms being approached.

4. Getting stuck on valuation at the expense of everything else. Valuation is important, no question, but I think it still takes up far too much time and attention during the funding process and subsequent negotiations. When investments are successful, no one ever remembers (or usually cares) about what the valuation of the first round was. For a company to succeed all team members and stakeholders must be aligned. That alignment comes from a reasonable valuation that is set properly and balances out the inherent risks in the opportunity to the investors, founders and employees. Entrepreneurs that turn down a term sheet hoping they will find another investor that will provide that same capital at a higher valuation are rarely rewarded for taking that risk. Similarly, a good and responsible venture firm that hopes to be around for a while would be foolish to structure a financing so Draconian that it has the effect of demoralizing the team and earlier stakeholders and hampering future fundraising prospects.

Smart, experienced entrepreneurs focus on finding the best partners, not necessarily the cheapest money. If an entrepreneur starts laying out lofty valuation demands early in the process when we are still far from a term sheet, it usually has the effect of throwing cold water on the relationship. Wait until the hook is set; then lay out a cogent argument for why you think the company is worth what you insist it is worth. You might not get that valuation, but you will have a better chance at finding the right partner and the proper amount of capital needed to accelerate the business.

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One Response to “Caution: Bad Partnership Ahead?”

  1. DS January 23, 2010 at 8:23 am #

    Excellent post. Someone on TheFunded should link to this.

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