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07/17/2007

Understanding Why Your VC Is Acting Crazy

One thing that many entrepreneurs don't fully appreciate is just how much the financial and organizational dynamics within a VC fund can affect how a VC behaves on their board. Over the years I have heard many stories from entrepreneurs expressing various degrees of frustration and mystification over a position taken by their VCs, usually with regards to an upcoming financing or an M&A transaction.  For example, in some cases a VC that has been very supportive about patiently growing a business all of a sudden becomes obsessed with selling the company or in others a VC that has been aggressively pushing the company to grow quickly all of sudden becomes extremely cost focused and lobbies hard to cut the burn rate despite the fact that this will kill growth.   After witnessing such abrupt changes in attitude and direction, many entrepreneurs are left scratching their heads wondering "What the hell is going on with my VC and why are they acting so crazy?"

The answer to this question can often be found by simply getting a better understanding of the current financial and organizational dynamics within a VC's fund, as these issues can have a profound impact on how a VC and/or their fund approaches a specific investment.  With that in mind, here is some specific advice for entrepreneurs in terms of what questions they should be asking VCs and what information they should be monitoring.

Financial:   There are several key pieces of financial information about a VC fund that you should do your best to determine before taking VC money and should regularly monitor once you have taken money.  These include:

  1. Fund Size: First, you should know how big the specific fund that is investing you is and you should calculate what % of that fund is likely to be invested in your business.  The bigger the % of the fund invested in your business, the more important the investment is not just to the individual partner on your board, but to all the partners in the fund.  Being a large piece of a VC's fund can often be a double edged sword .  While it usually makes it easier to raise follow on financing, it also makes the VC more downside focused and very sensitive to any deceleration in business momentum.  Conversely, if your company accounts for a very small percent of the fund, don’t be surprised if you don’t get a lot of love and attention from the fund and be forewarned that the fund will be much more willing to shut down the company or sell it off at a loss if you hit a big rough patch as the financial impact of such a loss will be limited and the effort required to “save” the investment would be better spent on the “bigger bets”.  This logic plays out not just at the fund level, but often at the partner portfolio level.
  2. % of Fund Called:  When a VC says they have a $500M fund, that doesn’t mean they have $500M sitting in the bank, it means they have $500M in contractual commitments and that they can “call” on these commitments whenever they find a worthwhile investment.  As a general rule, you are better off taking an investment early on in a fund’s life ( <20% called) than you are taking when its 75% called.  That’s because there is plenty of money available for both new and follow-on investments when a fund is 20% called and also plenty of time available for those investments to perform before VC’s will find themselves groveling in front of LPs trying to raise another fund.  Typically when a VC fund has called about 75% of their fund, they start fundraising for their next fund.  Like mating season, VCs in the midst of fundraising season tend to behave a little strange and have a heightened sensitivity to any M&A overtures that would result in any kind of positive exit for them.  Thus, don’t be surprised if your VC all of a sudden seems very interested in exploring that half-baked offer from your crappy competitor.  You should also not be surprised if the same VC that threw around money like a drunken sailor when they were 15% called, transforms in Scrooge when they are 90% called as the last 10% of the fund will typically be subject to a Darwinian struggle within their firm.
  3. Fund Performance:  You should try to keep track of how the specific fund that invested in your company is performing.  In general, if that fund is knocking the lights out, the fund will tend to be much looser with the cash and your specific VC will be much more pleasant to interact with.  However, you should be aware that in funds doing extremely well, it’s even easier for VCs to abandon small under performing investments because it won’t hurt their pocketbooks that much and they have an incentive to do a little “spring cleaning” as it will enable them to help justify raising a new fund.  Conversely if their fund is doing poorly, expect the VCs to be much more dilution sensitive when raising incremental money and expect them to much more ready to sell out for even a modest profit, especially when/if  they are preparing to fundraise.

Most of this financial data is not publicly available, so the only way you are going to get it is to ask the VC partner you are dealing with or cozy up to one of the LPs in the VC fund.

Organization:  As with financial information, you should also keep careful track of some key organizational data within a VC firm including:

  1. Pecking Order:  Some VC firms have very clear hierarchy’s while others don’t.  In the case of a clear hierarchy you can just look at the titles on their “About Us” page to see who is likely running the show.  In cases where everyone has the same title, you can generally determine who holds the most influence by determining which partner  has been there the longest and/or which has the most investment success.   Make sure to ask any VC you are taking money from how long they have been with the firm and what deals they have done.  Why does this matter?   Because VCs with tenure and/or strong investment success tend to have an easier time of pushing through both new deals and follow-on fundings, especially when it’s a close call.  Having that kind of pull on your side can make a big difference if your business hits an air pocket and needs to raise an insider round.  Conversely if the partner on your board is new to the fund or has been putting up goose eggs for the last 5 years, they will generally have a harder time getting financings done within the partnership.
  2. Size of Portfolio:   The number of deals that an individual VC partner is responsible for will often have a large impact on just how much value and support you get from a VC.  If a VC is already on 10 boards, don’t expect to see them devoting 20 hours a week to helping make your company a success.  For some entrepreneurs this is exactly how they like it, but for most this can be frustrating when you really need a specific introduction or piece of advice.  Size of portfolio can also impact how easy/hard it is to raise money from a VC.  A partner with 10 boards is likely to apply a pretty high screen to doing an incremental deal, while a partner with just 2 boards likely feels pressure from within the partnership to do more deals and thus is likely to have slightly lower standards.  Once they make an investment, a partner with 10+ boards will probably have a tendency to bail more quickly on poorly performing deals than one with just 3 because the one with 10 has to triage their time and can always justify killing off a poorly performing deal if it means that they will have more time to spend at their biggest potential winners.  In general, it’s a good idea to keep track of the other boards your VC partner sits on and how those companies are performing.  Their bad mood at your board meeting may be result of another company’s performance and not your own.
  3. Firm Messaging/Focus:  VC firms tend to evolve their market positioning and messaging over time, usually in response to wherever the most money is being made.  Early stage firms start doing late stage deals, technology firms start doing media deals, Austin firms start doing Dallas deals, etc.  You should make sure that your company’s positioning in terms of stage, geography, and sector focus is consistent with where the firm is heading.  When raising money, definitely take this into account as this will prevent you from wasting your time with a firm that really has no intention of investing in you.  After taking an investment, monitoring this will give you a sense of how committed the firm is likely to be to your company and may help explain strange changes in attitude or outlook on the part of the firm and/or your particular partner.

In closing, when trying to figure out just why a VC is acting "crazy", you can’t just think about the problem in terms of your own company (although it may indeed have everything to do with your company), you have to consider the financial and organizational factors that the VC is dealing with within their own firms.  Once you get an understanding of this, you still may not like what your VC is doing but at least you will have a better understanding of why they are doing it.

July 17, 2007 in Venture Capital | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.