Is Your Startup Ready for a Venture Capital Partnership?
Welcome to Spencer Trask Perspectives, a monthly interview series with our CEO Bill Clifford and writer John Essick. Mr. Clifford has generously agreed to share his unique insights and expert opinions on topics such as business development, deal flow, C-suite management, startup culture, entrepreneurialism, and more. We welcome your feedback, and encourage you to submit questions to askST@spencertraskco.com for Mr. Clifford to potentially answer in future articles.
Venture capital firms play an important role for young companies ready to take the next step in their evolution. In 2018 alone, the venture capital industry invested over $131 billion in new startup companies in the US, placing that capital in 2,123 new companies. Today, Mr. Clifford discusses the best timing to seek out venture capital funding, and how to find a VC firm that is the right match.
John Essick: Is it a foregone conclusion that most startups will require the funding support and managerial guidance that a venture capital firm can provide?
Bill Clifford: The whole subject of venture capital and its role in nurturing the growth of early stage companies from their earliest inception (which can literally be from a couple of design drawings on a napkin, up through and including a listing on the New York Stock Exchange) could fill a book. That said, a well-chosen and solid relationship with a VC partner could be the single most important and rewarding decision a founder/entrepreneur makes in the lifetime of their enterprise.
Whether and when to approach a VC firm is the classic dilemma faced by all founders when dealing with venture capital or any other external equity investors. Accepting external equity investment by definition means that the founder(s) is/are selling some portion of ownership in the company to a third-party investor at a valuation that is mutually agreed upon.
In theory, the founder is seeking to retain as much ownership at the highest possible valuation and the investor is seeking to acquire the most equity possible at the lowest possible valuation. While these are the theoretical opening positions, both sides realize that this is more than just a financial transaction — it is the beginning of a long-term working relationship. The founder must realize that owning 100% of a company that ends up being worth nothing because it failed to attract investors, yields zero return to the founder.
Conversely, the VC firm must realize that leaving the founder and the other key players in the company with little to no financial upside will result in a demotivated team that will not perform at the levels needed to make the startup a success. So, the initial investment transaction has far reaching implications well beyond the numbers of the initial investment.
JE: At what point in its growth should a startup begin approaching VC firms for capital?
BC: This is the question that every entrepreneur asks himself or herself and unfortunately there is no magic formula and no easy answer. Each business model or startup is totally different, and every founder’s circumstances are totally different.
Take, for example, the invention of a totally new sports drink that would revolutionize the industry. Creating the drink would require manufacturing plants. Next, there is the matter of distribution, such as identifying channels and retail outlets. The soft drink may require FDA approval depending upon its ingredients. If its marketing claims are particularly boastful, it may need to have done certified trials and testing.
Each of these steps is time consuming and extremely costly. The founder may have been able to pay for the original formulation using personal funds or by borrowing from friends and family. However, it would soon be clear that to launch the company would take funding beyond the reach of most individuals. The normal course would then be to seek VC funding, and in this case the founder would be bringing in the VC firm early and therefore accept the fact that a large portion of the ownership would be shared with the VC firm and their investors. The expectation is that the upside would be so great that the total return to the founder would still be substantial.
Another case may exist with a software developer who constructed a software application that was truly novel and would find great demand in the marketplace. Since the product could be downloaded from a website and required no ‘manufacturing’ so to speak, the founder could wait until the product was ready for launch before considering the need for venture capital. In this case, the need would be for national rollout marketing, website support, telephone tech support, and developers. The founder, in this case, would keep a disproportionately higher percentage of the equity in the company and use that equity to attract more developers to expand the product line to include other products and services over time.
JE: What would you identify as the most important factor a startup should consider when choosing a VC partner? Would it be the VC’s success within their particular industry, a balanced portfolio across different business sectors, or perhaps the level of autonomy the VC does or does not offer for the current startup’s leadership?
BC: Selecting a VC partner is a critical decision and not one to be made in haste, nor one that should be made without extensive consultation and advice of third-party advisors. Many founders/entrepreneurs make the mistake of selecting their VC partners solely on the basis of industry reputation and this can be a disastrous mistake. Others rely on the advice of well-intentioned but unqualified advisors, such as their personal CPAs or stockbrokers. While these individuals may have some passing financial competence, they are ill-equipped to evaluate the qualifications and “fit” of competing VC firms bidding for the investment opportunity.
The decision is important enough that a startup should in fact hire a professional advisor, such as a major accounting/auditing firm, or a consulting firm that has expertise in the startup’s business and can serve as a liaison between the startup and the competing VC firms.
As for what to look for in the VC firm itself, it is important to get to know the individuals from the firm that the startup would be working with on a regular basis and gain an understanding of the VC firm’s methodology. This would include meeting schedules, reporting schedules, revenue expectations, other quantitative targets, organizational changes, and budgetary authorities. Startup management should also understand how much unspent capital remains in their funds for future investment should the company require subsequent rounds of funding.
Many VC firms may have direct experience with other companies in the startup’s specific industry and therefore have deep competitive knowledge that they can bring to bear to assist the company as it prepares to go to market. The VC firm can also be of assistance in recruiting talent to fill out the management ranks with industry knowledgeable talent at all layers. A startup’s VC investor will become more than just a source of investment. It will become a business partner in all aspects of the business operations. That’s why the selection of the right VC firm will often be the most critical aspect of a startup’s future success.
JE: Should founders worry about giving up too much control of the company they started when partnering with a VC firm? Is it possible for founders to stay in charge?
BC: That’s one reason it is so important that the startup understand exactly what they are looking for in a VC firm.
Some founders have a very narrow vision of what their company should look like when fully formed and functioning, and they may have absolutely no vision or passion beyond seeing their company to that point. They may have no interest in expanding the scope of their responsibilities to include general management, financial management, human resource management, regulatory reporting, investor relations, and all of the other duties that come with being the CEO of an expanding enterprise. These attributes define many, if not most, of the founders of the 2,123 new companies founded in 2018.
However, for some founders, the initial financing of the company is just the beginning of a longer journey of a vision and mission that they and their VC partner share. That journey may include many steps along the way, such as future financings (future rounds referred to as B rounds, C rounds, and so on). There may also be many hurdles to overcome, targets set and surpassed, new products developed and rolled out, and new markets attacked. Sometimes additional VC partners will be introduced to share the risks as the total investment grows in size and the scope of the vision and mission continue to grow.
Throughout the process, founders may bring in all the business talent they need underneath them in the organization to manage the day-to-day operations, run the finances, or build the infrastructure, but they are the embodiment of the company and continue to drive the vision and the mission. Founders cannot comprehend the thought of giving up creative control of the company that they have built, and at a certain point they have no more need of their VC partners, who have likely long ago cashed out their equity interest and no longer exert any control over the company. These are the messianic leaders who command unyielding loyalty from their employees and even from their shareholders who believe in their vision despite ups and downs in the company’s financial fortunes.
The brand and the founders have become one thing in the marketplace and their identities have become inseparable. This situation may not be right for every founder, but it is the case with some of the business leaders making headlines today, such as Jeff Bezos, Elon Musk, Larry Page, and Sergey Brin.
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About Bill Clifford
Bill Clifford is Chief Executive Officer of Spencer Trask & Co., a privately owned advanced technology incubation firm. Prior to joining Spencer Trask & Co., Mr. Clifford served as Chairman of the Board and Chief Executive Officer at Aperture Technologies Inc., General Partner of The Fields Group, and General Partner of New Vista Capital. He is also the former President and Chief Executive Officer of Gartner Group, the world’s leading authority on the information technology industry, user and vendor technology strategies and market research. During his tenure at Gartner, annual revenues increased from $175 million in fiscal 1993 to $780 million in fiscal 1999.
Mr. Clifford currently serves on the board of directors of Cybersettle Inc. and SWK Holdings (SWKH.OB). He has been featured in CEO Magazine, Leaders Magazine and Forbes, and is a keynote speaker and panelist at numerous Technology Industry conferences.
