Is Your VC a Chicken or a Pig? Part II: The Role of the Lead Investor – From Term Sheet to Closing (and Beyond)

In Part I we talked about the critical importance of focusing your fund raising efforts on identifying a lead investor – a “pig” – and reaching agreement on a term sheet with them before you spend significant time lining up “chickens” to “follow” along in the deal. Today, we’ll look at what role your lead investor plays post-term sheet agreement when it comes to getting your deal closed.

The first role of the lead investor post-term sheet is working with the company to build out the investment syndicate: that is, to find and close on chickens/followers. The lead becomes, in effect, a part of your pitch team – albeit, without abandoning its primary role as an arms-length investor/skeptic.

The “selling” role of the lead includes identifying, prioritizing, and even pitching potential followers. That typically includes folks the lead brings to the table from its own network as well as appropriate candidates the company suggests. While the company will still be front and center in pitching chickens, the lead is usually the primary due diligence source for potential followers, both “deal” and “legal” due diligence, and actively shares their own thinking on why the deal is compelling with various chickens.

This dual role, working with the company to build the syndicate while also being the principal due diligence resource for the syndicate, makes managing the company/lead relationship complicated as well as critical. The lead, at this point, wants the deal to happen and is committed to making it happen. But only to a point. The lead’s enthusiasm is tempered by its continuing obligation to act in the best interests of its own investors. In addition, its credibility is on the line with other investors, which is something that can cut both ways in terms of how it reacts to any bumps in the road on the journey to closing.

The lead also manages the “deal” part of the deal: that is, the concerns of followers about the terms of the deal. On that score, the lead should focus on convincing followers that the term sheet is “good to go” as is. Indeed, the company should resist any material changes to the term sheet based on follower concerns, just as it would if the lead was the only investor. The whole point of agreeing on a term sheet was to finalize the material terms of the deal. As a practical matter, one or more immaterial changes to accommodate a valuable follower may be acceptable. Any material changes, though, should be viewed as putting in play changes the company might want in exchange, or even grounds for the company backing out of the deal altogether.

The lead also manages the legal process associated with negotiation of closing documents and related legal requirements. Typically, there is one counsel for the investment syndicate, and that counsel works through the lead investor and is paid by the company out of closing proceeds from the financing. (If a follower wants to have an independent legal review, they should pay for it, and that counsel should work through the lead and its counsel in terms of communicating any concerns to the company.) If a lead can’t persuade followers to work through the lead and its counsel, that’s a good sign that the lead is not up to the job.

Once the deal is closed, the lead is usually the “point” investor for the rest of the investment syndicate. If the investors have a director on the Board, it will usually be someone from the lead investor. (Someone that should have been identified at the term sheet stage). When the company has news to share with the investors – good, bad, or indifferent – the lead is usually the first to get it, and often has input on what to share with the rest of the syndicate, when, and how. As with the period of time from the term sheet to the closing, this dual role of investor/advisor can be complex and must be managed carefully.

Lead investors make deals happen, and typically play central roles even after the closing. Smart entrepreneurs know that raising money is first and foremost about getting a credible lead’s name on a solid term sheet. Be a smart entrepreneur: don’t waste time and energy collecting followers until you’ve got a lead for them to follow.

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Is Your VC a Chicken or a Pig? Part I: What a “Lead” Investor is, Why You Need One, and How to Find One

One of my favorite clichés involves chickens and pigs. More specifically, it observes that as interested as chickens may be in breakfast, it’s the pigs that are really committed.

That’s a good way for startup entrepreneurs to think about courting venture capital investors. Collecting a flock of very interested venture investors – chickens – is fine and dandy, but you won’t make much progress towards getting a deal done until you’ve got a pig at the table. So don’t waste a lot of time chasing chickens around until you have a pig corralled. You know you have got a pig in hand when you have a solid term sheet with a “lead” investor inked.

Truth be told, most VCs think of themselves, or at least present themselves, as lead investors. I suppose most probably do lead a deal now and again. That said, though, in any given deal, there is generally only one lead investor. (Co-leads are fairly common, but even in those cases one of the co-leads in fact plays the role of the lead.) That is, one investor who not only wants “in” the deal but wants to “own” the deal.

The first big role of the lead in a deal is to let the relevant chickens know that someone has pig-like interest in the deal. That someone likes the deal enough to put up a big bunch of capital (usually the biggest chunk) and to do most of the heavy-lifting of getting the deal done (which, as we’ll see, is no small thing). That resource commitment, coupled with the signal to the market that a credible (well, hopefully) investor is that serious about the deal, is typically the inflection point when the chickens start getting serious about actually committing some eggs to getting the deal done.

If getting a lead investor lined up is the sine quo non of getting a venture financing done, how do you go about it? Simple. Qualify potential investors as leads before you spend too much time with them. Limit your initial investor solicitations to folks you think are possible leads and folks you think might be sources of referrals to possible leads. When you get a meeting with an investor, if there is any potential interest at the end of the meeting be certain to ask if yours is a deal the investor would consider leading (and if not, can they refer you to any investors who might be).

Step two is to avoid wasting time with investors who are not qualified leads until you have a signature (or handshake) on a term sheet with a lead investor; a term sheet that outlines all of the material terms of the investment. Depending on who the lead is (their reputation in the market), and how big a piece of the deal that the lead is taking (how many other investors with how much more money will it take to fill out the syndicate), agreement on a solid term sheet is the point where most interesting investment opportunities become likely deals.

Next time, we’ll talk about what roles lead investors play after the term sheet is signed.

 

Should You Take Your Startup To Silicon Valley?

I’ve advised many flyover country entrepreneurs that if their sole goal in life is to raise the most money for their startup, at the best price and in the shortest period of time, they should move to Silicon Valley. That is where good entrepreneurs raise the most money in the shortest order and at the best price on a pretty consistent basis.

Lately, I’ve been thinking more about that advice, and while I generally stand by it, I’ve come to the conclusion that there is an important exception: a class of startup entrepreneur that, in fact, is usually better off launching in flyover country than Silicon Valley. The idea of an exception to the “move to Silicon Valley to get the best deal” advice came to me as I started thinking more closely about a corollary to that advice, to wit that if, having moved to Silicon Valley you can’t raise capital, at least you will have found out faster that your startup is not VC-worthy.

It’s that last word, “worthy,” that hit me as needing more thought. Over the last couple of days, it gelled that some entrepreneurs might fail to raise capital in Silicon Valley – not because their startup is not worthy of investment, but because they are not ready to play on that particular stage. In which case, going to Silicon Valley may result in failing to get a startup financed not because it was a bad idea, but because venture capital’s Broadway was not where it should have started out.

Here’s the deal. For entrepreneurs that know how the venture capital business works (in reality, not just in theory); have a track record that suggests real knowledge of what makes the best startups tick; and have meaningful entrepreneur, investor, and service provider networks that include a few solid Silicon Valley contacts, taking their startup to Silicon Valley makes sense. (Again, with the qualification that getting the best deal as fast as possible is the only factor in the decision.) For other flyover country entrepreneurs, maybe not so much.

My thinking in this area was kick started a couple of weeks back when I met with a 20 years-old-ish Northeast Wisconsin entrepreneur who had what seemed like a pretty good idea for an app. With less than $50k, he had taken it as far as 10,000+ users and some very good press. He had pretty much everything you look for in an entrepreneur: vision, passion, integrity, flexibility, an ability to make things happen with minimal resources, and a desire to learn. But, when we talked about the possibility that he should pick up and move to Silicon Valley, it occurred to me that if he did he would most likely be eaten alive.

What this entrepreneur lacks that would be a huge problem for him in Silicon Valley won’t be hard for him to learn here in Wisconsin if (as I am sure he will) he puts his mind to it. He doesn’t know either the substance of the venture capital business or the lingo (which is surprisingly important, particularly when a VC knows you are from the sticks). While he has great entrepreneurial instincts, he has not lived, even vicariously, in the high impact entrepreneurship world. Right now, the number of folks in his network who do have that knowledge and experience, and those connections, can be counted on the fingers of one hand.

These may seem like small things, but they are important things and things that pretty much every entrepreneur who gets funded in Silicon Valley has. They are things that folks like gener8tor have made a business out of providing to their portfolio entrepreneurs (and in fact lots of other entrepreneurs). And things that a small but real cadre of Badger folks with that kind of experience and those kinds of networks are eager to share with folks who are otherwise as compelling as the young man I met with several weeks back.

So, if you are an otherwise Silicon Valley-worthy high impact entrepreneur in flyover country, but don’t have a solid understanding of the ways and lingo of the venture capital business, a well-grounded understanding of what separates the startup winners from the losers, and a decent network of folks that have those things that you can leverage all the way to Silicon Valley – don’t go to Silicon Valley. At least not yet. Learn what you need to learn here, connect with the right folks, and when you are ready to play on the Silicon Valley stage, well, decide what your priorities are then.

 

 

Ways Entrepreneurs Spook Investors

The perceived quality of the entrepreneur is, for most venture investors, the single most important factor in evaluating a startup investment opportunity. As they say, an “A” team with a “B” opportunity usually wins out over a “B” team with an “A” opportunity.

One way to approach the “what makes for an “A” entrepreneur” question is to look at what makes a good entrepreneur. Today, though, I am going to take the opposite approach. What traits can make even an otherwise compelling entrepreneur come up short in a venture capitalist’s eye. Here are some too-common entrepreneurial qualities that spook investors.

  1. The “No Competition” Entrepreneur. Few things turn off more venture investors faster than an entrepreneur who insists she has no competitors. If you are convinced you don’t have any competitors, you are wrong. Every dollar that a customer spends on your product is a dollar they didn’t spend on something else. Maybe that something else is very well defined (say, an alternative dog walking app for smart phones) or maybe it is very amorphous (say, personal entertainment). More likely closer to the former than the later, but you get the idea. If you are one of those entrepreneurs who just can’t find any competition, don’t expect to find any investors, either.
  2. The Defensive Entrepreneur. My personal (least) favorite. Ask any question and these folks perceive a personal attack on their integrity, competence or both. Most investors just don’t want to give their capital to entrepreneurs who can’t put their ego and insecurity aside to answer questions directly. Even – probably particularly – when the answer is “I don’t know.” Defensive entrepreneurs send an all-too-clear message that when the going really does get tough, they will look for excuses, not answers.
  3. The Big Business Entrepreneur. This one bit me big time fairly early in my career. Going into the second round of a deal where I was the “suit” for the seed and A rounds, we needed an industry pro to take the CEO role at the B round. We figured someone who could run a billion dollar division of a Fortune 500 competitor could surely run our little startup. Huge mistake. While there are examples of folks who have transitioned from managing big businesses to the startup world, they are outnumbered by folks who took the leap and cratered. If you are a “Big Business” manager transitioning to the entrepreneurial world, you need to make it crystal clear that you understand how managing a startup is different than managing a big established business, and that you are the kind of person who can do both. (If you don’t know the difference, you are not that person.)
  4. The “God Complex” Entrepreneur. Typically, but not always, an academic. Most often, someone in the life sciences, who has figuratively (if not literally) held life in her hands. Alas, the skills associated with saving lives, whether via brilliant surgical technique or cutting edge research, just don’t have much in common with running a high impact startup business. The few folks who have made the transition prove the rule. Pretty much the way Michael Jordan proved that exceptional basketball players don’t make even adequate minor league baseball players.
  5. The “I Can Do It All” Entrepreneur. These entrepreneurs – and they are a dime a dozen, I’m afraid – missed out on Econ 101, or at least the day they explained the law of comparative advantage. I’ve yet to find a good entrepreneur who was not better at some things than others, and who did not also know that focusing their personal efforts on the tasks where they add the most value is the best thing they can do to make their startup prosper. On the off chance that you in fact can do it all – don’t.
  6. The “It’s All About Me” Entrepreneur. I’ve followed this one down one too many rat holes. They can be hard to spot, but as soon as you conclude that an entrepreneur’s worst nightmare is not failure, but success with someone else at the helm, run, do not walk, to the nearest exit.
  7. The Uneducable Entrepreneur. Look, I get it. Entrepreneurs are often wrong, but never in doubt. But the good ones, even when reluctant to acknowledge their mistakes, are very good at learning from them. Good investors don’t generally rub their entrepreneurs’ noses in their mistakes, but they don’t write many checks for entrepreneurs who don’t learn from those mistakes.

I am sure there are other spooky entrepreneur traits, but this list covers a big piece of the territory. If you see yourself here, you might want to think about making some changes in your entrepreneurial profile. It will likely make raising capital easier. Even more to the point, it will likely improve the outlook for making something good happen with any capital you raise.

Raising Capital for Your Startup: It’s About More Than Money

Most of the time for most entrepreneurs, raising money for a startup is not a lot of fun. Absent some combination of a hot deal and a hot market, fundraising is a real chore, too often full of demoralizing turndowns and even more demoralizing walls of silence. Still, as bad as it can be, the process almost always includes some important opportunities that good entrepreneurs will seize and use to their advantage.

The first opportunity the capital chasing process offers is self-reflection. Asking other folks for risk capital forces you (at least if you expect any success) to think about your business objectively, from the perspective of an outsider. And not just any outsider, but a jaded professional investor. Vision and passion are certainly appreciated by most of these folks, but as table stakes, not closing arguments. To seal a deal, you will need to get back to the cold hard realities of your value proposition, your business model, your evolving competition, your financing plan, and your exit strategy. Mission critical stuff that can get lost in the fire drill of day-to-day startup life.

Another opportunity worth grabbing on to in the fundraising process is the learning opportunity. If you have been at all careful about qualifying your investors, you will be talking to folks who very likely know a lot about the environment – technology, competitive, financing, exit, etc. – your startup is living in. If you listen carefully, and ask good questions (you should, in all events, be vetting potential investors as much as they are vetting you), you will almost certainly learn a lot of valuable information from the fundraising process, as much or even more so from investors who turn you down.

Finally, the fundraising process will give you valuable feedback on your teams’ capabilities, collectively and independently, in an area – raising capital – that will only become more important as your capital needs grow on the road to your exit. Raising capital is a skill in its own right – indeed as mission critical a skill as there is. Getting a periodic handle on where your team measures up in that regard may not be worth the trouble in and of itself, but when you need the money you might as well get as much besides money as you can out of the process.

Approaching the fundraising process as a learning opportunity, as well as a way to generate needed capital, may not make the effort any more fun. But it can make it a lot more rewarding.

Building Your Startup Team: Complementarity and Chemistry

Most professional venture investors believe the best predictor of startup success is the quality of the team. Good teams can and do fail, but as team quality drops below “awesome,” the chances for success drop very fast. Thus the cliché that most investors will gravitate to an “A” team with a “B” opportunity over a “B” team with an “A” opportunity.

There are a lot of reasons team quality is so critical to startup success. The incredibly stressful startup environment is the biggest. Startup teams need to accomplish difficult goals with minimal resources in terms of time, capital, and people. Additional stress accrues as outside forces – competitors, markets, technologies, etc. – evolve and force teams to make significant adjustments, often including basic “pivots” (business model, for example) on the fly.

If the extraordinary stresses of the startup environment explain the importance of getting the team right, they also offer a clue to what makes a superior startup team. At the foundational level, what separates the superior startup team from the merely good startup team is complementarity and chemistry.

Complementarity is pretty straightforward in concept, if not always in execution. Within the confines of available resources (financial) and the constraints of team chemistry (more later), you need to make sure the team includes top-tier players at the mission critical startup tasks (i.e. the tasks that need accomplishing in the current round of funding), as well as the flexibility to successfully “wing it” with respect to important ancillary functions.

The trick to building a complimentary team lies in recognition of, and dealing with, the well-established HR principle that when people get to choose who they work with – or who works for them – they tend to choose people like themselves. Now, if you are a founder, and thus most likely very confident of your own near-perfection, that might not seem like a problem. If you’ve got perfection, why not clone it if you can?

Consider if Apple had been founded not by Jobs and Woz, but by Jobs and … Jobs. If you know the Apple story, you know what a catastrophe a Jobs/Jobs founding Apple team would likely have been.

The bottom line is that however perfectly suited you may be for leading your startup to fame and fortune, building a team of clones is seldom the best way to go about it. Instead, look for people with different skill sets. And as much or even more so, different personalities and perspectives on business, technology, and life. The most successful startups – even those like Apple in the years after Jobs returned from exile that were dominated by a leading personality – build leadership teams with diverse skills, experiences, perspectives, and personalities. Just ask Tim Cook.

And that leads to the second, and harder to execute, aspect of assembling a superior startup team: chemistry.

It’s not enough to assemble a team that “covers the waterfront” in terms of skills, experience and personality. You need to make sure those folks can also form very strong bonds with each other (thus the “chemistry” analogy). Because in the constantly changing world of the startup, relationships between key players on the team are going to be under almost constant stress as company circumstances evolve and people have to adjust to changing opportunities and challenges. As anyone who studies morale in the military will tell you, folks in foxholes are motivated more by their loyalty to the folks around them than to “the cause” as such.

On that last point, one of my favorite quotes from an entrepreneur came when he was asked what he would tell his team at the beginning of his next startup journey. He replied: “Folks, we are going on a very long and difficult journey. On this journey, we will carry our wounded – and shoot the deserters.”

The quality of the team has long been the most important factor for most venture capital investors, for good reasons. As you think about assembling your team, particularly in the early days, don’t make the mistake of hiring folks because they look like you, or because they are a perfect skills fit. Look more for folks who compliment your skills and personality – and that look like the kind of people you want on your side when the going gets very tough. Because it almost certainly will, likely many times.

Back to the Future? Venture Investing in Flyover Country

The term “Venture Capital” covers a lot of ground, even when confined to the traditional institutional funds at the heart of the industry. Funds come in many flavors based on factors including stage of investment, industry focus, geography, and propensity to lead or follow in deals.

I’d like to suggest another basis for classifying venture investors, one that I think is absolutely critical when considering the unique opportunities – and challenges – of investing in places outside of the major established centers of venture capital investing. Places like where I grew up, and after twenty years in Silicon Valley and North Carolina, returned to some years back: Wisconsin.

My classification is based on two alternative paradigms for investing capital and managing investments: Nurturing and Managing.

The Manager Venture Investing Paradigm

The Manager paradigm dominates the venture business today (certainly in terms of capital deployed and public mindshare). It is characterized by large funds, many in the billions of dollars (see Softbank’s $100 Billion fund for the current outer limits of the industry) with multiple levels of investment professionals, many of which do not have early stage operating experience or even STEM educational credentials. The “value add” Manager investors provide is largely in terms of the later stages of expansion and exit planning and execution.

The Manager paradigm is ideally-suited to the contemporary Silicon Valley venture capital scene and in terms of number of deals and capital deployed the large majority of Manager paradigm investing occurs in Silicon Valley and a handful of other major venture capital hubs. Today’s large funds simply can’t efficiently make and manage smaller deals. Even those that operate affiliated “seed” funds typically make larger initial investments than their traditional seed fund peers, and limit those investments to deals that they perceive as having mega deal potential (and capital needs) going forward. As a result, the Manager paradigm funds are much less likely to invest in raw entrepreneurs who need a lot of hand-holding on basic operational blocking and tackling. Their deep pockets also make them more likely to focus on capital intensive growth/brand-driven exit metrics than profitability.

Now, the Manager paradigm may get all the headlines, and skew the statistics such that Silicon Valley round deal sizes and valuations or as much as an order of magnitude or even more than the comparable figures in flyover country markets, but it is not the only venture investing paradigm. In fact, it was preceded by a very different and still important, if no longer as publicly prominent, paradigm.

The Nurture Venture Investing Paradigm

The modern venture capital era began in the late 1940s and hit its stride in the 1970s.  Throughout that period, and into the 1980s, even the largest venture capital funds seldom exceeded $100 million and most were only a fraction of that. The prototypical Nurture VC was someone with industry operating experience as well as a STEM education. Further, these smaller funds had minimal junior staff compared to the layers of analysts, directors, junior partners, etc. that make up the bulk of the investment professionals at today’s larger venture funds.

The early decades of the venture business were characterized by something else, besides smaller funds: less experienced entrepreneurial teams. With the industry’s small size, and even with fairly rapid growth in the 1970s, it took awhile for the “serial” entrepreneur to emerge as a regular part of the deal flow. It was probably not until well into the 1990s that most venture-backed Silicon Valley startups included founders and senior managers well-versed in the art of building a high impact company from experience at prior venture backed emerging companies.

When you put all of these factors into a pot and stirred them up, you came up with the Nurture venture investing paradigm. An investment model based on VCs focusing on startups where they could add a lot of value to the deal in terms of the basic nuts and bolts of defining and building the business. Indeed it was a time where the venture investor was often involved – as for example Brook Byers and Genentech – in the actual conception of the business, recruitment of the founding team and formulation of the business plan. Sometimes well before it was even clear there would be any resulting investable deal.

The industry’s structure during the ascendancy of the Nurture paradigm had other implications, among the most prominent of which was the emphasis on profitability as an exit metric. This was not because Nurture investors were any smarter than today’s Manager investors, who by comparison are far less concerned with early profitability. Profitability was part of the Nurture paradigm simply because the typical Nurture fund – even when factoring in syndication of investments – simply did not have sufficient capital to support a portfolio company burning tens or hundreds of millions (or as per Uber recently billions) of dollars of capital a quarter.

The Nurture paradigm led to venture capital’s first golden age in the 1980s. It also sowed the seeds of the Manager paradigm which arrived on the scene in the later half of that decade. The Manager paradigm was launched, ironically enough, when some of the great Nurture firms started raising the first wave of mega funds with hundreds of millions of dollars and, before long, even billions of dollars to deploy.

Implications for Flyover Country Venture Investing

If there is still a meaningful role for Nurture funds in Silicon Valley, there is very little room – today – for Manager-modeled funds outside of Silicon Valley and a handful of other of the larger venture investing centers. And that is something that too many folks in flyover country just don’t understand. And something that is making it even more challenging than it needs to be to foster the emergence of a meaningful high impact entrepreneurship and investing sector in still nascent and emerging flyover markets.

I saw the problem in North Carolina circa 1990, and I see the problem in Wisconsin, today. Regional folks who want to foster a vibrant high impact entrepreneurship and investing community look to Silicon Valley and, seeing how the Manager venture investing model dominates the headlines, conclude that we should be doing the same thing here. That we should invest as if our entrepreneurs had the same kind of “been there, done that” startup experience and networks that their Silicon Valley counterparts enjoy.

Well, they don’t. The opportunities and challenges of venture investing in Wisconsin in 2017 are indeed comparable to the opportunities and challenges of venture investing in Silicon Valley. But Silicon Valley circa 1975, not 2017.

What places like Wisconsin need, in terms of venture investors, is Nurture VCs, not Manager VCs. We need small funds, run by hands-on partners who bring their own “been there, done that” high impact startup operating and investing experience to the game. People who are willing to get down in the trenches with entrepreneurs to help shape raw talent and ideas into fundable deals; and who are willing and able to start doing that even before making an investment. Venture investors who can proactively help their portfolio entrepreneurs achieve profitable operations supporting attractive exit opportunities with lifetime risk capital needs that don’t exceed even the average A round in today’s Silicon Valley.

Unfortunately, instead of Nurture funds led by experienced startup entrepreneurs and hands-on investing professionals helping raw entrepreneurs with good ideas build modest companies that offer solid investment returns with limited capital, what I’ve seen here in Wisconsin is mostly investors with little or no venture backed startup operational or seed/early stage risk capital investing experience casting about for the kind of startup teams and capital-ready deals that fit the Manager venture investing paradigm.  Teams and deals that we just don’t yet have enough of in Wisconsin to support a sustainable high impact venture-driven startup community.

Don’t get me wrong. I think – know – that Wisconsin and places like it have the raw entrepreneurial talent and capital to become small but important and sustainable centers of high impact entrepreneurship and investing. But getting there is not going to happen unless and until the folks who want that to happen understand that right now we need Nurture venture investors, the kind that built Silicon Valley, not Manager venture investors in the mold of those who get the headlines in Silicon Valley today.