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Managing a Mail-Order Marriage: Building Trust With Your VC Investor

Katherine Hammer, Evolutionary Technologies International Inc.
Robin Lea Curle

Most businesses require capital at some point in their existence. In our case, it was relatively early. In the fall of 1991, even before we landed our first customer, we began to look for capital from venture capitalists (VCs), and it was with significant fear and trepidation that we did so.

Robin had been in the software industry for more than sixteen years and had previously been vice president of sales at two software start-ups and one turnaround. In those positions, she helped raise money from VCs. She knew that if she lost control when taking the funds, anything could happen.

In contrast, I was new to the business world, and I had a technical background. I was just the type of chief executive that VCs--with justification--have come to distrust. It didn't help that it was 1991, and we were women at a time when upper management in most high-technology companies was almost exclusively male.

Despite these obstacles, we were successful. In our first round of financing, in November 1991, we raised $1.5 million from Menlo Ventures and Admiral Bobby Inman. Admiral Inman had committed to invest individually as a "business angel" three weeks before we received the offer from Menlo. Since then, we've closed three more rounds for an additional $13.5 million, adding Arete Ventures, New Enterprise Associates, and Cornerstone Equity Investors to our list of investors.

We attribute much of our success to Inman's presence on ETI's board--and to his commitment from the onset to giving us the chance to run the company rather than bringing in new managers on the assumption that we'd fail. Yet, there were two other factors that we believe were critical, and that we want to bring to the attention of entrepreneurs.

In large part, VCs worry that first-time entrepreneurs will not have the instincts or skills required to run a company. So, entrepreneurs must learn to manage that mistrust in order to build trust and respect. In our case, we acted from a position of paranoia in which we assumed that our investors expected us to fail and that they were waiting for the first sign of failure to replace us.

It is equally important to recognize that the potential for conflict of interest is inherent to the relationship due to the different obligations of the VC and the entrepreneur. These conflicts arise chiefly during the company valuation for financing and when planning the VCs' exit strategy. Even as trust evolves, the potential for these conflicts won't go away. Consequently, it is important to understand why the potential for conflict exists.

Building Trust and Respect

Ultimately, what one should strive for in all business relationships is trust, whether it is with your investors, your customers, or your employees. The difficulty in developing trust with VCs if you are a first-time entrepreneur is that from their point of view, investing in your company is sort of like marrying a mail-order bride. The due diligence process when they are getting to know the management team, the product (or product idea), and the market is like the exchange of letters and photographs during the courtship: small samplings and snapshots of "what could be." And just as prospective grooms (or brides) are filled with doubt about the wisdom of what they are undertaking, VCs frequently experience a kind of "buyer's remorse" the moment they sign the check--unless they have managed to place one or more key executives within the company as part of the funding process. These managers are usually known to the VC, either because they have worked with them in some other portfolio company or have been successful in managing a similar type of business in the past.

But if you bring in new management as a condition of a venture round, now you are in the predicament of marrying a mail-order partner, as opposed to the VC. If you are a first-time entrepreneur, chances are, you are fairly green and will make mistakes as you learn. At the same time, you are being asked to trust that this stranger, however appealing he (well, probably it will be a he) was during the courtship, will not disparage you to your investor to his own advantage.

For this reason, it is wise to wait as long as possible before raising venture money, if not until you have a sales history, at least until your product is almost ready to ship. Whether you raise money from an angel or pay for the initial development by doing "work for hire" with a customer, do whatever you can to reduce the period of time between raising venture capital and generating revenue. Moreover, hold onto control of your company as long as you can if this is your initial entrepreneurial effort.

Manage the company--and the Board's role. Many VC investors want to have monthly Board meetings when they invest in a start-up so they can more closely track the company's progress. While monthly meetings can be a drain on the company's management, the more thorough you are in preparing your Board packet and the more forthright you are in discussing the company's position--weaknesses as well as strengths--the sooner your investors will settle for something less demanding like a monthly conference call or, as happened in our case, letting the company determine when calls are required between Board meetings.

We have found the discipline of preparing for our Board meetings to be like confession, an exercise that is good for the soul. Having to regularly step back from the day-to-day and assess the company's progress against your forecast gives you an opportunity to recognize when you are getting too far afield of your original goals. If this happens, it is important to question your basic assumptions rather than attributing the failures to one factor or another. Ultimately, you have to hit a plan--if not your initial plan, then a revised one. It is unrealistic to expect a VC to continue to take chances with someone whose judgment can't be trusted. A false start or two is expected, but if these are too serious or too frequent, it is unrealistic to think that a VC will give you more money without making substantive changes to the company and/or its management.

A second factor to consider is how you want to manage your Board. First and foremost, you must be scrupulously honest about any problems you are encountering, for if investors later find out that the company has had some problem that you have not discussed with them, you have forfeited any chance you had at gaining their trust. On the other hand, when presenting a problem, it's best to provide an analysis of the probable causes, as well as management's plan for remedying the situation. What you must be very careful about doing, particularly before you have developed trust, is asking for advice about operational and/or marketing matters, because once you have established a pattern of asking for and following the Board's advice about running the company, it will be very hard at some later time to tell them that you either don't need their advice or don't want to follow it.

Finally, the quality of your Board meetings will be a function of the quality of the members. If, in the process of raising VC money, you don't like a potential investor's attitude, avoid doing business with him. If someone is unpleasant or adversarial during the courtship, it is highly unlikely that the situation will improve after the wedding.

Leverage your investors' experience and contacts. One of the benefits of having VC investors is that if they have previously invested in businesses similar to yours, they probably have extensive experience with business models for your industry, potential customers for your product, and access to strong candidates for management positions. Even though we have advocated the benefits of having a bit of paranoia upon the outset of the post-funding relationship, as mutual trust is built, you'd be foolish not to avail yourself of your VCs' experience. However, while you should never directly reject help or advice, it is important, particularly early on, to evaluate whether the parallels your investor is drawing between your company and another seem right to you. Likewise, you will be more likely to benefit from their candidates for management positions once you have hired (and most likely fired) several without their help.

Just as it is important to control the type of advice you ask from your Board, it is equally important to disagree when you detect that one or more of your investors has the wrong business model for the company. For example, one of the potential investors we met with believed that the best way to establish a product like ours was to focus on gaining market share in one vertical industry at a time, while we felt that it was important to demonstrate the general applicability of the technology across industries. Obviously, with this basic disagreement between us, that investor would not have been a good fit. It is important to disagree in these cases because widely divergent views on a business model can lead to dissension about how to operate and build the company.

Understanding the Potential Conflicts of Interest

The marriage between a company and its VC investors isn't for life, but only until investors can obtain an exit strategy. Typically, VCs get the money they use for investments from people and institutions that enter into a limited partnership which includes a date at which the limited partners' funds will be returned along with profit, either in cash or in publicly traded stock. Therefore, many VC term sheets will not only include a redemption date, but a minimum rate of return expected on each share of preferred stock if the company does not go public or is not acquired for cash or publicly traded stock, and is in the position of buying out the VC investors' stock.

Because by definition the relationship between the company and the VC is of limited duration, there are at least two times at which a VC's best interest may not coincide with the company's: valuation on another round of private financing; and the timing and nature of the investor's exit strategy.

Valuation on intermediate rounds. Because most VC investment strategies allow the VCs to buy enough shares to maintain their initial percentage of ownership on subsequent private rounds, the VC investor may agree that the company needs to raise an additional round, and agree as to the amount of the round, but not want the same level of valuation that the company does since the greater the valuation, the more the VCs will have to pay for their additional shares. On the other hand, the company--particularly the management and employees who have a significant number of shares--will want to minimize the number of shares issued for obtaining the capital so as to dilute their position as minimally as possible.

VCs will argue, and justifiably so, that the value of an employee's stock is determined by the success of the company and not by the percentage of the company any particular employee owns. However, there are at least two cases where the number of shares issued can have a significantly adverse effect on the company. For example, in situations where a vote determines whether or not the company pursues a particular course, such as being acquired, if the management and the employees no longer have a controlling percentage, then their wishes may be overridden. In the second case, if too many shares are issued before the company pursues liquidity, then it may be necessary at some point to perform a reverse split, where employees receive fewer shares than they previously owned as part of the transaction. Reverse splits, though, don't affect how much an employee's stock is worth. Three hundred shares valued at $10 per share is worth the same as three thousand shares valued at $1 per share. But if the employee has been "counting his chickens," a reverse split can be demoralizing.

One way to mitigate this conflict is to have talked with several prospective new investors to get differing opinions about the company's worth. Then, with these different opinions tucked into his back pocket, the entrepreneur should present only a few to the board, saving the highest valuation for further negotiation. If the existing VCs think the valuations presented are too high, the entrepreneur can reach into that back pocket for the ammunition to negotiate the deal that's best for the company.

Agreeing on the exit strategy. Finally, the VCs' need for an exit strategy within a fixed period may motivate them to encourage the company to be acquired or to pursue an initial public offering (IPO) sooner than management would otherwise feel comfortable. Note that this type of situation could only occur if the company is doing well. (If the company is not doing well, an IPO is not possible, and an acquisition offer would be considered a godsend by both management and the investors.) However, if the company is doing so well that such a situation should arise, then it is likely that sufficient trust and goodwill have been established between the company and management for a compromise to be negotiated. One possibility is finding another private investor willing to buyout the VC at what the VC considers a good return.

Like a good marriage, a good relationship between entrepreneurs and their VC investors depends on trust and--particularly until that trust is established--a reasonable balance of power and an appreciation of the other's needs and motivations. With that, and some measure of success, you may well be a management player that the VC recommends to one of its future portfolio companies.

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