Updated October 25, 2011Doc Sheldon
This is Part Two of a series, dealing with some of the considerations faced by both entrepreneurs and investors, when they join forces in a venture. Part One can be seen here.
Occasionally, some industrious soul comes up with an idea that is so new, so revolutionary, that it totally changes the face of its niche. And once in a great while, their idea may actually create a niche where none previously existed. The former is normally referred to as disruptive. The latter may or may not be, depending upon its level of success and its trickle-down effects.
Obviously, the folks that give birth to disruptive ideas are creative by nature. They supposedly use the right side of their brain more than the left. It’s the right side of the brain that tends to gather information… information that the left half then analyzes. The attribution of creativity to one side of the brain over the other has been debunked, but for illustrative purposes, will serve.
What does that have to do with entrepreneurs and investors, you may ask? Think of them as the two hemispheres of a brain. The entrepreneur, most often the creative (right half) type, might recognize a need, conceptualize a solution and develop a plan. But creative people are often so focused upon the destination that they don’t see the potholes in the road. That’s where investors often complement the entrepreneurial spirit… acting as the left hemisphere of the collective brain, they’ll spot the potholes, and help the entrepreneur chart a path around them.
Which is most important? Neither. Or if you prefer, both. They’re a collective, so either one, acting alone, is lacking something. Only acting together, do they have the best chance of covering all the bases. That’s not to say that there are no creative people capable of covering the bases themselves. But it’s a rare individual that is equally comfortable and capable acting in either realm.
When two such individuals can partner in a venture, and their characters and abilities resonate, the results can be extraordinary. Recognizing the value of each other to the relationship is the key factor in building and sustaining such a dynamic, and while not crucial, it is certainly a factor is some of the most notable successes.
Do Opposites Attract?
Since we’re talking about left-brain and right-brain personalities, one is tempted to say that we’re talking about opposites, but that really isn’t necessarily the case. In fact, more often than not, the entrepreneur and the investor may have more in common than is obvious at first glance. Angel investors, for instance, often choose the arena in which they’re most likely to invest, as a pet project. Profitability is obviously a concern, but many invest in certain fields of interest for their own reasons. Sometimes altruistic, sometimes mercenary… but always business. Their objectivity can complement the entrepreneur’s inherent optimism, and keep a venture on track. But they’re often motivated by common interests, beyond just making money.
What’s the Chemistry?
Obviously, there’s usually some chemistry at work when an entrepreneur and an investor tie their futures together. This is particularly true when the investor is an angel investor. Angels are usually the first investor, at least outside of friends and family, and often get involved in a venture when it’s still just an idea.
With no demonstrated marketability, the angel must necessarily have a higher level of confidence in the entrepreneur’s ability to bring the project home, whereas first or second round VCs have the benefit of viewing performance data.
So where does this chemistry manifest itself? For many on both sides of the fence, I think we can list some attributes that most often come into play. Honesty, integrity and reliability are pretty likely candidates. Some less obvious characteristics might be willingness to take responsibility and accountability, along with a sense of compassion and a passion for the venture.
The investor should certainly have business acumen and a willingness to take risks, tempered with a healthy dose of patience. The entrepreneur should be technically strong in the niche, with a solid reputation and a strong focus on goal attainment. Of course, it goes without saying that if one or both sides has previous successes behind them, it’s a major plus.
There are a great many points to be negotiated up front: control, direction, milestones and exit strategy are just a few of them. Some of these will hold more importance for some than others, but without a doubt, they affect everyone on both sides of the equation.
Certainly, to the entrepreneur, it is usually important to preserve their vision of the company. It’s not easy to relinquish control to others, and a drastic change of direction can be disheartening.
Yet, most will understand that the angel isn’t disposed to simply deliver a pile of cash and hope things work out well… they’ll want to know that the agreed upon plan is being followed, and that appropriate adjustments are being implemented, as required.
From the entrepreneur’s standpoint, it’s normally important to that they maintain control over the day-to-day operations, including hire & fire decisions. Nobody wants to be forced to hire someone else’s useless son-in-law or made to pass up on a super-tech that rubbed someone the wrong way. By the same token, many companies have spent themselves out of business with inflated payrolls and benefit packages that were out of their league.
Strange as it may sound, the entrepreneur may have to worry about their own job if things aren’t progressing according to plan. Having to step down as CEO can sting, even when it may be the best thing for the company. But being shown the door would sting a lot more. Addressing this question ahead of time can keep the entrepreneur’s dream from being taken away entirely.
And then, of course, there’s the planned exit – or the exit strategy. This speaks most to the ability of the investor to cash out, but can definitely affect the principles, as well. This is an area that needs to be nailed down very cleanly, addressing all the details and contingencies, so as to avoid situations that can turn into disaster for everyone concerned.
To give you a little more insight, here are a few comments to specific questions from both the entrepreneur’s point of view and that of an angel investor:
As a start-up, what percentage equity do you feel is imperative for founders to maintain?
Steve Gerencser, entrepreneur:
This can be a challenging question to answer. If there is no chance of success without investment capital from someone, then you are more likely to give up more ownership than you otherwise would.
After that, it’s as little as possible while getting as much funding as possible is the best answer. In theory your investors will have similar visions and goals making retention of 51% ownership less necessary to maintain. In most cases your decisions would be limited to the agreement with the majority shareholders, or board of directors, anyway, so you may not have total control even if you have 51% ownership. For example, Mark Zuckerberg owns just 24% of Facebook and Bill Gates owns an estimated 9% of Microsoft.
Rand Fishkin entrepreneur:
There are others that are far better qualified to answer. Paul Graham in particular: http://www.paulgraham.com/equity.html. I don’t know that I’d be concerned with the percent so much as the value and expected returns vs. risk.
As an angel, do you normally like to stay involved after a first-round VC infusion, or do you prefer to bow out?
Nova Spivack, angel investor:
I work as a “venture producer” so I am extremely hands on from concept stage all the way through a Series B at least.
What do you feel are the three most important things for an entrepreneur to protect when accepting outside funding?
Steve Gerencser, entrepreneur:
1. Your vision. If your investors do not see your company the way you do then you will spend more time arguing with them than actually building your company.
2. Your culture. If you are a tie-die and flip flops company that works from 11pm to 10am with a culture of bending over backwards every time for every customer, then a venture capital agreement with a 65 year old oil fund manager may not be the best fit for you.
Tony Hsieh, the CEO of Zappos, started out as an investor and ended up as the CEO. He wrote a great book about corporate culture and how that culture made Zappos what it is today. It is definitely a great read for anyone running a business, regardless of their growth goals. http://www.amazon.com/Delivering-Happiness-Profits-Passion-ebook/dp/B003JTHXN6/ref=kinw_dp_ke?ie=UTF8&m=AG56TWVU5XWC2
3. Your job. Make sure that the contract has provisions in place that allow you to remain at your company, even if you step down as CEO to some other position, and makes it painful for the board to simply send you on your way. There is no feeling worse than having your dream taken away from you.
Rand Fishkin, entrepreneur:
#1 – Enough control and few enough restrictions to be able to quickly set and change the strategic direction of the business. At the end of the day, responsibility and authority needs to rest with a single individual or things get frustrating and then, usually, messy.
#2 – The ability to choose when or if they step aside (being forced out of a CEO role kills more companies than it saves, IMO).
#3 – The right to hire, fire and manage the team. When CEOs have boards that stop them from hiring the people they want and letting go of the people they don’t, it’s a no-win situation.
After investing, do you prefer to be involved in major management decisions, or are you content to let the management team handle operations?
Nova Spivack, angel investor:
I am very hands on and usually work as a virtual co-founder of companies that I invest in, at least in the first year or two. This means I speak to the CEO several times a week, if not daily, and work as a coach, and advise very actively on product, marketing, hiring, business development and fundraising.
This not common however – most angels and VCs are a lot less hands on. However I think this hands-on approach adds a lot of value to companies in the early years. Not all startups need it, but studies have shown that for most venture funded startups that turn out to be successful, mentoring of this nature is a critical factor in their success.
What are your preferred options for exit strategy?
Steve Gerencser, entrepreneur:
My biggest goal for an exit strategy is one where the principal people responsible for making everything happen are not ‘forced’ out but can leave if and when they choose to. After that it’s just numbers and dollars. And in the grand scheme of things those tend to mean less to me than the feeling of building something lasting that can provide for many people over many years.
That said, vestment in stock ownership is a pretty standard process for most financing scenarios. Generally stock vests over five years with founders starting with one year vested at the time of financing. If your company is more established you may be able to increase that amount anywhere from 3 months to a full year.
For me, though, I’m more interested in what the investor would consider a good exit strategy for them. Their exit strategy should coincide with my goals fairly closely so that we don’t end up in a situation in the future where we are at odds over what to do next with the company.
Rand Fishkin, entrepreneur:
I would say that having everyone’s equity on equal footing in a sale is optimal. Preferred shares getting their money out “first” is reasonable, but having a liquidation preference above 1X is generally a bad idea, because it means misaligned incentives in a sale. There’s times it can work, but I think it’s much cleaner and easier to keep shares equal in a profitable exit.
Do you look more at trailing revenue and the balance sheet or at the business plan and market potential, when deciding whether to undertake a full evaluation?
Nova Spivack,angel investor:
Early stage companies almost never have revenues or balance sheets, so that’s really not a factor in my decision process. Instead, I work with teams to project the market size and revenue growth opportunity in the future, as well as a cost projection. A realistic financial projection is key to my decision making process, but this is entirely prospective and speculative at best. However, with a lot of experience and pattern recognition I am usually able to make fairly conservative and accurate projections with teams I get involved in. Of course a good business plan (in Powerpoint format) is key to this process as well.
(Check out Part Three of this series)