The dark side of venture capital: Five things startups need to know

By Conner Forrest                                                              March 10, 2014, 5:34 AM PST

Venture capital funding is a great tool for entrepreneurs, but its implications are often not fully understood. Here's what VC-seekers need to know. 

Image: iStockphoto/darak77

Nearly $27 billion dollars was invested by venture capitalists in 2012. That $27 billion was invested across 3,723 deals, making the average deal hover at a little over $7 million.

While that number may seem staggering to many people, it's about average for VC investments made since the dot com bubble burst between 2000 and 2001, according to the National Venture Capital Association (NVCA). Yes, the economic impact of the dot com bubble was horrendous, but it did spawn a renewed sense of innovation in startup development.

Companies are running leaner than ever, and because of that VCs are more willing to invest in companies who don't pride themselves on their burn rate. Still, raising venture capital funding can be a risky business if you aren't realistic about what to expect.

Here are some things to think about if you are considering raising your first round.

1. Statistically, you will fail

The venture capital investment process is a complicated one and potential companies are vetted thoroughly before they are committed to. With that being said, just because your company is backed by a major VC you aren't guaranteed success.

Think about those 3,723 deals that happened in 2012. In that same year there were only 49 IPOs and 449 mergers and acquisitions (M&A) deals. Granted, those exits came from companies that were invested in probably a decade ago, it is still an interesting ratio to consider.

Micah Rosenbloom, a venture partner at Founders Collective, said that historically, only one out of every 10 companies that a firm invests in with a given fund will be successful. That's not to say that all of the remaining companies will fail, though. According to Tomasz Tunguz, a partner at Redpoint Ventures, "Typical portfolio company failure rates across the industry defined as either shutdowns or returning capital are roughly 40%-50%."

This isn't to discourage hopeful founders that are seeking capital, but to ground your expectations in reality. Besides, entrepreneurship is about having the courage to fail, right? The fact that you are more likely to fail is a fact of life for venture-backed companies, it is not an expectation for the VCs making the investment.

"You never invest in a company thinking that it will fail," Tunguz said.

A VC investment in your company does not guarantee success, but it does mean you have someone in your corner who believes you have what it takes to make this thing work. Once you have a VC in your corner, you have to make sure you are in sync on what it will take to make this a worthy investment. More importantly, you have to know how long it will take for this investment to pay off.

2. There is a timeframe for ROI

"Typical venture funds are structured as 10 year commitments for the limited partners who invest in the fund," Tunguz said.

Venture capital firms are ten-year vehicles for investors, but that doesn't mean that all companies will be ten years old when they return on the investment. Rosenbloom mentioned that initial investments are made in the first three years. After the portfolio has been establish, a firm will typically make follow-on investments over the remainder of the fund's lifecycle.

Ten years may sounds like a long time, but you have to consider how long companies like Coca-Cola have been around (since 1892) and some companies that were started in the 2000s have a comparable valuation to Coke. Founders Collective is usually the first institutional round in a company, and Rosenbloom said that they aren't looking for the next cool invention.

"As a venture capital firm, we are not in the business of funding inventors or inventions, we are in the business of funding fast-growing companies," Rosenbloom said.

Considering the first three years as initial investments, a company could only have seven years to "make it." Some VCs, like Rosenbloom, consider seven years the average age for ROI, and the data from NVCA supports that claim.

The NVCA reported in their 2013 Yearbook that, of the 49 IPOs that happened in 2012, the median age for IPO was 7 years old and the mean age for a company to IPO was 8 years old. While some have argued that it is taking longer for startups to mature, Tunguz argues, "The gestation period will likely fall some because of the tremendous exit activity in M&A and IPOs in the last 24 months."

To help you make it through the whirlwind of growth that can happen after an investment, you have to know how much capital you need and when you need it.

3. You can take too much funding

"All too often, entrepreneurs will think of raising a Series A round from a reputable VC as the end goal and don't think they can be successful unless they do so. So they reprioritize raising capital over building a valuable product or service and usually end up asking for too much money too soon which ends up in a failed fundraising attempt or a raise on bad terms for the entrepreneur," said Hrach Simonian, a principal at Canaan Partners.

As I mentioned in a previous article, knowing how much money you need can make all the difference in your venture capital experience. It starts by understanding how much money you need and only raising that much money. Raising too much money can force entrepreneurs to make decisions they aren't ready to make.

"If you raise too much money, you have to swing for the fences," Rosenbloom said.

You want the amount of money you raise to coincide with the benchmark you are trying to hit. If you don't have a specific benchmark in mind (which you really should), a good rule of thumb is to consider the amount of capital it takes to sustain your operations for 18 months, then add 25-50 percent for added flexibility and seek to raise that amount of money.

Tunguz said that raising too much capital is far from the gravest sin to be committed by an entrepreneur, "But having a huge sum of money in the bank can entice founders to dramatically increasing burn rate or diffuse the company's energy among many projects. It can be challenging to maintain the same execution discipline created by the scarcity of capital when the bank account is overflowing."

Another risk of raising too much capital is setting the bar too high for your exit. By doing so you will run the risk of not being able to grow into the expectation that was set by raising a large amount of money.

Remember to raise enough to get yourself to the next stage where you can assess whether or not you need to raise more money. Keep in mind that once you choose a firm and raise those funds, that VC will probably get a permanent seat on your board of advisors. Choose carefully, because you are usually stuck with that investor for good.

4. You can't fire your VC

Too many founders abdicate their due diligence when it comes to the firms they end up pitching. Each venture capital firm has its own general focus on specific sectors or verticals. Taking that to a more granular scale, each partner within each specific firm maintains investments in a focused area of expertise.

Founders typically don't appreciate the incentive structure on the side of the fund, which is based on the size and the dynamics of that fund. Understand how the fund makes money to determine if it is a good fit for you. The size of the fund will be a good determinant for whether or not your company will present a quality investment opportunity for the partners.

You have to think of your VC firm as another partner in your business.  This leads to one of the single most important aspects of your startup/VC relationship: Make sure your goals for your company line up with your VC's goals for his or her investment. By aligning your goals with those of your VC, you can help potentially avoid a disaster scenario.  

"The disaster scenario is that the founding team wants to do something different than the board," Tunguz said.  

The risk/reward curves are different for entrepreneurs than they are for VCs, and board members (including your VC) have a legal responsibility to take into account the goals of the investors. So, if your company is losing steam and an acquisition opportunity comes along that is in the best interest of your investors, they might push you to take it, even if it means you don't get paid.

But, of course, you can avoid all that potential heartache by not taking funding to begin with.

5. Failure isn't death

Micah Rosenbloom describes venture capital as jet fuel. If you want to drive somewhere 100 miles away, you'll probably drive there. If you want to get from New York to Los Angeles, you're going to have to fly, and you will need fuel to power that jet.

Venture capital gives you potential—the potential for major success and the potential to fail spectacularly. The good news here—the gospel of venture capital if you will—is that failure is not the end of the story if you play your cards right. Despite stereotypes, most VCs are actually looking to build relationships with entrepreneurs, not just make money off of them.

"The Valley is small, and life is long," Tunguz said.

According to Tunguz, when it comes to his work at Redpoint Venture, great relationships are the motivation, because even if you fail it's not the end of the world. What is much more important is how you fail and how transparent you are throughout the process. If you keep people informed when you hit a snag and ask for help with a problem, you can build trust with your investors.  

Venture capital investors want to know that you will be a good steward of the funds they placed under your control. If you can prove yourself a highly competent entrepreneur and someone who will push as hard as they can to make an idea work, failure will not mean the end of your career as an entrepreneur. At that point, even if you fail, past investors and people involved with your company will be far more likely to fund your next project if they trust the way you work.

As an entrepreneur, burning bridges is unwise. Treat people with respect to build social capital, but don't see them as just a resource either. Other than that, always remember that if you're going to fail, fail big and go down swinging.  

Conner Forrest is a Staff Writer for TechRepublic. He covers Google and startups and is passionate about the convergence of technology and culture.