Venture Model Makeover & Diet Plan—Step One


A lot of people have been asking lately if the venture model is broken. But it seems to me that it’s just decrepit. Like an aging, rotund former football star, the venture industry is scratching its head and realizing that its glory days are long past. The industry collectively doesn’t really know how to handle its new reality. In the heyday, top-quartile funds might have gotten away with treating their important stakeholders arrogantly, but given that even top-quartile firms have not provided great returns over the past 10 years, venture GPs will need to make herculean efforts and adhere to a strict regimen in order to make the upcoming cut. With almost the entire industry needing to raise new funds over the next two years, there may be few survivors. I propose a three-step makeover plan for those paunchy firms that are on the edge.

Step one: Stop devouring entrepreneurs. These tasty morsels can be irresistible, to be sure. They work for years to create a business, innovate, and execute, and they bring the fruits of their labors to you. GPs, you must learn to control your appetite and realize that these individuals are not going to continue to feed you if you chew them up and spit them out.

A case in point was hinted at in an earlier post about “down” being “the new up” by Michael Greeley of Flybridge Capital Partners, chairman of the New England Venture Capital Association and a board member of the National Venture Capital Association. Greeley made the argument that venture-backed companies “should be considered fortunate to just raise capital, at any price, in this environment.” I don’t mean to pick on Michael, as he is only reporting on the current prevalence of this kind of thinking among VCs, but why should a company be lucky to take in financing that wipes out the ownership of everyone but the venture funds who participate, just because we are now in a tough economy? Venture capital is a long-term game that is meant to take companies to an exit years from now when the economy will probably be completely different.

One could argue that it’s only reasonable and good business to protect the venture firm’s downside at the founding team’s expense, but is that really true? Usually the founders are only left with a small percentage of the company after a few rounds of funding even in the best-case scenarios, so for an additional 5 to 15 percent of the equity is it really worth … Next Page »

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Daphne Zohar is the co-founder and CEO of PureTech, a Boston-based life sciences firm focused on translating academic innovation into commercial success. Follow @daphnezohar

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18 responses to “Venture Model Makeover & Diet Plan—Step One”

  1. Mark Klopp says:

    Daphne makes some excellent points about our job to enable entrepreneurs to build these ventures and the need for everyone to be able to share in the upside of a successful company. There are significant negative longer term implications on future deal flow and venture fund sustainability from a reputation of repeatedly diluting out of founders, angel and seed investors on any kind of stumble or missed milestone or just because it’s difficult to raise money.

  2. The dynamics are bit more complicated and nuanced that I think Daphne presents. The key for entrepreneurs is to seek to work with financial partners who’s own strategies are in alignment with theirs. For example, it doesn’t matter where the economy is, if a venture signs up with a large fund, that investor needs a very large exit to move their needle and will push the company to achieve that exit. Conversely, if the investors are too small for the opportunity, it can be underfunded, run too conservatively and lose ground to competition. There’s nothing more dilutive to founders equity than death.

    Also, even in the shoot-for-the-moon scenario with a recapitalization along the way, current management will always get taken care of. Sure the initial founders’ equity might be wiped out, as Daphne points out, but for the management team to continue, they’ll get more options at whatever rate the investors will bear. And, the more likely the chance of the venture’s success, the more negotiating leverage management has. Founders who have left the company are a different story, of course, but that gets back to the ultimate scale of the venture, the match of their skill set to it and the growth progression.

    Ultimately, it’s a challenging business development and operational problem. Down markets–and recessions–highlight the consequences. It’s there regardless of the economy and in some ways more painful in up markets because the mistakes are easier to make.

  3. Daphne Zohar says:

    Thanks Mark. That’s an excellent summary.

  4. Daphne Zohar says:

    James – alignment between the company and the venture fund is key of course but assuming that you have that dialogue prior to funding, you have agreed on a vision and a funding plan. Question is what happens after and why a tiny bump in the road or a poor economy wipes out the founder holdings. Also in the case of a win, have the entrepreneurs received the kind of return that justifies them bringing their next company to that fund?

    Regarding management/founders, you are missing the point. Management is usually well taken care of but management team that is brought in by venture funds tends to be domain expert managers not entrepreneurs.
    The folks who create companies are entrepreneurs (the initial founders you refer to) and they are usually replaced by the time there is an exit. Perhaps one of the problems is that the industry uses the term “entrepreneur” to refer to managers.

  5. Daphne-Generally agree on both points but think there are a couple distinctions and one big issues that’s implied but not yet stated. On the first, at least we at CommonAngels and most of the venture firms we’ve worked with have been pretty loathe to implement a recap over a “tiny bump” or a even a poor economy. The first course of action is usually a bridge round and sometimes the second and third as well.

    On the second point, yes, founders (vs. mgt) need to be rewarded otherwise there won’t be founders in the future. Perhaps I wasn’t clear here: whether founders are still with the company later very much depends on the pressure to grow the company at a rate that requires different skill sets or continues to give them a meaningful role. More organic growth and lower exits tend to play well to founders’ skills vs. trying to scale quickly by bringing in managers of managers, who hire their lieutenants and so on. I’ve had some very successful retentions of founders and some unfortunate departures and feel the loss of a founder usually is a blow and setback to a company’s culture and institutional knowledge.

    The bigger issue that’s implied here is that “venture capital” as we know it doesn’t just need to have a makeover and diet but has an opportunity to change in form and structure to match specific companies’ needs and situations. Clearly, that’s part of what you’re doing with PureTech Ventures. It’s also happening with other new organizations such as TechStars and Y Combinator. CommonAngels itself is a continually evolving structure, and now a member of the National Venture Capital Association, which seems to reflect NVCA’s own openness to evolve as well.

  6. Daphne Zohar says:

    Thanks Jim. I agree with most of what you said. Regarding a recap, whether it’s a bridge followed by a down round or a recap the result is the same if it leaves the entrepreneurs with hardly any ownership. Thanks for your comments!

  7. Jules PieriJules says:

    When I read your piece I was reminded of a book reviewer I met while living in Dublin. She had a regular column in the Irish Times, yet she only reviewed foreign books. I asked her why. She said, “This is a small country and I want to still be able to get a pint out in public without getting thumped on the head every time I meet an angry author.”

    You’re in a small industry….you are brave to risk thumps on the head! (from your peers, I mean.)

  8. daphne zohar says:

    Thanks Jules – some of my friends and colleagues who are great venture capitalists are really trying to change this paradigm and the rest hopefully have a sense of humor :) I have a hard head in any case…

  9. This is a great post and 100% spot on. However, I think VCs who themselves have never been entrepreneurs will in many cases have no idea what you are talking about.

  10. I love this post! Straightforward and a refreshing viewpoint. I hope it generates the debate it deserves.

    I have always believed that effective relationships work when the players value is understood, resources are applied effectively, and course corrections are made as needed to meet or exceed the objectives. The entrepreneur is key, along with a clear business purpose. Resources including cash can be gathered through a number of sources. If VC funding is needed and at a minimum the three points above are addressed, a solid foundation can be built.

    Your post represents the essence of a solution to build a better foundation.

  11. Terry says:

    I enjoyed your viewpoint. When can we expect part 2, 3, and 4 etc.?

  12. I was pleasantly surprised to see that I was referenced in my good friend Daphne’s recent Xconomy post. To clarify though, I made those observations nearly five months ago in the vortex of the economic crisis; my advice was to entrepreneurs who absolutley had to raise capital this past spring – it was more important to see the company survive I felt than hold out for a higher price and/or marginally better terms given the capital markets were effectively closed at that time and it was not at all clear when they were going to re-open.

    In general I agree with much of what Daphne posits, but it is important to note that the most effective VC’s “get it” that in order to generate attractive returns companies must have compelling incentive structures in place for both founders and management. While some of the financial engineering tools Daphne alludes to may undermine those incentives, not all of them do. For instance, appropriately tranching investments (with step ups) retains more ownership to founders and management than had the company simply raised all that capital up front. It also ensures great focus on only those activities which will create value (and is not unlike the arguments for smaller VC fund size frankly).

    I tell all the companies that I am privileged to work with that “it is not how much you raise but rather how much you own” which is most important. Focus on your ownership and value-creating milestones and you will be in good shape.

    One last observation – in the event of a recap the investor has lost most, if not all, of his/her invested capital. More often than not, a recap occurs when something did not work out – who is responsible in that situation – the investors or management and the founders? Undoubtedly it is a shared responsibility but the investors invested in the team’s business plan, vision and ability to execute.

  13. Daphne Zohar says:

    Michael, good to hear from you :)

    Regarding your comments, I agree that tranches can be structured in a balanced way that provides economic incentives for the entrepreneurs (eg. by pricing at a step-up as you describe). The question is how often everything goes exactly according to plan: no delays, no economic fluctuations, internal venture fund prioritization remains consistent, etc., particularly in an R & D driven industry. In the case of a small delay or hiccup where the VC continues to support the company, why should there be punitive damages to the founders? If the investor walks, he loses the investment but usually the investor participates and then owns the same amount afterwards.

    I don’t think founders are necessarily to blame if there ends up being a recap. It seems to me that the entrepreneur’s job is to get a company started. This takes a lot of creativity, perseverance and hard work. Given that the innovation food chain is severely damaged, it is not good business practice to wipe out the founders and early investors who did their job and brought those deals to VC. I agree that VCs have a tremendous influence over the company post-funding and therefore share responsibility for both bad and good outcomes.

  14. Jonathan Kil says:

    What a thoughtful commentary on some of the more significant problems with VC investment strategies that can strangle the entrepreneurial life blood out of a start-up or early stage company. Perhaps this is why the has taken off in recent years.
    We were faced with some of the terms and choices that you stated (tranched round with no step up in valuation, more specifically, your a Phase I co now with a pre of $15M and want $10M to complete your Ph-IIs and you want $30M later to complete your Ph-III; typical VC response, $10M is too small, how about $40M, $10M now and $30M later when your a Ph-III, plus a participating preferred and approval right for any partnership potential on your lead product). While the company that chooses this funding pathway lives for the next 2 years, they will have no other way of fostering the COMPANY’S success. Company’s always need alternative funding and development strategies to be successful. Saying it is my way or else is the antithesis of a good partner.
    Some founders definitely need to step aside but it should be done with respect and an upfront approach vs I put in my money and you are out. In many cases the right founder will want a more accomplished executive to take the company to the next level and readily take a board seat to offer expert technical points of view.

  15. “In a world with no VCs, entrepreneurs WOULD bootstrap, work collaboratively with strategic partners, and create new models to finance their companies. Entrepreneurs have creativity and perseverance.”

    Here in Seattle, today something new is happening:
    we ARE bootstrapping.
    we ARE working collaboratively with strategic partners.
    we ARE creating new models to finance our companies.

    There is a way for founders to “win” this game by taking advantage of some key observed phenomena created by the actions of the last nine years (talked about in this article in Xconomy – We have to stop playing the game with the current players and current rules – that’s insane. The way to win is to stop playing their game – see the field – pick up the ball and play offense – take what the defense gives you. The founders that are finally willing to do this are the one’s that have the chance to dramatically change the way we start companies in our beloved industry…thus creating a more level playing field.

    For every action there is an equal and opposite reaction. Markets are like biological systems – they evolve, certain things are “selected for” just like in Biology – the only problem is that the natural selection or back-lash in this evolutionary process is dramatically delayed due to outside interference (federal reserve, Bernenke, etc) or conventional wisdom…,- “You can’t start a biotech company that has the ability to create billion dollar drugs without venture capital!”
    YES WE CAN. (sorry Obama campaign)

    The current players won’t change their game…..
    -then we, the founders, will – we ARE at North Coast Biologics
    So many people I speak with who would like to start new companies challenging the current model express their fear as a deterrent.
    -at North Coast we are not afraid. A good technology and unorthodox ways excel in this environment
    Since the days of our industry founders – and more so in the last 15 years, no one has worked hard enough to stay on course to complete the founder’s mission….for the entire game.
    -at North Coast we will work hard enough – if you have a technology that produces entities that people want to buy – it will pay enormously (not just monetarily) to expand and create opportunities that to some seem unconventional but to those “in the know” see the endless rewards.

    I was always jealous of my high-tech geek friends who could start companies in their garages. I always thought it was impossible to do that with biotech companies until I found a garage and fixed it up into a lab that is a fully operational cell and molecular biology facility with automation and high throughput capabilities furnished by Ebay, Craigslist, and local auctions from companies that took in venture capital, grew too fast, failed with their inflexible business plans, and fell from the stratosphere to the ground rather than growing organically (you know – the current model of waste and slash&burn).

    Daphne Zohar – I love your article. I WOULD enjoy meeting you for beers the next time I’m in Boston (in 2-3 weeks actually). You’ve brought up some very interesting points that warrant discussion and I am very interested in letting “the cat out of the bag” – ie. add some reality to some of the subversive methods that founders might use to leave the venture capitalist entirely out of the discovery phase of biotech – which I guess when you think about it, they have primarily avoided anyway. But imagine what it would be like to sell your drugs directly to the partners that need to fill their pipelines without having to raise a dime of venture capital. It sounds appealing….and is currently the new model here in my garage-lab in Seattle.

  16. Daphne Zohar says:

    Jonathan – thanks very much for your comments. I agree. Maybe part of the problem is that the venture industry has become desensitized to the perspective of founders (who cares – there is plenty of deal flow). Yes, but how is the quality of that deal flow?

  17. Daphne Zohar says:

    Johnny Stine – You’re on. Maybe at the Xconomist party… We are doing some of that direct partnering with pharma through Enlight Biosciences and I look forward to hearing about your ideas and brainstorming further.