The Truth About Venture Capital

Control Freaks

Kawasaki, who recently authored his seventh book, Rules for Revolutionaries (HarperBusiness, $25, www.harpercollins.com, raised $4.25 million for each of the first two rounds of financing for Garage.com, and raised $12.5 million more last September.

Which leads to another myth: Entrepreneurs risk losing control of their businesses to VCs. That may be true, says Spencer Kluesner, president and CEO of CyberLoan.com, a Denver firm with an online application system for business and commercial real estate loans. "Venture capitalists usually demand a larger percentage than an angel investor, and often take controlling interest, but your private company is probably worth only half that of a public company with the same revenues."

Which is to say, in the words of Guy Kawasaki, "I have never met an entrepreneur who, after an IPO or an acquisition, said, `I'm worth $22 million, but if I'd taken 10 percent less dilution I'd be worth $25 million. I'm unhappy.' You're either worth $22 million or you're worth nothing. Don't focus on [dilution percentages]."

What should you focus on? "Build a solid business before courting VCs," says Bill Tomeo, president and CEO of Tellsoft Technologies Inc. The Colorado Springs, Colorado, company, provides technology that enables customers to use any telephone to create, broadcast and archive live audio to the Internet. "Do your homework. Determine which firms play in your market, what their expectations are and at which stage they invest. Perhaps more important, evaluate your management team. Before VCs put money into your business, they want to ensure you have a [capable] management team."

Tomeo should know: He was brought in to assist the company's founders, former MCI engineers who lacked management experience, as part of TellSoft's initial $1 million round of venture funding. The founders remain aboard as executive vice presidents, and the company secured second-round financing of $7.3 million in October 1999.

In a recent survey of VC firms by Profit Dynamics, management caliber was the primary factor influencing investment decisions. The other determinants, in order of importance, were:

1. size of the company's market;

2. proprietariness, uniqueness or brand strength;

3. return on investment; and

4. potential for growth.

While two or three years ago VCs wouldn't even talk to inexperienced entrepreneurs, many VC Web sites now reflect a more relaxed posture, calling for "an experienced management team or the willingness to build one." It seems VCs are accepting the fact that the entrepreneur may constitute the entire management team.

Does that discredit the myth that VC firms are out to wrest control from founders? "It's not about replacing existing management, unless they're underperforming," says Kluesner. VCs, he says, look for "a balance that will provide investors with an outstanding return and motivate the founder to become wealthy in the process. We have never had a success where the company leaders did not become multimillionaires. The question is, how wealthy the founders will be relative to returns to our investors. And sometimes those founders are displaced."

Which may not be such a bad thing, argues Arthur Lipper, whose British Far East Holdings Ltd. in Del Mar, California, arranges financing for companies with extraordinary risk-related potential. "Investors frequently prompt management changes" when projections aren't met, says Lipper. He sees that as good for the entrepreneur, who, after all, is also an investor. "Coaches retire pitchers when they aren't performing. Why shouldn't entrepreneurs be retired [similarly]?"

To minimize the risk of being phased out, negotiate an employment agreement. But don't insist on control. Venture firms want top-level management--people who have taken companies public, have venture-backed management experience and boast a high-growth history. If that's not you, be prepared to step aside, because even if your technology is unique and the potential great, venture capitalists will walk away from an intransigent founder unwilling to relinquish control.

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This article was originally published in the February 2000 print edition of Entrepreneur with the headline: The Truth About Venture Capital.

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