Be Careful What You Ask For

By Frank Demmler

Last week, I started the column with a particular point to make, but by the time I finished telling entrepreneurial “war stories,” it would have taken me another column’s worth of explanation to tie it all together.

This week then, I’m going to lead off with last week’s original point to make sure it gets made:

SIX OUT OF TEN CEO-FOUNDERS OF VENTURE CAPITAL-BACKED COMPANIES ARE NO LONGER WITH THEIR COMPANIES WITHIN FOUR YEARS OF RECEIVING THEIR FIRST VENTURE CAPITAL INVESTMENT.

I hope that’s a sobering thought.

The road to hell is paved with good intentions

Once an entrepreneur and a venture capitalist have successfully proceeded through the mating process and have closed on a deal, everyone is supposedly on the same side of the table and pushing in the same direction.

In an ideal world the first-time entrepreneur will execute well against his plan. Constructive relationships will be created among management, investors and the board of directors.  Unanticipated events will cause minor mid-course corrections, but the company will weather those storms. Over time the company will grow and prosper ultimately providing an exit for the investors through an acquisition or initial public stock offering.  Presumably the entrepreneur has set the stage for his personal goals, be it cashing in himself, or achieving a platform for explosive growth through the liquidity event.  Everybody’s happy.

In fact, if you are the first-time entrepreneur, you expect this to happen.

If you are the venture capitalist, you hope this will happen, but you don’t really expect it to. 

Your experience is likely to be that over half of your portfolio companies will never achieve the commercial (and financial success) that had been hoped for.  Less than 30% will provide attractive returns, and less than 5% (1 out of 20) will be the “home runs” that “make the fund.”

Also, as a venture capitalist, while you really do hope that the founder-CEO will grow with business and continue in the role of CEO throughout this process, you know that’s highly unlikely.  Further, if the founder is not the long-term CEO, you hope that the founder is sufficiently mature and self-aware that he can play an ongoing and meaningful role with the company. But being realistic, you know that it’s better than 50-50 that the CEO-founder will have to be separated from the company.

You hope that this founder will prove to be the exception that proves the rule, but in your heart-of-hearts, you don’t really expect that to be the case.

 “How can this be?” you may ask.  Everything you’ve heard about this process has been that the investor bets on the jockey, not the horse.  You’ve heard the standard VC observation, “I’ll take an A team and a B idea every time over an A idea and B team. The A team will figure out how to make the business work. The B team isn’t likely to,” more times than you care to remember.  If this is true and they’ve invested in you, then they must consider you part of an A team.

The irony is that they do, at the time of the investment.  You are the right person to lead the company today.  You’ve gotten it this far and you will be important in taking the company to the next level.

frequent first-time entrepreneur behavior

BUT the likelihood that the company will achieve this new level without some serious challenges along the way is unlikely.  Will you rise to the challenge? Will you be able to work with your board and investors to take the necessary steps?  Do you even know how to respond to these bumps in the road? Do you have the skills to execute these responses?

Very frequently, in my experience, first-time entrepreneurs will assume a bunker mentality. Due to inexperience, misplaced loyalties, personality quirks, or any of a number of reasons, a first-time entrepreneur may do exactly the wrong things.  Instead of discussing the circumstances, he hides them.  Instead of preparing the Board and investors of likely unpleasant future events, he plays “ostrich” and hopes they go away.

All of these things undermine the relationship with the Board.  If it gets to the point where the Board doesn’t trust the founder, then a change in CEOs is the likely to occur.

Note that it isn’t the business issues, per se, that cause the separation of a CEO from a company, it is the relationship of the CEO with the board and their faith in him.

Even when your company achieves that next level, there are no guarantees that you will be an A player under these new circumstances.  The skills that made you an A player at the time of the investment may not be the ones the company needs to achieve commercial traction.  It is the rare person who can create a company as well as lead its commercialization efforts.

revisiting control

“But, I still own a significant part of the business.  They can’t just throw me out, “ you may protest.  Yes, they can.

Even if you owned over 60% of the outstanding stock at the time this occurs, the nature of the deal that you did with the VC to get its money will contain such provisions.

When you take outside investment, your company is no long YOUR COMPANY, particularly if the outside investment is from a venture capital firm. 

As part of the deal, percentage ownership and control will be separated.  Typically, there will be a shareholders agreement in which all shareholders, including you, will agree to vote their shares for a specific board structure.  For many early stage companies in this situation, it is common for the board to have five members, two nominated by the founder (or common shareholders), two nominated by the investors (or preferred shareholders) and one mutually agreed upon. Your signature on this shareholders agreement takes precedence over your percentage ownership rights. I do not know of any VC that would do a deal that didn’t have such provisions in it.

So, returning to corporate structure 101, the shareholders elect the members of the Board of Directors.  The Board then chooses the management of the company.  Since you do not have an absolute majority, you are at risk.  If the investor board members can convince the independent third party that a CEO change is needed, then you are out!

In most cases the “hand writing is on the wall,” and some negotiated separation can be structured.  If such a negotiated agreement cannot be worked out, the legal agreements will serve as the default rules.  In most cases, you won’t want that to be the case.  Work out a deal.

Advice to entrepreneurs.

1.     Accepting venture capital is not without its risks.

2.     Do not assume that you will be the exception that proves the rule.

3.     It is essential that you build constructive, positive, high-integrity, mutually respectful relationships with the members of your board and your investors.

4.     Be careful what you wish for.  You may get it.

5.     Build a network of mentors, advisors, professionals, and entrepreneurs who have “been there and done that.”

Frank Demmler is Adjunct Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at Carnegie Mellon University. (Website)