( When I was writing this, Steve Blank put out a great piece titled “VC’s Are Not Your Friends“. Highly recommended since it echos the message below. )
The startup community was set aflutter last week with news that Russian investor Yuri Milner has offered every startup in the current Y Combinator class $150k in convertible debt. It’s quite an incredible offer. The news coverage of this offer is overwhelmingly positive as it should be.
However, the offer also brings into question some of the lesser talked about aspects of fund raising, entrepreneurship and investing. That is that founders are not always aligned with investors when it comes to a )what the end game is for their company and b) the path to get there. Take this quote from the WSJ linked above, which makes an interesting comparison:
This blanket approach is akin to an index mutual fund where a money manager will invest in all 500 companies in the S&P 500, for example. SV Angel and Milner are assuming that there will be at least a few, if not more, big hits in each batch that will more than make up for the cost of investing in the others.
Now, what does a mutual fund have to do with aligning with your investors? When an investor runs a fund, that investor is investing in several companies with the expectation of returns. The size of the funds & investment dictate the desired returns. In general, though, the investor is hedging their bet that one or two of the aggregated investments will outperform all of the other ones, thus making back their desired returns. This is similar to how a mutual fund manager manages their fund. They can take certain risks knowing that unless they’re very, very unlucky, some of their risks will pan out and make up for the ones that don’t.
This strategy of a few successes canceling out all of the other failures pushes investors to steer & direct the company into becoming one of those successes. No problem there, that’s what they should be used for. The best investors bring more than cash to the table, they bring contacts, experience and credibility. However, they could, in fact, be detrimental to the individual company. They don’t need every risk to succeed, just 1 or 2 of them. While that sounds good to the investor, what about the risks that don’t pan out (for whatever reason ) ?
In other words, if an investor puts money into 10 companies and 2 are successful enough to get him his returns, that’s a good day. However, what about the other 8 companies with less than ideal returns? Some companies could just slow to bake. Some others will never attain the scale that most investors would like. Some could just be bad ideas or have bad execution. Some of those could be enough for the founders, but not for the investors. Hence the importance of being aligned and cognisant of what your investors want. Investors want exponential returns and that usually means growing & scaling the business. If the VC is prematurely pushing a company to grow, grow, grow without being able to sustain itself, the company could burn out quickly and lose its identity in the process.
Think of this like Intel or AMD overclocking their chips to see how fast each individual one can go. If they have to throw out a few that burn out, so be it. It’s worth it to find the ones that exceed their expectations. Good for them, bad for the chips that didn’t need the overclocking to work just fine. It’s great for you when you’re one of the former, bad when you’re one of the latter.
This rambling caution is just that: caution. It’s not a rant against investment, investors or the capital raising process. It’s simply the plea for entrepreneurs to understand the system they’re in, the deals that they make and who has what incentives. Simple economics argues that both parties in a deal will be self-serving first, collaborative second. It’s when one party misunderstands the others incentives and motives thats when things get dicey.