The Dark Side of Venture Capitalists

After talking about the dark side of entrepreneurship, we explore the dark side of venture capitalists. When do you know when you should not take money from a venture capitalist? What are the kinds of clauses and problems that you will face dealing with a venture capital?

My first encounter with the term venture capital is in a master class taught by Alan Burrell in Judge Institute, the business school in Cambridge University. Traditional entrepreneurship courses loved to trumpet the importance of fundraising with either venture capitalists and business angels. There are two characteristics of venture capitalists which make them different from standard investment bankers. The first is that they tend to make high risk investments and second, they have an appetite in high technology companies. To ensure that they are making the right investments, they adopted a process called due diligence to check up the validity of the startup, and also used typical financial instruments to calculate the valuation of the company. In short, they want sustainable, scalable and profitable new ventures.

Of course, in reality, there are startups which require venture capital and there are those which don’t. Oftentimes, I shook my head if an entrepreneur who wanted to start a cafe, a consultancy, a restaurant or a retail store enquire about getting venture capital fund for a startup. Why do such entrepreneurs will not gain the the VCs’ cash? It’s precisely the above three words that I cast in bold. Venture capitalists are not bankers. They are not here to offer a loan to you and if they do, be very careful. Even if you are high tech entrepreneur, it does mean that you should accept their cash. It’s best that you don’t. Unfortunately, most molly-coddled entrepreneurs will follow the standard textbook convention and get themselves into ridiculous situations. Here are the features of the dark side in venture capitalists, and so you are warned:

• “He who has the gold makes the rules.“: My mentor taught me this cardinal rule when I did my second startup in Cambridge. If you have nothing to exchange other than your business idea, you have to be extremely careful with venture capitalists, and sometimes even business angels. Remember I told the story of a business angel cheating a group of young entrepreneurs by valuating contacts with equity and subsequently capturing the company from them. Since they have the gold, they have the power to lock the entrepreneurs with legal contracts. When you sign off the contract, you are also trading part of the control of the company to the venture capitalist.
• Don’t be fooled that they are here to make big companies: Not all venture capitalists are like this. It is known that there are two groups of people who will become VCs. The first type are the investment bankers, who decided to quit a big bank like Goldman Sachs or Morgan Stanley to do wealth management for very wealthy people, and the second type are former entrepreneurs who understand the process of being entrepreneurs. Regardless of which group, their main task is to take the money of private wealthy individuals and spin back ten times the profits. Because their primary motivation is profit-maximization, they can sell your company out even if your company might become a Xerox or Microsoft. Lawyers are the group of people who they employ to ensure that their profits are maximized and the entrepreneurs are screwed. When you sign a deal with a VC, please make sure that you read carefully in the “terms and conditions” the powers of the investor. I am pretty sure that there is an exit clause that gives them priority to sell shares to anyone they choose.
• The founders are not owners but employees: Some venture capitalists are ruthless in their investments, i.e. they create the magical conditions in their investment contract that the entrepreneurs will end up becoming employees rather than owners of the company. They adopted a few standard strategies to do this: (i) they have high equity stake in the company, which allows them to have someone on the board of directors to micromanage you, (ii) they impose a clause that you can only afford a maximum salary of $X dollars, and (iii) they made clauses that the founders can sell the shares to no one, and they are the only people who can sell without permission.
• They reduce your worth: When valuating your company, they reduce the actual valuation. The reason for this is to increase their equity stake in your company. It is important that the entrepreneur should enquire with industry leader or other people about estimating the actual value of the company before taking money from venture capitalists. Of course, as the entrepreneur, please be ready to negotiate.

So, be prepared to deal with the dark side of the venture capitalists. In essence, bootstrapping is a better rule to start a business. Remember most successful companies did not start off with venture capital and the reason is that they want to avoid the above possible scenarios which may lead their company to demise.

Updates:
[1] Coincidentally, Bjorn wrote the other side of the story on the six Ps to clinch investment money from VCs.

Technorati Tags: Entrepreneurship, Singapore Entrepreneurs, Dark Side of Venture Capital, Fraud, Con and Sham, Venture Capital

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