A pier in Oceanside, California, at sunset

Why Venture Capital Doesn’t Scale Part 2: Venture Capitalists Prop up Organizations on Stilts of Cash on a Wavering Shore

by kirkcoburn
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In a recent blog, I mentioned that venture capitalists prop up organizations with cash (sometimes even when they’re mediocre). I am not going to touch SPACs, the hyperbole of my recent statement. Some people feel that we see more and more of this behavior among VCs, and I agree. The goal is often to underprice products or services, even at the risk of taking deep losses to ultimately cripple the competition. As discussed before, it’s how the game is played (and has been since the 1800s). 

But there’s so much more to it — so many other reasons one could prop up a corporation with capital. Many inexperienced VCs choose to supply an organization with immense funding for the sake of reputation. A sort of corporate “street cred,” if you will. They’re attempting to make a name for themselves using investors’ funds, and it’s faulty reasoning.

There are two faulty ways green VCs (and the potential investors vetting them) might think about this in the short term.

From a venture capitalists point of view:

  1. I was involved with Unicorn Corporation X. Therefore, I have mastered my job. I’m a winner, and I walk on water.
  2. Corporation X is now too well-known to compete against. My investment choice created a gorilla in the industry. Therefore, I walk on water.

Guess what? None of us walk on water. This kind of thinking can create baseless confidence that VCs shouldn’t explore, much less espouse! When less-experienced venture capitalists begin to believe these falsehoods, they begin to pitch these falsehoods to potential investors and founders — even if it’s subconsciously (did I say WeWork?).

The outcome becomes an over-confident VC, an inexperienced founder, and a misled investor. It’s like a trifecta of doom for money. 

The Wavering Shore Where Venture Capitalists Prop up Organizations

Today, I’m here to wipe away those concepts for the sake of VCs, founders, and future investors. My primary point is that a corporation propped upon cash stilts is still sitting on a wavering shore.

The point is that it’s not only about knowing when to get in. We need to know who we’re getting in with and what they’ve accomplished.

For Inexperienced Founders: How to Vet a VC

Dear Founders,

Great VCs will vet you. You should be doing the same thing. Learn as much as you can about the potential investors in their stable, too. These relationships will probably last longer than the average American marriage (eight years, per the US Census Bureau), and they’re far more difficult (read: expensive) to deconstruct. And like a vicious ex-spouse, their decisions can be practically impossible to reverse. 

Good thing there are other fish in the sea.

Talk to VCs, and Talk to Other Founders.

There’s a certain amount of salesmanship involved in investing. You will surely find a lot of type-A personalities in the field. They write books about their wisdom. They hang out with rock stars. Not that there’s anything wrong with that; you want a connected, competitive VC. That’s to be expected. There’s also a unique rush that comes from signing a great term sheet. But once that honeymoon is over, you need a venture capitalist who is quick with communication and ideas. 

I think Yanev Suissa of Sinewave Ventures says it well: “A lot of investors like the deal-making part of the job more than they like the executing-on-ideas part.”

You don’t want a VC who’s going to gallivant off to the Bahamas immediately after signing the term sheet. (Or do you?) Most founders want an investor who will take up the yoke and dig into the work right away. The VC’s other founders will provide you with a good understanding of his or her work ethic and interest level.

Of course, some start-ups would prefer a low-action VC. If that’s the relationship you’re searching for, be upfront about it! This will save time for everyone involved.

Ultimately, you want to know what a VC is like when times are tough. And no one can answer that question better than other founders who have worked with this investor. If the VC you’re vetting doesn’t care to share a founder’s contact information with you, this should be a huge red flag. 

Ask Questions

You must ask questions. Go over the game plan in detail. Lay all of your hopes and dreams on the table. Hopefully, the VC you’re vetting has some quality insights and directions to give you and questions to ask, as well. Take your time with these conversations. It’s not like speed dating. Remember, a background in your industry can be tremendously helpful, but it doesn’t need to be a deal-breaker (as long as you know energy well). A fresh outlook coming from another sector can be priceless.

After funding, the most valuable asset a VC provides to your business is credibility — again, back to the “street cred” idea. Evidence that a renowned investment firm is backing your company can be a massive boost to your reputation and have a tremendous impact on your business in other areas, like talent acquisition.

And that’s a significant point, particularly in a post-COVID world, when top talent might be hard to recruit. 

  • Ultimately, the backing of a renowned investment firm can create positive ripples throughout the entire organization and greatly impact your success.
  • Have no doubt, the business that attracts the highest-caliber talent in a competitive market — like CleanTech, or FinTech, for instance, has a considerable advantage.

Finally, look for believers. A venture capitalist who understands the value of your organization and your goals is key! If you get the feeling they don’t believe in your business or that they’re all bluster, move on.

For Investors: How to Choose the Right VC

A pier during a heavy storm, with large waves
When venture capitalists prop up organizations for the wrong reasons, they can’t withstand turbulence — or they do even when they shouldn’t.

It’s been more than 450 years since poet Thomas Tusser penned the phrase, “A fool and his money are soon parted.” That sage advice is only more poignant in today’s bizarre market. The best advice I could give to investors looking for a venture capitalist is to vet them thoroughly. When venture capitalists prop up organizations without substance, investors suffer.

The personal network of the VC you’re researching is vital. So be direct! Ask if they have made syndicated investments or have helped their portfolio companies get a follow-on investor. If you’re only looking to work in a specific industry like CleanTech, their network should include plenty of big names in your chosen industry. 

Character Traits That Matter

Apart from their track record, you need to understand a VC’s character. A new venture capitalist will become a big part of your life for the next few years, at least. Take time to analyze their “bedside manner.” Are they trustworthy and honest, or do they seem like shady used-car salespeople? Do they understand your business model and corporate culture? Do they call you back immediately, or the same business day, or within a week? Can you cope with their communication style? Your VC should become a coach and partner, never an opponent — and some personalities don’t gel together well. It’s nobody’s fault, just the nature of human beings.

Now, let’s circle back to the idea that venture capitalists prop up organizations artificially — for a time. Will an artificially propped-up corporation ultimately founder? It happens. In the case of WeWork, did the investors do anything but throw away vast amounts of capital on a business model that was never going to make money? It seems that way. 

Still, some VCs think they’re walking on water after an investment that ends up like the WeWork disaster. And that’s dangerous thinking for founders and investors. 

How Can VCs Make Money After Poor Choices?

I plan on addressing this in-depth soon. For now, know that venture capitalists do make money on investments that end up failing. That money comes in the form of MANAGEMENT FEES. The bigger the investment, the more they earn. The occasional wrong choice or poorly timed investment should be an utter career-buster. A VC’s record should be very important to both founders and investors. (But that’s a blog for another day.) 

So What Comes Next?

Whether you were involved with the WeWork catastrophe or not, if you’re like me, you’re ready to put 2020 behind you. The stock market withstood 2020 well enough, though there were some concerning moments of volatility. Still, morale is good. Consumer confidence is improving, and there’s no inflation to speak of. I’m feeling cautiously optimistic about 2021. And I’m not the only investor who thinks this way!

Morgan Stanley projects the S&P 500 will rise to 3,900 by December 2021. The big dogs of Wall Street are making confident, bold moves — particularly in the realms of Tech and the Energy Transition — as the year comes to a close. Stay alert for warning signs that start flashing when venture capitalists prop up organizations they shouldn’t (and I may write a warning on the pending SPAC situation as well), but there’s room for optimism.

Stay tuned for my next articles. We’ll take a look at management fees and think about how VC-backed companies are being protected by the government. It’s not just that venture capitalists prop up organizations; there are other problems, too.

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