Founder-fair capital

“The study of a company is not the study of a dead body… it is the study of things and relationships. They are very much alive and constantly changing… it is the study of people and people’s work, of their hopes and aspirations… a study of the determination of successive goals and of the victorious competitive drive towards them.”

Quoted from the “father” of venture capital, Professor Georges Doriot, this statement illustrates the most critical aspect of startup investing - understanding people and, in the case of early-stage companies, the Founders.

Perhaps due to an increasing realization of this concept, in the middle part of this decade, there seemed to be a mad rush for VC’s to launch or re-position themselves as “Founder friendly”. Some new firms even launched with the term "FF" incorporated into their fund name. The landscape they were painting featured investment terms that preserved large amounts of Founder equity, creating unusual offerings of nonvoting common shares, or the tolerance of bizarre nepotistic succession plans.

Fast forward to today and the Founder-friendly painting has turned into more of a pencil sketch. Maybe this was influenced by the renegade and bizarre behavior of the Kalanicks and the Neumanns of this world, who have run amok with little oversight or penalties, or due to a shrinking number of deals being written. Whether we see a total reversal or a subtle adjustment to the balance of power in early-stage investing, I believe there are some core tenets that early-stage investors and Founders should retain and deepen.

This article is my best attempt to articulate my belief system around investing in and supporting Founders. Also, for you entrepreneurs out there, perhaps you can find some value for when you are raising a round and choosing your preferred investors.

Let’s break it down into a handful of key areas:

The role of an Investor

• To pass on experience. One of the fundamental questions I encourage all Founders to ask is “why is this firm the best investor for us?” Flipping the coin over, a good investor has to ensure that the company in due diligence can benefit from her or his personal experience. This muscle memory may be derived from past/current investments or from a previous career, which has taken place in the same or complementary markets. It is the joint responsibility of the Founder and the investor, to determine if she/he is the smart money for you. The sense of satisfaction that I get from being able to shed light on a hitherto unknown subject for a portfolio company Founder is palpable and deeply rewarding. Your cap table is too precious to be filled with muted voices.

• To offer up your network. This goes hand-in-hand with experience - the contact list that an investor has earned over their life can be life-changing for an early-stage Founder. Also, expect the unexpected with the type of person that your Founders want to connect with. One of my angel investor friends is a retired NBA player and he has created friendships with people who have no experience in professional sports but are inordinately helpful to an enterprise SaaS startup. Your network connections should be given without an expectation of receiving a financial kick-back or reward. It is my job, as an investor, to connect Founders with people who are smarter than me and can help them grow.

• To be a reliable source of capital. A primary element of an investor’s job is to provide capital when they commit and when the Founder needs it. This doesn’t mean that the Founder needs to wait while an investor goes out and creates an SPV with friends, this means funding quickly and without any unexpected terms or conditions. Also, it is vital that the investor is upfront with their Founders on your appetite or capacity to invest in their subsequent rounds.

• To be a sounding board. In my experience, the most useful advice I have given to a Founder is not during quarterly meetings, but when meeting them over a coffee and discussing some of the hard issues affecting them personally or in business. It is our job to be available over the weekend for a call or a drink to discuss a Founder’s burning issues. It also our responsibility to let the Founder run their own company and to empower them to make the right decisions. It is not our job to run amok at the end of the quarter, derail board meetings (caveat: things may start to go this way if there are some serious lapses of judgment!), micro-manage, and/or to replace the CEO. If you have investors like that then I feel sorry for you and urgent steps need to be taken.

• To not pillage the cap table. Have a policy or a target for ownership. Unless the investor wants to run the company (alarm bells!) do not insist on selling unreasonable amounts of equity. This is explored further below.

• To not be a nuisance or greedy. I have seen investors become a bit of a handful when they get a little too ingrained in the weeds of the business. In the case of making co-investor introductions, it is our responsibility to only make qualified connections (i.e. those who are relevant and/or have the $$$). When it comes to new business leads, I will never make intro’s and have a personal back-end component from the seller or the buyer. It complicates things, projects the wrong behaviors for all, and also feels like double-dipping.

The role of a Founder

• To work hard and deliver results. Not really rocket science but you should never forget that venture investing is a high-risk asset class and early-stage investors often have little data on which to build conviction around their investment, other than a trust in the Founder and their passion. The definition of “results” varies from one investor to another, however, it often manifests itself as returns, revenue, solving hard problems, and building legacy. Crushing it these regards will always bring about a smile.

• To be transparent & honest. Never lie (even a little white one) to a potential or an existing investor. For one, you run the risk of running into scary things like securities fraud and, for two, it burns any trust that ever existed. Enough said.

• To build a company that inspires others. Founders who realize their weaknesses and hire intelligently to fill the gaps and build a succession plan, in my experience, are best poised for success. Microsoft is a great company because of its long line of remarkable CEO’s from Gates, to Balmer, and now to Nadella, and not because Windows is a simply amazing product.

• To act responsibly with the deployment of assets. I enjoy working with Founders who are judicious with the capital they have raised, the structuring of their cap tables and ownership, and the types of concessions they make when securing subsequent rounds of capital. Founders’ obligations should be to their existing shareholders, their employees, customers and themselves. Creative structures that compromise employee stock option pools and/or try to align common with preferred shareholders (hint: this never works) often fall apart when difficult decisions are needed to be made in the future.

Taking these two sides and their goals into account, I personally believe that Founder-friendly capital is a myth. No one wins when it is too lopsided in either party's favor. I much prefer the notion of Founder-fair capital, which is more achievable and mutually beneficial for all stakeholders.

So what are the core elements of Founder-fair capital?

• Ownership that promotes the right behaviors. As a seed-stage investor, I expect Founders to retain 65-70% ownership post the closing of their seed round. Recognizing that dilution will only accelerate in later rounds, it is important that Founders retain enough meaningful “skin in the game” to see their business plan through to the end and not be swayed by a 7-figure salary by a top Silicon Valley company. I have seen cap tables, at the seed stage, where the investors have purchased 90% ownership of the company, leaving the Founders with literally nothing and no ability to create an ESOP that will attract top-tier talent.

• Build a governance structure that protects all stakeholders in the business. Don’t wait until the Series-A to build a Board of Directors. By the way, it doesn’t have to be the Knights of the Round Table. Just the Founder(s), your lead investor, and an important industry advisor will more than suffice as Board members and add tons of value.

• Mutually-agreed business and growth plans. Agree on SMART metrics with your lead investors and adopt a reporting method that is accurate, easy to update, and able to be clearly presented within a two-hour board meeting. A major part of this is to make sure you assign goals and objectives to your investors, especially those who have promised certain actions or in-kind services.

• Maintain open channels of communication. Investors should make themselves available as much as possible to their portfolio company Founders for advice and off-record conversations. Spend time getting to know each other over dinner or coffee. This is potentially a 10-12 year relationship and we all need to like each other.

As always, these are my thoughts and they are entirely open to challenge. You must always do what is right for (in no particular order) the company, it’s employees, it’s shareholders and it’s customers. Stick to that and everything else will fall into place.

Best of luck