Venture capital can turn start-ups into winners, but at a price.
By Chris Nerney
Network World, 01/04/99
 When Mark Hoffman co-founded Sybase in 1984, he began with a 50% share of the fledgling relational database software vendor.
A year into the business, while looking for a second round of venture capital for his hot start-up, Hoffman received a swell offer from a prospective funding source. "One of the venture capitalists - not one of the original investors - said he'd give the company money," Hoffman recalls. "But I would have to leave so he could bring someone else in to run Sybase."
Oddly enough, Hoffman demurred. He had other venture capitalists who were eager to fund Sybase without giving him the boot.
By the time Hoffman stepped down as CEO in July 1996, Sybase had grown to become one of the top software companies in the world, with annual revenue approaching $1 billion.
Along the way, however, his share in the company dwindled to about 3%, the rest being absorbed by venture capital firms in later funding rounds and a public stock offering.
Hoffman, now CEO of electronic commerce start-up Commerce One in Walnut Creek, Calif., says the trade-off was worth it because the venture capitalists provided Sybase with the cash needed to increase revenue and compete. "Dilution of ownership is less a concern to me than undercapitalization," he says. "Getting your company capitalized properly is the most important thing."
Oh, there was one more benefit to letting venture firms in on the deal. "Even though I got diluted, in the end, I made more money than I ever thought I would when I started the company," Hoffman says.
And that is the true power of venture capitalists. Their money, along with operational experience and access to a talent network, can turn a company into an industry leader and create storybook wealth for the founders.
But venture capital usually comes with a caveat: In return for their millions, venture capitalists want control. For a venture capitalist, control may mean a seat on the board of directors, controlling shares in the company and the power to handpick a management team - including the founder's replacement.
Who calls the shots?
Giving up that kind of control makes some entrepreneurs leery.
"We've considered going the venture capital route," says Larry Chang, founder of privately funded Edge Technologies, a Java-based network management software start-up in Fairfax, Va.
However, ownership is important to Chang, who says he has talked with a couple of venture firms without reaching any agreements.
One major sticking point was that the venture firms insisted on a minimum investment that would have given them a larger share of the company than Chang wanted to surrender.
"If they're putting up the cash, they're going to call the shots," he says. "We hate to sign away the farm."
Nonetheless, Chang says the benefits of venture capital are obvious.
"Venture capitalists' money can catalyze marketing activity and help to get your name out there," he says. "In this industry, time to market is the real key. That's what venture capitalist funding brings."
For that reason, Chang says, "we have not ruled out getting venture capital."
Hoffman and Chang are among the few willing to talk openly, from an entrepreneur's perspective, about the downside of dealing with venture capitalists. The vast majority opts for discretion over candor - another sign of the power venture capitalists wield.
"Even though someone might have gotten screwed by the venture capitalists once, he may eventually want to go to other venture capitalists to get funded all over again," Hoffman says. "But if the entrepreneur's got a bad reputation, that just won't happen."
Raising the stakes
Another entrepreneur, Didier Moretti, says it's virtually impossible to compete in the enterprise market today without venture backing.
"The amount of dollars you need to launch a successful business in the enterprise software space is easily double what it was five years ago," says Moretti, founder of marketing automation software start-up Annuncio Software in Los Altos, Calif. "Payroll and office space costs have increased tremendously, especially in Silicon Valley."
More than anything, he says, the Internet has raised the stakes for start-ups and investors.
"Because of the opportunities being opened by the Internet, people are willing to make bigger investments," Moretti says. "This intensified competition totally changes the game. Now you need to be very fast and build a lot of momentum very quickly. It's like sumo wrestlers. These guys are huge, but they're very fast, and the fight can be over before it begins."
Besides the expertise and guidance venture firms bring, "with venture capital comes some healthy discipline," Moretti says. Venture firms establish checks and balances often missing in entrepreneurial companies.
Money, money everywhere
In one tangible way, venture capital has more power than ever - investments in network firms are at record levels. More than 700 network firms received a total of $3.64 billion in venture funds in 1997, according to the quarterly PricewaterhouseCoopers/ Network World Venture Capital Survey. Through the first nine months of 1998, the survey shows that 620 network firms snagged $3.7 billion.
But the money flood doesn't mean that start-ups should grab any old $5 million that comes their way.
"When there is a lot of money to go around, picking the right venture capitalist is even more crucial," Moretti says. "You shouldn't just go with whoever is going to offer you the best deal money-wise. Because with so much competition and so much noise in the industry today, having the right partner is very, very critical for building momentum and credibility for the company."
The two prime sources of venture funds are individuals with pension funds and college endowments looking for someone to manage their money and provide a decent return. And getting a good return is the prime directive for any venture capitalist, according to Todd Dagres, a general partner at Battery Ventures of Boston.
"The entrepreneur has to realize when you take in a venture capitalist, you're taking in somebody whose sole responsibility is to make money for his investors," he says. "He will not relent on this and may have a shorter term expectation than the founder."
Battery Ventures' goal is to make 10 times its money in less than five years with any one investment, Dagres says. "If we can put in $3 million and make 10 times our money, then that's a good day's work for me."
Taking control
It's a good day's work for Dagres but potentially a lot of stress for the entrepreneurs, who may find themselves losing control of the decision-making process. Venture capitalists, especially early-stage investors, usu-ally grab a couple of board seats and a chunk of stock.
Even if the venture firm is a minority investor, it can still wield considerable control, especially if it has preferred stock. "Preferred stock has certain preferences," Dagres says. "We have blocking rights on significant actions that could affect our position. Mergers, acquisitions, liquidation, raising more money - we have to agree to things like that."
Promod Haque, general partner at Norwest Venture Partners in Palo Alto, Calif., concurs that venture capitalists, especially early-stage investors, can exercise terrific leverage without owning majority share in a start-up.
"On a first round, we might only own 30% of the company," he explains. "But that doesn't mean anything because as soon as the money runs out, if we're dissatisfied and we don't reinvest in the company, it makes it very difficult for the start-up to get funding elsewhere. Everyone's going to ask, 'Well, why is your seed investor not investing any more?'"
Sometimes that leverage extends to drastic personnel moves. "If you perform, they'll pretty much leave you alone," Commerce One's Hoffman says. "If you don't perform, they're going to come in and ask the tough questions and force you to make the tough decisions."
Or venture capitalists might make some tough decisions themselves, such as firing the CEO.
"In one of our early-stage deals, we did have to take the founders out," recalls Peter Mills, a West Coast partner at CMG's Information Services @ventures investment affiliate in Andover, Mass. "It was awful. It was a year into the investment; it wasn't as if we just went in there and cleaned house. We gave these guys an incredible leash, but they were taking the thing over the cliff. The only way to save the company - and we did - was to make a move."
Mills and other venture capitalists emphasize that ousting the founders usually is the last resort.
Choose carefully
"The last thing you ever want to do is replace people," says Bob Fabbio, a managing director of TL Ventures in Austin, Texas.
Fabbio has been on both sides of the venture capital fence. He was involved in starting Tivoli Systems and Dazel. Like Hoffman, Fabbio has had venture capitalists try to fire him. As a venture capitalist, Fabbio says he has tried to learn from his experiences as an entrepreneur.
"You get venture capitalists who stand up on a pulpit and proclaim who should be doing what, without regard for how it affects people and their lives," he says. " And there are too many guys in the business who are ruthless that way."
Venture capitalists say it's critically important that their background and style mesh well with the needs of the entrepreneur and company.
"The chemistry absolutely has to work," Fabbio says.
One way entrepreneurs can make things work, Fabbio says, is to choose a venture firm in which the partners have a track record of success in the market being targeted.
In cases in which it's obvious that the founders lack the background or skills to bring a company to the next revenue level, venture capitalists say honesty is the only policy.
"If we find an opportunity we like but we see that the CEO can't scale the company, we'll have that conversation with the founders before we make the investment," CMG's Mills says. "It's a tricky conversation to have. But we've found that if you're right upfront with people before you commit, everyone understands the rules of the game."
Sometimes the venture capitalists need to know when to walk away, even if the company obviously has promise.
In one case, Mills says, "we had an entrepreneur who said all the right things about working with us, but you could feel the passive resistance and it was evident this was going to be a problem.
I turned to a partner and said, 'Somebody's going to make a lot of money on this deal, but it's not going to be us.'"
Norwest's Haque says the advent of the Internet has spawned a lot of younger CEOs with good ideas and technical knowledge but little experience as managers and team builders.
"I've got to know how willing they are to let us complement them," he says. "Is the CEO's ego under control? I've got to understand his psychological make-up."
Haque says he even has hired industrial psychologists to help him understand what makes a start-up's founders tick.
To help start-up founders over their fear of commitment, Haque encourages them to "think of themselves also as investors in the company."
"They've got a lot at stake, they own a lot of the company, and therefore we're in the same boat together," he says.
"What I try to convince the entrepreneurs of is make sure you're part of a big, winning team, and think of the size of the pie rather than just the slice," says Battery Ventures' Dagres. "Because some entrepreneurs try to get too big a slice of the pie, they settle for venture capitalists that aren't quite first-tier and end up with a bigger piece of a smaller pie. "
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