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“If we are doing things right and our company founders are successful, then over the long run we should be successful. If we get to the point where our founders are successful but we can’t be, we should be rethinking our business.”
I have a philosophy. A thesis. An entrepreneur thesis. I’m not talk about the age old debate amongst investors whether you back entrepreneurs, markets or products (or as many people like to hedge – product / market fit). I’m unequivocal on that topic. It’s entrepreneurs I back. I’m on the record as saying I’m 70% management, 30% market. We’ll have that debate another day, I promise.
Today’s post is about my investment thesis. It’s what I call the “entrepreneur thesis.” My investment philosophy is to back the best possible entrepreneurs I can and to stick by them through the growth (or sale) of the company. I’ve outlined already what I believe makes a great entrepreneur and I’ve stated unequivocally that this is a subjective view of what it takes. But when I’m looking to invest the dollars that my Limited Partners have entrusted my firm with I’m going with my view.
So what is this “entrepreneur thesis?” It’s the view that I back great entrepreneurs and help them pursue their dreams no matter what. Sometimes this will mean we collectively double down and try to build a bigger business and sometimes it may mean selling earlier than I had thought we would. I know this sounds Polly Anna-ish. I’m not just writing that “I love entrepreneurs” to curry favor with startup CEO’s. Anyone who has ever worked with me knows that I’m no pushover and I’m certainly not a wallflower. I’ll argue my point vociferously. But I don’t believe in betting against founders.
Let me explain.
A few years ago I was having dinner with a friend of mine who works for one of the biggest known Silicon Valley firms. He was telling me about a deal he had done. He invested $8 million in a company in the computer networking space. They had an offer to be acquired for $80 million, which would have dramatically changed the lives of the founders forever. My friend blocked the deal. It was “only” a 2.5x for him.
His logic was, “when I invested the management team knew that I wanted a multi-hundred million dollar exit so they shouldn’t be surprised. This return won’t be enough for me to justify to my partners.” I literally said to my friend, “You’re a dick. Do you not see the consequences you’ve weaved? You’ve now got a management team that hates you. They hate you for life. They will tell every other entrepreneur in town not to work for you. Presumably they are talented if they created a company worth $80 million. They’ll never work with you again. Nor will any of their friends or colleagues. Are you that short sighted?”
I kid you not when I use quotes there. My wife was really uncomfortable because she was there and so was his wife. I’ve known this guy and his wife for a LONG time. My wife was actually mad at me for being so blunt. But she knows it’s a character flaw of mine so she forgives me (I hope).
To this day I still don’t understand what he was thinking.
I’ve had the conversation of what will happen upon an exit with founders so many times I feel like a broken record. Before I outline my views let me give you one more story.
In 2006, Steven Dietz, a partner at my firm, GRP Partners, had given me $500,000 in a seed in convertible debt when I started my second company, Koral. GRP Partners had also funded my first company. I had an offer to sell my company to Salesforce.com in 2007. Steven knew that from a fund perspective he wasn’t going to earn the amount of money that a typical VC might look for since we were selling early. But he also knew that it would change my life forever. He was grateful since I stuck with my first company, BuildOnline, well beyond when others would have (since I had taken great dilution during the dot com bust.). He decided to let me earn. I will never forget that.
So it was kind of obvious when Steven and Yves Sisteron (the partner on my first deal) offered me a role as a partner in their firm that I would work here. I knew that we were aligned intellectually and ethically. I had initially called them wondering if they’d fund my third venture. I never imagined I would switch sides of the table.
So, to my thesis:
1. Work with the best at early stages: I’d like to get involved with capital efficient companies early in their lifecycle. I want to back entrepreneurs that I believe have similar ethical values, are fun to work with, trust me, have big aspirations, are willing to work hard, are smart and want to have an impact on the world. I want to see small amounts of money go in and I often tell these entrepreneurs, “I don’t have a goal for you to come back and quickly ask for more money. Go slowly if you need. Spend wisely – you need to “grow into your valuation.” And by investing smaller amounts at early stages I am impacted if a quicker-than-anticipated sale happens. I view this as The Patzer Opportunity.
2. Go in planning for a big outcome: I tell each person that I am going to work with the same story. I hope to build a billion dollar company with them. GRP Partners has created more than a dozen of these so as a firm we know something about creating big companies. I don’t go into deals with a plan to sell for $20 million. $100 million at least.
3. Keep options on the table: I believe in my bones that entrepreneurs shouldn’t “over raise” capital. They should right size their capital raises. That doesn’t mean being cheap. That doesn’t mean raising the least amount possible. But it means not over raising money. I know I’m being vague. Each situation warrants different amounts. But let me give you an example. If you can raise $2 million or $10 million up front (maybe you’re a hot entrepreneur in a hot space) I know that my vote would be with the $2 million (again depending on the situation). If you raise $2 million you preserve your options. Somebody may come along and offer you $25 million to buy your company. You might like to accept that. It might just change your life (for example if you personally own 33% of the company). Or if you didn’t sell and the next round comes along. You raise $5 million at a $20 million post money. That by definition means you were hot. You should still be able to sell for $50 million. At each step you preserve your options. If you go to quickly to take down a $50 million round from late stage funds you have one option – go big or go home.
4. Don’t block founders from selling: OK, so if you raise $2 million at a $10 million post money (e.g. maybe I own 20% of the company) or $5 million at a $20 million post (I own 25%) shouldn’t I block that sale of a company a cheap price? This is the “Patzer Problem.” Some people assert that the later stage investors didn’t make a high enough return. My view: If you’re absolutely convinced that it is the right thing to sell I need to support you. My bet: if you sell and I helped you earn and was a key contributor to your company then you’ll tell everybody you know to work with me. Over time I should see great deals as a result. When you go to do your next company (most entrepreneurs do) you’ll call me first in the way that I called GRP Partners for both my second company and my third (which never materialized).
5. Persuade you and align you to swing for the fences with me: But of course there is more to my views. I’m hoping that when your $25 million or $50 million exit comes along I can convince you (if I believe it) that we should swing for the fences and create a larger company. If I really believe it I ought to let you earn now by taking money off of the table. I have already written about this. I believe our incentives need to be aligned at this point in time. You need to have your “feed the family” money so that you want to swing for the fences. You also need to believe that the higher outcome is possible. If I’m not willing to let you take money off of the table and if I’m not willing to put more money into the company to help you achieve your goals then how convinced am I really about the upside?
I’m not trying to be nice to entrepreneurs so you’ll read my blog or take my money. It is simply the thesis that I believe in. It’s the “entrepreneur thesis.” Let me outline the contra viewpoint, which is seldom expressed openly, but it what I believe gives our industry a bad reputation.
• Large early stage rounds – Too many investors whose funds are too large feel that they need to put “a lot of capital to work” in order to justify being involved with your company. So much so, that when I was raising capital in 2006 and asked for $2 million several funds told me that they wouldn’t give me money unless I’d take $5 million. And they actually hinted that I could get a better valuation. Tempting. The problem is that it takes options off of the table. And the same logic that forced them to put $5 million to work also forces them to block your sale at prices that might just change your life.
• Change management teams – A lot of well known, historical VCs have a belief that management teams are expendable. You simply bring in a more talented team after your $10 million investors and the founders become senior members of the team but don’t run things. I accept that this may sometimes happen. But it’s the absolute last course of action for me. I believe that a motivated founder trumps a well-hired mercenary CEO any day of the week.
• Outsized returns through sharp elbows – OK, here is what it boils down to. I really believe that some firms have the strategy of edging out the entrepreneurs, bringing in a new management team, recapitalizing the company, minimizing the founders’ share and taking maximum ownership for the VCs. This is dreadful behavior but I truly believe that some firms go into investments with this mindset. I’ve heard very similar stories in the VC corridors. “Well, we’ll just do their next round and take 50% of the company. They’re struggling to raise funds anyways.” Look – it does happen. And sometimes it is warranted. I just don’t believe that any VC should go in with this strategy. It’s why I always tell entrepreneurs to reference check their VCs.
Listen, who you work with matters. Brand isn’t everything. And firms that get outsized returns on occasion to so at the expense of the founders. My thesis is that I should align myself with my customers (the CEOs) as it is the most likely path to great financial returns for my investors. And if I’m in this business for a long time I’m betting this will pay off. You? Taking VC money is more difficult than marriage. At least if you fall out of love you can legally get divorced in America. Not so venture capital. Raise wisely.
Update: After reading the comments I want to make one thing clear. I don’t believe this strategy has any sacrifices – I believe it will mathematically pay off bigger over time. Why?
– getting invited to be in the handful of deals each year in the US that really matter vs. getting mediocre deals
– getting the best entrepreneurs to work with you multiple times
– finding the right balance where sometimes the “early sale” doesn’t happen because you allowed some founder liquidity (on a case-by-case basis) that enabled you to swing for the fences where other entrepreneurs may have pushed for an early exit when incentives weren’t aligned
*photo taken from the Mint.com blog