This post was originally published at The Kernel, an excellent deep-dive blog on the start-up scene. Think The Economist for technology.
Not being able to make it to a meeting for lack of cash in your pocket – not enough even for the bus – is a level of financial and emotional trauma that most people in business never experience. Well, good for them.
In the two decades since my first forays into entrepreneurship, aged 14 with an Atari ST fanzine, followed by an ill-fated satirical magazine called TIT (think Viz meets Private Eye), I’ve found myself entirely brassic more than once.
A desire for financial security is not a good character trait in those wanting to be entrepreneurs. Consequently, perhaps, most people have not chosen to create and run a start-up. By “create a start-up” I mean having an idea and starting from scratch, on your own, with no capital.
Most institutional technology investors have never run a start-up. That lack of experience at the coal-face of business is the root cause of many a problem between company founders and their investors. This is my subject this month.
Financial acumen should surely be a given for venture capitalists, although writing this sentence feels peculiar when tech venture is today one of the worst performing asset classes in Europe. Europe’s venture capital firms are being spurned by their limited partners, and most are unable to raise new funds. Many European firms have disappeared from the market, or are running as ghosts of their former selves.
Looking at the numbers, European IPOs from venture investments yield returns similar to the US, but European trade exits for tech start-ups underperform compared to our transatlantic cousins. The reasons are complex. A 2008 reportattributed the overall performance gap between Europe and North America to a segment of “poorly performing companies”, but this generalisation gives few tangible clues.
The first thing is to recognise that even in the birthplace of venture capital, the United States, all is not perfect if you pull back the curtain. CNN Money summed up the US venture industry last year by saying: “It’s no longer a market of four tiers; it is the rarefied best and then the rest”.
But while early stage investment in Europe for tech start-ups is more plentiful than it ever has been, by most metrics the Old World lags behind the US, in both scale and success. In short, European tech venture performance continues to be a source of embarrassment.
Sadly, I can’t offer you a silver bullet. I’m no expert on the intricacies of the finance and investment industry. But let’s focus on the things that a VC can control. How can we help tip the European tech investment needle in the right direction? Ignoring a founder’s usual bark of wanting fairer deal terms, greater capital deployment and higher valuations, the most obvious target is a greater focus and understanding of what Sequoia calls “human capital”.
Many European tech investors lag behind the best of the US venture community in recognising how valuable a dedicated start-up founder can be, even if that individual might not be the perfect chief executive when a company scales.
This disdain for the entrepreneur can extend to an under-incentivisation of the start-up team as well (though that too can be the fault of the founder). Not many European start-ups have option pools of 20 per cent or over, but that is pretty normal in California.
One UK VC I worked with persuaded all non-execs and employees to sign away the rights to their options at investment, promising to re-instate them from a new pool. Unsurprisingly, none of the options ever re-appeared. Such behaviour is not only unethical, but naive in terms of motivating staff and creating good karma between investors and the senior management team. It does little for your reputation and deal-flow either.
It is true, of course, that the fabled West Coast has plenty of horror stories about “evil” or incompetent investors too, which leaves one counselling first time start-up entrepreneurs to view their new-found VC friends with suspicion from day one. Hardly ideal.
Maybe I’m now the one being naive, but this is not the most expedient way to create the next billion dollar start-up. Let’s face it: it is the few which feed the many in the venture capital model.
One big reason a chasm can form between founders and their investment overlords is practical: like the tragically blinkered army commanders of World War One, VCs often seem to carry arrogance and a sense of entitlement into the board room, consequently making poor strategic decisions, or, equally inappropriately, insisting on bad operational ones. Thankfully it just costs thousands of pounds, instead of thousands of lives.
Too many VCs I meet lack experience and wisdom forged in the trenches of the business battlefield. It is not surprising, then, that the experience of not having enough money for the bus would be an anathema to most venture firm associates, principals or partners.
It is also unrealistic to expect them to understand the pressures entailed in running a tech start-up or being a small business owner. Many VCs have not even run a team or a led a department in their (often all-too-brief) previous careers, let alone convinced a flock of disciples to follow them into the abyss and create something from nothing by starting their own business.
OUTSIDE THE COMFORT ZONE
Worse still, a career in banking, trading, consulting, distress capital or another process-driven corporate environment, with their clear hierarchical ladders and ample support infrastructure, often seems to give the VC misplaced sense of superiority.
“Success” in the financial sector is not to be derided, but the nitty-gritty of having to do everything yourself, on a shoe string, in a team of just two or three, with no money, while trying to persuade often intransigent investors to give you money, is a unique stress which is life-swallowing and not something you can understand from reading about.
And most people from a corporate environment simply don’t get it.
There are exceptions. Some of those exceptions are people I am happy to count as friends and respected acquaintances. These are people who understand, from real-world experience, what it takes to nurture a product or service from birth through difficult puberty to proud maturity – or premature death.
These people are the future of the European venture industry and if you are looking for money, I’d recommend seeking out this rare breed.
But the problems inherent to the European VC-entrepreneur relationship remain threefold. First, VCs often don’t even realise that their understanding of a technology or market is lacking.
Second, the entrepreneur-VC conversation is often at odds when it comes to aspects of managing the business or comprehending operational challenges.
Third, the worth of a founder in a start-up is often underestimated, causing at best ill-feeling and declining motivation, or, at worst, if the founder is removed, a large opportunity cost for the business and ultimately the fund itself.
Most entrepreneurs are pragmatic enough to recognise their failings, and will take on board sensible business suggestions, which are backed up with tangible facts or defensible experience. It is, after all, part of the start-up mantra to iterate, to discover what works. That, by definition, requires an acceptance of failure and the need for improvement.
As we’ve established, the problem is many VCs neither have this experience nor this working philosophy. Yet often they lecture start-ups on what their product should look like, or meddle too deeply in the operations of the business.
A shiny new VC associate once said to me “You entrepreneurs are all so emotional.” It was not meant as a compliment.
You have little choice but to operate somewhat emotionally when you are a start-up entrepreneur. Where would the endless energy to persevere come from otherwise? If you made decisions entirely logically, you would pack up immediately and do something with a greater statistical chance of success.
And this statement suggests not just thinly-disguised contempt, but demonstrates perfectly a lack of empathy and understanding about what it takes to run a start-up company. For this VC, as for many, his is simply a job. A secure, well-paid step upward on the career ladder.
This ignorance is the same reason TV shows like “Back To The Floor” and “Boss Undercover” make such good television: the chief executive often has no comprehension of the day-to-day challenges facing his or her workers, the people who actually make things happen.
Morgan Stanley and McKinsey have the resources and departmental staff to support whatever you need to do to perform your role. In contrast, as a founder, you are the organisation: you are the department for everything.
On the bright side, having left a venture firm to create their own start-up, more than one VC has told me: “I had no idea how incredibly hard this is … it is 100 times harder than I imagined.”
If they ever return to the venture world, those students of experience will, I’m sure, be infinitely more successful than other investors who have no practical grasp of start-up challenges.
An experienced European VC said to me: “I think it is impossible for a venture guy who invests early not to have real operating experience. Even if it’s two years working for someone else’s start-up (most great VCs weren’t phenomenal company builders) you need to know the struggle it is to build something.
“I also think people need to know what it takes to grow something large, it’s a whole set of new lessons in scaling that again you just have to live through. This you can partially pick up from the board perspective but you need real experience to give you good perspective. I think guys in the US get this. Guys in Europe don’t. If you just count up the number of [VC] partners in the US who have operating experience you’ll see it.”
A lack of hands on, real-world experience is the biggest problem facing VCs and tech entrepreneurs, especially in Europe.
VETTING YOUR BACKERS
As an entrepreneur, what can you do? Well choose those VCs who have the hands-on business experience. And get drunk with them before you sign the deal. No, seriously. You’re getting married. You’d never marry a girl or guy you’d not got wasted with, would you?
Find out what makes them tick, what they’ve done in their lives. What have they learned in business? How have they failed? Discuss other start-ups, especially ones which have gone through difficult times. Discuss how they would handle a divorce.
My unnamed European VC says “Venture people are financiers, so we have to think and act like investors, meaning financial capital. But we’re also company builders, which makes a good 50-75% of our job about people … it’s a tough thing to understand if you’re not used to dealing with it.”
Do the following exercise: take the top 20 firms in the US. Look at the partners’ bios. Look at how many:
- started a company
- worked at a start-up
- were execs of a start-up (VP or higher)
- sold or took a start-up public
- worked at a tech co
- were execs of a tech co (VP or higher)
- hold engineering degrees
- have MBAs
- worked in banking
- worked in consulting
Then repeat that process with the top seven firms in Europe. The whole exercise should take you less than an hour. The resulting disparity is shocking.
If you are limited partner, you can help the European tech ecosystem (and your own return), you should only give your money to a fund if the team is entrepreneur-heavy.
Because, unlike regular businesses, start-ups are defined by a set of unknowns. They are not straightforward enterprises. It is usually a messy, pivoting, imperfect machine, run by one or more impassioned individuals who have sacrificed a regular life for the promised land of thenextbigthing.com.
But there could be a significant improvement for the success rate of European tech funds, and the start-ups they invest in, if venture firms simply hired more people with real, tangible hands-on experience, rather than the the cookie-cutter, MBA-toting ex-finance guys they favour.
Just look at career politicians for another example of what happens when people make decisions about things they have no real-world experience of.