Early Investing

Why Founders Refuse VC Money

Why Founders Refuse VC Money
By Andy Gordon
Date March 31, 2021

Venture capital (VC) investing isn’t all it’s cracked up to be. Last week I talked about the many things that crowdfunding does that appeal to founders and investors alike. Today, I’d like to focus more on the VC side of investing. And why founders do not always seek or accept VC’s offers of money and help.

Without funding, nothing else happens. Getting money so that product/service development can happen is the top mandate for founders. And close behind is getting some much needed help in finding prospective partners, marketers and technology specialists. Tiny undermanned startups with dreams of conquering their markets need plenty of money and help.

The problem is VC help comes with strings attached. Equity ownership gives VC firms a significant voice in the company’s plans. VCs often push for fast or hyperfast growth. They want the founders to go big and dominate their market. Grow revenue into enormous sums. And, as soon as possible, achieve a major liquidity event worth at least a billion dollars (or more). 

Some founders are on-board with those objectives. But not every founder wants to pursue hypergrowth at all costs. Not every founder wants to forego profitability for several years. Big exits are universally sought — but for some founders that means $500 million valuations and not $5 billion. Some founders want much more time to achieve a big exit than their VC investors are inclined to give. 

So founders have to be very careful that there is a framework of shared strategic objectives before accepting VC money.

VC help makes sense for a small minority of startups. Most VC investments — outside those made by the top dozen VC firms — are badly matched and destined to make both VC partners and startup founders miserable. 

Many VC investors have a wealth of knowledge and business acumen to share. But in a recent survey of VCs and startups, the perception of that assistance differs markedly. The vast majority of founders characterized the help as non-critical. They said that VC partners came to their board meetings unprepared and held up critical decisions. They also noted that partners often lacked the knowledge necessary of their startup’s daily operations and most pressing challenges to make informed contributions. 

Not surprisingly, however, the vast majority of VC partners considered their assistance central to the startup’s success. 

There are other, more hidden disadvantages in accepting VC money. VCs typically insist on “pro-rata” rights. It’s an investment agreement that gives the investor the right (but not the obligation) to participate in one or more future financing rounds to maintain their percentage stake in the company. If the company is doing well and meeting its milestone objectives, VCs tend to reinvest. But if startups are behind schedule, then VCs may hesitate to reinvest. 

Because of this dynamic, whether an existing investor/firm exercises its pro-rata rights becomes a signal to other investors. And a negative signal can hurt a startup’s ability to raise money through no fault of its own. 

There’s a host of reasons why existing VC investors may decide not to re-invest. They may simply want to keep their powder dry (which happened a lot in 2020). Or they’ve prioritized another company in their portfolio. These reasons have nothing to do with performance. Yet other investors will treat the lack of reinvestment as a red flag. 

VCs also obsess over a clean capitalization table, or cap table. Cap tables show the breakdown of shareholders’ equity. And VCs dislike having a lot of investors on a startup’s cap table. It’s messy, they say (whatever that means). An early-stage VC investor in the company (or even a prospective one) might try to discourage startups from going the crowdfunding route over cap table concerns. This arbitrary preference unnecessarily limits a founder’s funding optionality. And if the startup proves to be an outstanding investment opportunity, VCs will look past the cap table and happily invest in the later rounds. 

So unless founders manage to get an investment from one of the very few super-successful VC firms, they end up facing an unreasonable amount of stress and loss of control with little-to-no benefit.

VCs aren’t nearly the great deal that their reputations lead us to believe. The thing about reputations, though, is that they take years and even decades to build up. But they can fall apart much faster — just ask GE or Facebook, iconic brands that are fast losing consumers’ respect. 

I wonder if VCs themselves realize this discrepancy between their reputation and performance. Perhaps a little. They’re just beginning to acknowledge crowdfunding as something that’s legitimate… though they think it’s hugely flawed. 

I’m not saying that crowdfunding has all the answers. But in many of the areas where VC investing is most problematic, crowdfunding offers an attractive solution. Founders have a choice when looking for capital in the early rounds. And increasingly, they’re choosing crowdfunding. It’s a trend that’s not going away anytime soon. 

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