Conflicted Capital
blog.aaronkharris.com
blog.aaronkharris.com
The week after we closed our series A they told me I had to hire a COO. I asked, "You trying to get me to hire my replacement?" "No, we'd never do that. How could you even think that?"
Less than two months after we hired the COO they fired me. The COO was made the CEO and he ran the company into the ground.
The lesson for founders is to never, ever, ever give up control of your board/company. Always maintain control of a majority of the board seats.
Maybe you're too close to the situation so what you say above feels to you like a universal truth but it actually doesn't help me as a reader.
To raise the quality of discussion, we'd need to know what your realistic options were at the time you raised Series A.
E.g... Did you have meaningful revenue making VC capital optional? Did you need VC money to have a runway and make payroll for a few months?
In other words, if you're in a situation where rejecting VC money means your business shuts down, it becomes a moot point if you're still 100% in control of all board seats.
As for board seats composition, was it something like You=1, VC=1, and Independent=1? If so, was the independent automatically on VC's side to fire you or were they truly independent?
If you don't want to get into the details to maintain privacy, that's understandable. But also understand that your advice born out of your experience doesn't have enough context for us.
To raise the quality of discussion, we need for all the email and Signal messages from the investors / VCs for a variety of deals to be made public. That would be a major step towards reducing the amount of information arbitrage in start-up funding (not to mention blog posts like the OP).
(with tons of apologies to Margaret Thatcher)
But founders should talk to other founders about their experience with different investors. The good, the bad and the ugly.
In those situations, you can make it clear - in objective terms - what happened and why you would not take money from them again. Don't call them names or anything.
Did they at least buy you out or did they literally rob you of your company?
I think, in Germany it's different, sorry.
Examples from Charlie Munger [1]:
"One of my favorite cases about the power of incentives is the Federal Express case. The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had one hell of a time getting the thing to work. And they tried moral suasion, they tried everything in the world, and finally, somebody got the happy thought that they were paying the night shift by the hour and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked."
"Early in the history of Xerox, Joe Wilson, who was then in the government, had to go back to Xerox because he couldn’t understand how their better, new machine was selling so poorly in relation to their older and inferior machine. Of course, when he got there he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine."
[1] https://www.butwhatfor.com/charlie-munger-the-psychology-of-...
So, why should the person screening the candidates suggest the strongest candidates?
This is why I tend to suggest equal seniority individuals should not screen candidates. It's a subconscious thing ("He's too aggressive" "She seems like not a good culture fit" "He is too senior for this role") that most people don't think of directly, but happens.
A stock compensation helps in that regard: hiring strong individuals will help ship a better product faster and should increase the stock value. Meanwhile traditional stack-ranking and a mostly salary compensation will encourage individuals to make sure they are seen as the top performer no matter what.
But in that situation, I can give top performers more equity, but in the grand scheme of things, thats not much incremental total dilution to the average employee. We all still make more the same way - when the company makes money or is sold.
If you are at a larger company that is a going concern for a long time... it gets a bit harder and takes some more thinking.
I'm not saying that participating in bubbles cannot be economically rational, but venture capital today is especially suited for making decisions that are bad for everyone involved, prioritizing future valuation over good business.
It's the same growth or sustainability choice we keep failing at as a civilization.
This venture model is good for unicorns like Facebook, who's network effect allows it to be eventually profitable, but the rest of the industry is not profitable. But VCs are, because of their management fees and because they avoid to be the greater fools, otherwise known as the bagholders who end up paying for it. VCs tend to encourage wasteful spending in the name of valuation on salaries, rents and user acquisition. It's a Ponzi-scheme where the bagholders tend to be limited partners and employees of the funded companies.
See, that's an important difference between investors and VCs.
A VC firm or division gets (say) $1B, and a deadline: invest it all by end of quarter. All they can invest in are what come through the door. They know most of those have no future. A few do, but not enough to absorb the whole allotment. They can't not invest. What to do? No choice, really; invest it all, with 9 of 10 expected to flop.
Having identified, at the outset, which should flop, start milking them. There's no reason to waste that money, even though it's lost to the actual investors. Make them spend their nut where it will do somebody some good. Maybe make them hire a crony, who will hire more. Make them use a pet staffing agency. HR pros are (to first order) all grifters, so provide them one of yours. Make them buy software from one of the not-flops from this round or last quarter's, or somebody you own part of, personally. Be creative. You can draw it out, deposit more cash from next quarter's infusion, and extract that. Maybe they can build, code, patent something of value that can be bought for pennies at the bankruptcy.
There are a million variations on this, all used.
If I had a wish to materialize an ideal VC firm, it would be a place with both business types and highly skilled engineers who are on top of their skills and continue to build things.
idealab is somewhat like this. they cycle in engineers to work on an itch for a limited time on salary, then go through an internal round of fundraising (pitch idealab itself for seed money), then seek external rounds if there is traction.
branch[0] is a company that successfully launched from idealab this way. they started as a shift-swapping chat app for hourly workers and have branched (haha) into payments now.
But raising money is a choice that some founders will make because their businesses require it. If you don't need it, don't raise it. If you do need it, go into the process and decision with as much information as you can get.
I am willing to accept that, it may not be possible to have such a process. Perhaps to succeed in the “real world” you absolutely need to be fantastic at marketing and pitching.
I’m trying to describe what a process would look like that I personally would find enjoyable to work with, ignoring the reality of what might actually be required.
Basically a product studio with LPs
I'm increasingly convinced that very few products need to be companies, and the insistence that they do is why a lot of them end up so shitty.
With that said, I think running a product studio before you find product market fit or the killer company is not a bad idea, especially if you can work directly with LPs to source the funds. Then the challenge is just making sure people don't step on each other's toes when you staff the winner.
But one of my goals at the moment is to *not* double-down on winners. The thesis being, whatever is working, is clearly working.
I think a lot of products are killer, and should be left alone, and "doubling-down" or "iterating" might make them worse.
For example, Reddit v. HackerNews
Then you will likely end up so far diluted that you won't make enough on your winners to cover your losses. It's a tricky balance to find.
Does anybody know how to parse this?
If there is a right of first refusal many investors will decline to engage in future rounds since if they end up negotiating a good deal it might fall apart at the last moment.
Your existing investors have a vested interest in making you successful. A higher valuation is more acceptable to them than to outsiders (due to being able to officially mark up their investment, which helps them raise their next funds and improve their apparent performance prior to liquidity). Founders also have a far better idea of what kind of support they can expect from an existing investor than a newcomer.
Of course, as a seed stage investor, I am biased in my views on this. But I do really believe that making potential adversaries out of your existing investors is a deep mistake.
Cynical viewpoint coming in:
VC investors are only "good people" because that is what currently drives the market for dealflow. What I think a lot of entrepreneurs miss is that VCs are finance professionals first and foremost. If the market dynamic starts to change, you might see them behaving differently but still aligned ultimately to the interest of their LPs.
TL;DR - VCs who create good content, are helpful, are nice to founders, etc. ("founder friendly") in a professional context are only that way because it's generally what has been proven to generate good leads for deal flow.
In a frothy environment like the present, founders really do have a lot of leverage because the demand for investable companies in many ways greatly outstrips supply; you see this in the SPAC craze. But in other environments, LPs and VCs have a lot more leverage over founders. When that is the case, it is only reasonable to expect them to behave according to their incentives. Now one could make the argument that it's still a poor long-term decision for VCs to sour community goodwill if they want to be in the game long-term. That may be the case, but it doesn't mean that a cunning VC cannot profit from exploitation in the medium term, enough to enrich themselves to the level where a poor reputation doesn't prevent them from continuing to operate.
It's important to not over-anthropomorphize the way that financial professionals operate as agents in a system with incentives. When they do something unsavory, it's generally not meant to be personal even if the result is incredibly unsavory.
Where and how personal ethics, business ethics, business needs, financial incentives come together and produce results is immensely complicated.