Why Entrepreneurs Seem to Be Growing Fangs

One of my favorite business school professors, Andre Perold, used to like to say that in every transaction in the financial markets, there are only two types of actors:  wolves and sheep.  As you might expect, the wolves have the edge in the encounter, due to superior market information or negotiating position.  If you find yourself in a market transaction and don’t know for sure that you are the wolf, then, sadly, you are the sheep.

Venture capital investors are historically accustomed to being the wolf.  During most periods, there has been a supply and demand imbalance that favors the VCs.  Entrepreneurs needed a lot of money, there were only a few VCs with money (it’s a shockingly small industry, with less than 500 or so active firms, according to the NVCA), and the VCs got to sit back and leverage their position of superior information and insight to choose their deals and drive favorable terms. 

In recent years, this imbalance has been turned upside down.  Entrepreneurs need less capital – even life sciences and cleantech start-ups are applying lean start-up methodology to be more capital-efficient – and information about VC deals is more transparent than ever (15-20% of all VCs now have blogs and the amount of information publicly available about how the business works is easily 100x as compared to 10 years ago, when I was an entrepreneur raising VC money).  Thus, for particularly “hot” companies, when there is momentum and competition, the entrepreneurs have become the wolves, and the VCs find themselves donning sheep’s clothing. 

As a result, many VCs – particularly bigger funds – are chasing “hot” deals aggressively, irrespective of price.  Facebook, LinkedIn, Groupon, Zynga, Twitter and many others are able to raise capital at extraordinary valuations.  For these investments to pay off, the investment thesis is based on a strong IPO in the future.  But the wrinkle in these momentum investments is that the currently weak IPO market is stretching out time to liquidity more than ever.  Thanks to their position as the wolf, founders (and angel investors) can often get liquidity from their late stage investors (particularly through Digital Sky Technologies – a Russian Bear in the transaction mix?).  

But the VCs, and in turn their LPs, are left holding an illiquid bag.  One LP complained to me the other day:  “The founders get liquidity, the angels get liquidity, and the pressure to go IPO is taken off the shoulders of the board and management team.  All fine and dandy – but where’s my liquidity?!”  A little IRR math shows the price of this elongated time to liquidity – a 5x return in 5 years yields a 38% IRR.  If the VCs decide to allow founder liquidity and put off an IPO, they’re likely taking on an incremental 3-4 year holding period (most major shareholders don’t get liquid until 1-2 years after the IPO).  To achieve that same 38% IRR in 9 years, a 20x return is required!  If the founders take money off the table, they are incented to go for the bigger win and don’t mind taking the time to get there.  But the early-stage VCs might certainly have preferred a $250 million exit and immediate liquidity to waiting four more years for the billion dollar exit – and the same IRR. 

Some VCs are well-positioned to chase the hot deals and patiently back the big winners.  Others are better off investing in capital-efficient businesses and taking the $100-200 million exits when they come along, even if it means selling their best companies too soon (“We are suffering from PME – pre-mature exit,” one micro-VC confided with me last week).  

Which path is the right one?  And who has the edge in the market flow in the coming years?  No one knows for sure, and every situation is unique and must be evaluated as such.  But with so many options to choose from, those entrepreneurs I’ve been noticing with larger fangs seem to be smiling more than ever before.

12 thoughts on “Why Entrepreneurs Seem to Be Growing Fangs

  1. I really enjoy reading this blog. If we don’t act like the wolves we will be eaten by some bigger and more fierce animals. It is a world of competition out there in the field of business and if we don’t act like the wolves then we won’t survive.

    Like

  2. Like everything else, the entrepreneurial world is a pyramid. At the top of the pyramid, there are more top VCs than there are top entrepreneurs, and thus entrepreneurs become the wolves as you mentioned in your posting. On the other hand, as you travel down to the middle of the pyramid, there are more mediocre entrepreneurs chasing mediocre VCs. As you reach the bottom of the pyramid, there are substantially more bad entrepreneurs than there are bad VCs. Hence, considering a holistic view of the entrepreneurial market, the ecosystem has not changed – VCs have been, are, and will continue to be, the wolves, even though as you mentioned, the reverse is true at the top of the food chain, which is nothing new.

    Like

  3. TypePad HTML Email
    Hi Harry – I agree with you. Egos need to
    be checked and all motivations need to be clear and on the table.  I posted a
    blog on this topic at OnStartUps: 
    Know The Exit Before You Enter.
     

    Like

  4. That reflection is all too close to home for me Jeff…try a mortgage, two current ginormous college tuitions, and a third tuition appearing up in three years. VERY motivating.
    But it’s also a real proof point of commitment on the entrepreneur’s part to pursue a startup in the face of those very adult demands (and assuming no previous meaningful exit). I’d assign an extra dose of belief and nerve (and probably not a little insanity) to any entrepreneur managing those pressures.

    Like

  5. Good post Jeff.
    I think you really highlight an important point for everyone in the ecosystem – which is the question of where you stand.
    As it goes now – there are many constituents in the VC world, from founders, to angels, to early stage VC’s to late stage VC’s – and all of them in many cases – have differing alignments and needs.
    Probably one of the keys to investing in this new world is understanding all of those needs and making sure you just don’t end up on the wrong end of a founder cash out – leaving you – as a later stage investor – holding the bag for a very long time.
    While I love the 38% IRR you use – since the 10 year average for VC is currently under 0% – it is wishful thinking – the reality is such that there are very few 5X in 5 year deals out there. Which makes it all the more important to make sure – as an investor – you understand everyone’s motivations and have some control over an exit.
    I truly appreciate Tony Hsieh and Zappos and the culture they built there – love the service – but if Sequoia pushed them into selling to Amazon – then good for them. Far better to do that and take the big win – then to expand into other items – try and take on Amazon at their own game – and ultimately get a simmilar return some 10 year later – or less!

    Like

  6. Agreed. Anecdotally, the 20-something founders I know don’t even think about exiting early. They’re going large or going home. The 30- or 40-something founders who have been through a cycle or two, and perhaps experienced the angst of ending up with a bunch of worthless stock at some point, have an easier time taking a few chips off the table (aka selling early if things are really tracking, hitting Second Market).

    Like

  7. Really good post, Jeff. It sums up many of the things I’ve been thinking about recently. I’ve been working off the thesis that “cheap, lean, and exit early” is the new model for (most) startup entrepreneurs; here’s the slide deck: http://www.seedstagecapital.com/2010/07/startup-m-exit-strategy.html
    I’ve seen some basic research that shows that raising a smaller amount (1-2 angel and seed rounds, for example), and thus retaining 65%+, and exiting within 3 years can be more impactful (for the founders) than going for the big win but suffering multiple rounds of dilution and a long time horizon.
    Of course, the emergence of secondary markets adds another variable to the equation (indeed, it reduces the argument for exiting early if the entrepreneur can have his cake and eat it too…i.e. gain some liquidity early while also holding on for the big win…bunt and swing for the fences in the same at-bat, so to speak!)
    Good stuff, keep more of this coming! Nathan Beckord

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s