Venture capitalists buy and sell companies for a living. They’re often bank executives, MBAs, or entrepreneurs — or a mix. They’re not the kind of people to make mistakes with money.
So why would these smart, if vilified, people make investment decisions that run counter to their goals? Let me tell you a story…
I’m friends with a successful early-stage investor who operates with surgical precision. He invests in fledgling startups that fit a specific profile. He wants to see revenue, know their industry, and take a controlling majority. He’s built quite a business this way, and it’s not uncommon for him to sell companies for triple what he paid.
Well, we met for lunch recently, and he didn’t seem like himself. He’d just invested $1.5 million in a tech company outside his niche. He took a minority share without operational control. The company’s founders weren’t interested in a quick turnaround.
My friend found himself playing the wrong game. He’s done this dozens of times, yet he entered a deal that’s completely misaligned with his goals.
A big reason why VCs make such mistakes has to do with human psychology. The sunk cost bias befalls the rest of it, but it seems particularly true as the money and time invested grow.
During the vetting process, VCs sink time, money, and mentorship into early-stage companies. In some cases, they become so entangled in the success of the business that they fear losing the energy and work that they’ve already put in.
To circumvent this psychological trap, start every relationship by sharing investment goals. For example, we seek to triple or quintuple our investments in five years or less at exits below $50 million. Work out the numbers together, explain the type of financial return they should expect, and describe the dilution that might happen upon exit.
Term Sheet Turmoil
When VCs find themselves tempted by investments they know they should skip, they sometimes try to exert control over the term sheet. This document is the legal equivalent of a handshake between a founder and an investor. No one calls it a statement of goals, but that’s essentially what it is.
If you’re tempted to force your will on the term sheet, that’s a good indicator your goals are out of alignment. Instead of fighting for turf on the term sheet, gauge investor-founder goal alignment before the meeting. Examine the company’s finances, growth curve, and exit goals to determine whether the founder shares your plans. If he or she doesn’t, don’t even bother drawing up a term sheet.
Start with the Finish
When VCs invest, they’re looking for a profitable exit. In many cases, so are founders. The details — shares, control, exit timeframe — are the things that need to be worked out.
Start every relationship by looking to the end of the road. List out individualized, concrete goals. Be honest about the returns you want to achieve and when you want them. Only make the investment if you can agree on those at the outset. Then, commit to holding one another accountable to discrete, achievable goals on a quarterly basis.
As a VC, your investment strategy is what makes you an expert. Not every founder will have the same plans or want to play your particular game. The sooner you accept that reality, the better your investment outcomes will be.
Brian Botch is a founding partner at Tricent Capital, a venture capital firm based in San Francisco, California, that makes data-driven investments to deliver frequent, consistent, and rapid returns for investors while creating life-changing economic events for founders.