To VC or Not VC: That is a Question!
This was written by John O. Huston, Chairman Emeritus of both Angel Capital Association and Ohio Tech Angel Funds, with a little help from us. The great thing about John is that he is both highly experienced (with more than 100 invested companies) and ruthlessly honest about his own experience – good, bad and ugly.
His perspective here is from the standpoint of the Angel investor, although entrepreneurs will also find this perspective on VC investors to be very valuable.
In my view, two major attributes of VCs are: (1) They are better than Angels at replacing underperforming CEOs and directors, and (2) They can invest many multiples more money than Angels. However, neither of these attributes automatically improve Angel returns. It doesn’t really improve VC returns, as the returns for most of them are worse than for Angels! The question Angels need to answer is this: Do my returns benefit when VCs join the cap table? After about a decade of experience, most active Angels will have enough personal (or at least local) data points to point toward an answer.
But the answer will depend upon whether you are counting wins vs. losses or financial returns. Anyone who has spent time with Wall Street traders has sensed how attuned they are to their personal win/loss record. They continuously track the number of trades they executed that provided any profit. This is compared to the number of their losing transactions, and this metric is used in addition to whether they have made money for their firm (or their clients!) in any given year.
I am not suggesting that VCs are like traders, especially because their time horizons and daily activities probably require markedly different personalities. Nonetheless, it can be highly illuminating for experienced Angels to complete the Outcomes Scorecard below to arrive at their own answer. Obviously, the purpose is to parse all our outcomes to date in terms of dollars and not just our win/loss record.
When completed, this grid also illuminates whether we have achieved the two most important metrics of savvy investors: Have we written more checks and invested more money in our winners than our losers?
- Exits, both positive and negative, must have already occurred to be counted.
- Only cash profits count (no embedded gains or value of stock/other assets received).
- This grid overlooks any attempts at calculating an IRR. The vastly longer holding periods that ensue after VCs invest lowers the IRR so much that this exercise would only reveal a BGO (Blinding Glimpse of the Obvious).
Some observations from my personal data:
- A few famous studies of returns of Angels belonging to Angel groups suggest that those making follow-on investments will realize lower returns than those who are “One Check Wandas or Willys.” This is a misguided conclusion because it does not address whether the investor had the opportunity to invest a second check. Some of my better exits occurred when my first check was in the last Angel round prior to an exit. And too often, I was not allowed to co-invest with VCs when they joined the cap table. It is essential to know for each instance in which you just invested once whether you had the opportunity to invest further – but purposely chose not to do so? Take no credit for a brilliant non-decision.
- Anyone who is revolted when VCs take actions detrimental to Angels must be presuming that VCs will be willing to abrogate their fiduciary responsibility to their LPs in order to preserve relationships they have with Angels – to whom they have no fiduciary obligations. I would never ask anyone, especially a friend, to do so. The assumption that there is EGC (Exit Goal Congruence) between Angels and VCs is absurdly naïve.
- In instances in which my portfolio companies approached VCs in desperation, the VCs’ behavior was just as malevolent as we deserved. The blunder I made was not to assess at the outset whether VCs would be a “necessity or a nicety” for an M&A exit (since I never presume an IPO is possible). From the outset, we had not allocated our cash to achieve precise milestones the VC community expected, and we had exhausted the patience and capital of Angel investors. We deserved the result.
- I doubt the Outcome Scorecard would be very insightful if it were completed on a national basis because the availability of VC funding varies so much by region.
But the VC industry is essential to America’s innovation community. This is obvious when so many behemoths have been spawned with VC support. And, as mentioned at the outset, VCs provide some important services to their portfolio companies and, by extension, to previous investors – albeit often at a high price for Angels. It would be shortsighted to overlook the many skills VCs can provide our portfolio companies but that few of us can. In my experience, the most important are:
- VCs are excellent at vetting IP, often having IP counsel on retainer. As an investor, I have always felt more confident about the “Freedom to Operate” and the allure of my investee’s IP portfolio after VCs have joined the cap table.
- VC directors can provide domain expertise exceeding that of our Angel BOD members.
- VC industry specialists excel at making introductions to suppliers, customers and potential acquirers.
- VCs also have a larger and geographically disbursed list of people who can help in building the team. Too often Angels struggle to replace an underperforming CEO because few talented candidates will sign on unless there is at least a year’s burn rate in the bank. Having less capital, Angels are hesitant to provide the requisite war chest to attract an outstanding new CEO. VCs not only have the dry powder but also generally have more experience in replacing CEOs than most Angels. This holds true regarding underperforming directors, too. The arrival of VCs always prompts an evaluation of BOD composition.
Once VCs join the cap table, the primary responsibility for raising future rounds shifts from the Angels to them. VCs are more likely to be able to attract top-tier co-investors than an Angel-only funded venture can. This is especially true for Early Stage companies located in flyover states who seek coastal VCs. The same goes for engaging top-tier law firms, most notably those with vast M&A experience that may not seek startup clients. Finally, VCs are more experienced at IPOs than most Angels. And they have the appropriate investment banker contacts.
In light of the value VCs can provide, it might appear that my answer to the question of “To VC or Not VC” is obviously in the affirmative. However, the right answer for my style of investment is usually “No.” For the reasons below, I no longer invest in ventures in which an exit is unlikely unless VC funding is obtained:
- The availability of VC funding can change significantly. Even well-performing businesses might have to accede to predatory VC pricing terms in a tight market. The volatility of the VC market is an additional layer of risk.
- Attracting VC funding. The funding must be obtained on TC&V (Terms, Conditions and Valuation) that do not destroy my economics.
- The lack of EGC (Exit Goal Congruence) means VCs cannot be concerned about me. If my economics affects their LP returns, I become invisible. The preference stack results in VCs being able to reap a return at an exit price significantly below what I need to even get my investment back.
My data from the Outcome Scorecard reveals that VCs precluded my being able to continue to invest in my winners, which limited my upside. Angel returns hinge on a few outlier exits and VC fiduciary responsibility requires them to capture as much of every winner’s upside as possible for their LPs. Going forward, I prefer to be able to help drive my invested companies toward an M&A exit, and being inside the boardroom gives me the best chance to do so. I do not expect VCs to keep me involved as an observer (let alone a Director) since our exit goals diverge significantly.
Summary – I had not heard from one of my invested companies in four years so presumed it had expired. Suddenly a $130MM acquisition was imminent and I received a 2X return after a nine-year holding period. The VCs had replaced four CEOs and were handsomely compensated for their success in turning the company into a targeted acquisition. Without them, I would have suffered a total loss. However, the extent to which my upside has been truncated by VCs has massively offset this one return. I now prefer to support entrepreneurs whose ability to grow wealth (theirs and mine) is not determined by how they are treated by VCs they have yet to meet. However, this merely reflects my 19 years of experience plus my risk appetite. Your mileage may vary.