Can venture capitalists destroy their startups?
Although the statement may sound counterintuitive, it is certainly possible.
The primary reason for this is the high-risk, high-reward nature of venture capital.According to research by Josh Lerner from Harvard Business School, only 20% of VC funds had better than 20% returns and nearly one in five funds had negative returns.
Added to this is the pressure on venture capitalists to show high returns. The tools at their disposal to do this consist of an array of stochastic parameters and metrics that may not be able to establish sound valuation models. For example, some companies, such as Alphabet Inc. (Google) (GOOG) and Facebook (FB), create entirely new industries and business models that cannot be valued using traditional metrics.
Thus, venture capitalists have great incentive to pressure founders and micromanage them (under the guise of mentorship) to funnel maximum returns for their investment. In some cases, this takes on the form of success conditions inserted into term sheets, which guarantee a minimum return on investment to venture capitalists, if the startup goes bust.
For example, Square, the payments startup that IPOed recently, had a ratchet provision in its Series E round that promised extra shares if the company debuted below an IPO price of $15. The ratchet provision ensured that investors cashing out on Square’s IPO got their promised returns. But, Square’s valuation (and perception) in the public markets was hit.
In other cases, this can take the form of wrong advice and lack of cooperation to achieve the founder’s vision. The case of Steve Jobs, who ran out of favor with the Board of Directors at Apple (which also had two venture capitalists, including an original investor in the company) is already well-known.
The actions of venture capitalists can also be counterproductive to a startup’s existence. We saw evidence of this during the dot-com bubble when greenhorn founders were rushed towards growth and IPOs by venture capitalists. As the business environment floundered, the same startups failed, and venture capitalists abandoned them or clashed with founders about the company’s direction. Eventually, very few survived the bloodbath.
Here are two cases of startups, where venture capitalists were responsible for shuttering them.
Shai Agassi started Better Place promising a revolution in the electric car market. Unlike Elon Musk’s Tesla (TSLA), which caters to a premium audience, Agassi wanted to build an electric car for the masses, which could travel up to 30 miles without refueling and more with the aid of a network of electric charging stations. He received the backing and funds of world leaders and the cream of venture capitalists for his vision.
Unfortunately, he promised much but delivered little. Five years after he first outlined his idea, Agassi had sold only 100 cars. The funds evaporated but growth had not come. The board, which consisted of venture capitalists turned against him. During a June 2012 board meeting, they asked him to step outside the room and, after a private conference, found another operating chief and CFO. They also refused further investment in the company.
Agassi attempted a side maneuver and managed to talk his co-conspirator and most vocal supporter on the board out of the move. In response, Alan Salzman, a board member, resigned in disgust at the move. When Agassi asked for additional bridge funding for further development from the board, he was refused. About three months later, Agassi handed in his resignation letter and a year later, the company filed for bankruptcy.
To be sure, venture capitalists did not overtly destroy the company in this case. But, they hastened its demise by refusing to cooperate with a termagant founder.
eLink was one of the hottest startups in Washington D.C., during the dotcom bubble. It was an IT services company that dispatched Cyber Super professionals to install high-speed internet at customers’ offices and perform an odd assortment of telecom-related tasks. The company raised $90 million from notable venture capital firms in the area and had 130 employees. But, the founders of the company were “edged” out by their funders, presumably because they were considered too young and inexperienced.
Not that experience made a difference to their startup’s fortunes. Much like other startups during the dotcom era, eLink also went bust even after it had hired the services of Bill Prisco, a telecom veteran from Bell Atlantic, to replace the company’s founders. In a later interview with Fortune magazine, Epstein said: “As we get a little bit wiser about business, we look at (leaving eLink) as war wounds we’re really proud of.”
While it is the founder’s vision and energy that takes a company from idea to fruition, venture capitalists exert an equally powerful influence and can make or destroy a startup’s fortunes.