How Incentives Cause CEO/VC Relationships to Go Bad

I was at a dinner the other week that had roughly 15 attendees — let’s call it 10 CEOs (many of prominent NYC startups), 3 VCs and 2 service providers. While the general purpose of the evening was to network with some great people and build a couple of new relationships, the host did pose a few questions to the group for discussion. The topic that got the most play was around CEO/Board relationships. Many of the CEOs stated bluntly that they either have a board member or board in general that is fundamentally disruptive to the business. While there were several reasons highlighted, the misalignment of motivations/incentives was the common cause, so I thought it would be helpful to lend a perspective on why this happens and provide a few thoughts to help avoid this situation.

First, I find that many founders don’t contemplate how money flows in VC land and how it affects behavior. So to start, I’ve outlined the players in the supply chain of capital and their motivations (note: this is very much generalized and not near all encompassing — It’s merely in a effort to provide context to my point):

Endowments, Pension Funds, Foundations, Other NFPs and Family Offices: Everyone in this group is motivated by long term preservation of capital. They aren’t fundraising based on performance metrics and the CIO is focused on creating a very broad based portfolio that yields a single digit return with a very low risk profile (again, in general). They’re looking to pick the best managers possible within each strategy, but again, their time horizons are infinite and therefore have no incentive to optimize for short-term returns.

Fund of Funds: The Fund of Funds are a major source of capital for VC firms. Like VC firms, they raise capital every three to five years and their ability to do so is primarily based on returns and their general access to the “hot” funds at any given time. Their primary sources of capital are the players identified in Group 1.

VCs and Crossover Funds: This group is the primary suppliers of capital to startups. They source their capital from both Group 1 and Group 2 (There are several other sources as well, but not relevant for this discussion) and raise money on average every 3.5 years. Their ability to raise money is generally based on returns and access.

Companies: Founders and CEOs are trying to build companies that are going to be around for the long term. To enable that to happen, in the short-term they need to raise capital. While capital can come from many sources, VCs are the primary one. A company that is preforming well will raise money, on average, every 12–18 months.

Using this framework, let’s look at how these incentives can create misaligned interests between CEO and VC.

The VC has 3.5 years to show signs of top quartile returns in order to raise money for its subsequent fund. If it doesn’t, then its FoF investors will disappear immediately — remember, they need to show they can invest in top quartile funds in order to raise money from the first group — and the first group of investors may be willing to stay around longer if they believe the long term trends for the fund look positive, but it turns out their feet can get cold pretty quickly as well. What this means for the VC is it needs to figure out quickly if a company has a chance at being a top 20% performer in its portfolio or not (look up what the VC power curve is, if you don’t already know the concept). To do that, it throws enough money at the company to spend aggressively in order to see if it can grow at an exponential rate. If it’s growing rapidly, great, the company can go raise it’s next round of financing from another VC who will invest more money to enable it to grow even faster. If the growth rate begins to plateau or grow at a more linear rate, then the investor begins to lose interest and allocates more time to his faster growing companies (note: it’s not this straightforward and there are a bunch of nuances, but it’s directionally correct).

Good CEOs are constantly thinking about how to build a great business that can stand the test of time. No great business was ever built in a matter of a couple of years. However, capital is the lifeblood of the business and an obvious, at times easy place to source that capital is from VCs. In order to raise money, the founder must show a believable 12 to 18 month plan that takes her to the next major set of milestones. Once VC money is invested, the perpetual balance of short-term vs long-term success begins. At the time the capital is invested, both parties (VC and Founder) generally share the same vision and are excited about the future.

Fast-forward three months. The company is behind plan and not growing as quickly as expected. The VC wants answers, which can be a host of things — longer sales cycles than expected, operational items that need to be solved before spending more on sales and marketing, weaker product/market fit than anticipated, etc. Now the VC is getting nervous and begins to provide advice that optimizes for the short-term, leading the CEO to spend time and resources solving problems that provide little to no long-term benefit. When this happens, frustration sets in on both sides and the relationship between CEO and VC begins to strain. If the situation perpetuates, then it will ultimately lead to a complete breakdown in trust and respect.

There is a large amount of variability around when and to what extent the VC begins to panic, but whether it’s three months or a longer period of time, at some point, if you’re company isn’t a positive outlier, the attention and the relationship with the VC will change. As a Founder/CEO there are ways to identify which VCs will be more likely to act in a negative manner during times of uncertainty. This isn’t a catchall and ultimately, I believe firmly in following your intuition, but I offer these four pieces of advice:

First, understand what fund a firm is investing out of and where they are in the deployment cycle — keeping in mind the 3.5-year guideline. If it’s a fund that was just raised in the past few months and you’re one of its early investments, then there’s plenty of time and plenty of investments to be made before it’s forced to raise again. It’s always great to be an early investment in a new fund. If the fund is farther along in its deployment cycle, take time to look at their other investments in the fund and how they’ve done. If Uber is in there, then there’s not much pressure, fundraising for them won’t be an issue. If it seems more average (remember, only top quartile funds are “guaranteed” to raise), then be mindful of this data point as you progress with diligence.

Second, the reputation of the firm is not necessarily the reputation of the partner. Do your diligence on the Partner in the same manner he or she is doing diligence on you. There are very reputable firms that have a Partner or two who I would never recommend one of our companies work with. By the same token, there are less brand name firms with Partners who are amazing to work with on both a personal and professional level. Not only are firms under a lot of pressure to show strong performance, but the individual Partners are as well. If it’s a Partner who doesn’t yet have a “win” on the board, his or her pressure is even greater. The implications of this can be if things aren’t going exactly to plan, their willingness to show patience and stay the course may be more challenged than others.

Third, don’t ask the VC to connect you to other portfolio Founders at his or her discretion. Do some research and figure out which companies have done well and which have underperformed. Ask to speak with CEOs from both. Otherwise, they’ll pick the two or three that are crushing, where it’s a complete love fest.

Finally, set expectations during the diligence process about your vision and how you expect to achieve it. It sounds obvious, but most founders aren’t explicit in this area. I suggest you speak frequently to the Partner who is doing the diligence; recap the discussion points via email (it both confirms what you believe each other is saying and it creates a paper trail). It’s your job to be as comfortable as possible that the Partner understands your business entirely and is truly in it for the long haul.

I recognize two critical factors while proffering advice on this topic. First, not every founder has the luxury of running a business that is in high demand and has a lot of optionality on who they take money from. Second, most founders hate fundraising and want to get it done as fast as possible, so they can focus purely on operating their company. While I appreciate these variables, I suggest you keep in mind that when you raise money from a VC (or anyone for that matter), you’re agreeing to give up some level of control and must acknowledge that it is a long-term relationship that you have no way of undoing if it doesn’t work — other than you walking away from your company. Keeping this in mind should help you make more informed decisions on whether a specific VC is right for your business.

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