It's amazing to see the differences in thinking among VCs. Totally opposite schools of thought can be present and we are not talking about some decades in time between the ideas.
What's the purpose of committing the management in an early stage deal?
The first line of thought is to tie the guys in as deep as possible. Demand a relatively large personal investment and keep it as the collateral that the management will do all they can to keep the thing afloat.
The second approach is to take the standing where risk-investing means dedicating money by the investor and a management means dedicating work to the deal. This means that since the management is earning their living from the venture there is enough risk exposure for them already. Naturally if one has created wealth already and has no mortgage loan on the line a small invest would not do any harm as a sign of commitment.
The first 'old school' counts on the fear and threat factor more than anything. The management cannot afford to mess up with the venture or at least it will have serious consequences for the personal situation. The other approach usually believes on positive incentives instead. It's more worthwhile to make the venture and the perks so appealing that it makes no sense to jump off the venture any time soon. Incentive metrics could include benchmark to profitability, growth and other important milestones as stated in the biz plan. In another words they look for the future and try to maximise the chances for the optimal outcome.
From the risk management perspective startup investing is anyhow risky. It's less than one third of all deals that are worthwhile even for the management. Portfolio management methods scream red when considering the case of a CEO & founder in a startup. First of all, the person has dedicated considerable amount of time and effort for the case from 0-2 years before the seed investment. When the seed investor comes in the founder can be required to invest some more personal wealth for the case. In this phase the entrepreneur earns the living from the venture, has invested additional money for the case (or taken another mortgage for the house) and is required to keep the company in the very steep growth track for several years for the optimal growth. All eggs are nicely in the same basket. (Life is risky and it is not necessary to become an entrepreneur...)
How about from the investors point of view? You get what you measure. If you are loading the management with high personal risks you are getting most likely what you ordered. This means that the management becomes extra cautions not to rock the boat. They prefer to take the safer route in order not to jeopardize the whole venture and become personally liable for the losses. This means that the startup cannot be geared optimally for the growth and targeted for the highest possible valuation alternative.
Similarly when the times are bad it takes a lot of courage from the management to keep calm and make the right choices and fight for the survival of the venture. I doubt it is possible to give 100% performance if one's own job is on the line together with the extra money committed to the venture by personal loans and second mortgage among others. If one has to worry about where to get the next month's living its difficult to be objective and positive about the future.
Finally it's interesting to think about the management cash commitment from the point of view of sunk costs. How much does it really matter how much money you have really committed to the deal? It's done already. No matter what you do or which way the venture is going, you still have to pay off the personal loans anyhow. Your thinking is guided by the thought that one has to secure the monthly loan payments in all the circumstances.
Posted at September 17, 2004 07:54 PM | TrackBack