What Venture Capitalists will not tell you.

To hear them tell it, venture capitalists aren’t too different from entrepreneurs. They build great companies. They create jobs. In short, they feel the entrepreneur’s pain.

But one of the first steps to a decent relationship with a VC is accepting just how different the two of them really are. It is a fact that compared to entrepreneurs, VCs have different loyalties, sometimes diametrically opposed interests, and a lot less at stake.

Having been interacting with VCs for around three decades now, I thought of sharing with you what a VC will not tell you.

So here we go…

1. Savvy VCs understand that less than 1% of venture-backed technology startups will ever achieve a $1B+ mark cap. As a result they seek category potential, not current company performance. They look to identify companies leveraging technology to build and dominate new market categories. If the category is big enough and the category king is dominant enough, current valuation is almost irrelevant. The key to making their investment decisions is understanding category potential and the ability of the category king to define, develop and dominate the space over time. As a result legendary VCs study category potential. not current TAM (total available market). They ask the question, “Can this become a giant new space?” Then they ask, “can this founding team summon the balls, brains and bucks to become the company dominates this giant new category?” if the answer to both is yes,  they start drafting term sheets. If not, you are dead in the water. Bottom Line: If you haven’t positioned yourself this way, flesh out your value-proposition accordingly as this is the simplest way to get your message across.

2. Venture capital is a very rare form of financing. In the US, the most active VC market in the world, around 1,000 companies get new (as opposed to follow-on) VC financing per year.  That’s 1,000 investments vs. the roughly 4,000,000 businesses started in the US each year (many of which are not VC-grade to be fair … and it’s still only a tiny percent of companies that want VC funding that get it). The numbers/odds get even worse when you go to Canada, Europe or Asia. Bottom Line: Venture capital has huge mindshare and mythology. There is a lot more money to be found in family offices and the pockets of high net worth individuals. If you haven’t started talking to family offices such as us at Blackhawk Partners maybe it is high time to start doing so if you want to access to much less restrictive and more ample capital.

3. As an industry, venture capital’s return on investment is seriously behind that of the public stock market. For the 10 years ended last September, the average internal rate of return (or IRR) for U.S. venture capital funds was 6.1% annually, according to data from Cambridge Associates. During the same time, the Nasdaq rose 10.3% annually, and the Dow Jones Industrial Average returned 8.6% a year. Given that VCs skim the first 20% of annual venture fund profits off the top, pension and stock fund managers who invest in them — and who is known in the industry as limited partners — have begun to wonder what they were paying for. Bottom Line: Time to wake up folks and smell the coffee and know facts from fiction if you intend to make the right decisions.

4. VCs have their own investors — their Limited Partners, or LPs; and usually have to suck up to them, too. The very top VCs don’t have to wine-and-dine their LPs.  They just pick up checks.  But most VCs have to sell up just like you do.  In fact, they have to do more of it in some ways, because they probably have to do it to 15-20 core LPs, vs. a founder who just has 1-4 VCs.

5. VCs, as individuals, aren’t that diversified and don’t do very many deals. VC firms, as entities, get pretty diversified.  But the average VC partner only does 1-2 deals a year.  Just one or two.  Yes, that’s more diversified than you as a founder, of course.  But not as diversified as you’d think.  So their deals really need to work.  So they don’t really want to take much risk.  It’s one reason why it’s harder to get VCs to take a risk on you than you might think, and why you need to have 100% of your ducks in a row when you pitch.

6. A smaller VC v/s a larger VC may be one of the most important decisions you’ll make.  The smaller the fund, the more aligned with you they are.  They make less in fees and more on the carry.  And more practically, they can’t keep up with the dilution, like you.  But because they can’t write the large checks, they need someone else to.  And small VCs also need to buy a lot for a small amount.  If they can only invest $2-$3m and want to own 15-20% … that pretty much puts a cap on small VC valuation potential.  By contrast, Big VCs can write a big check.  In fact, they want to.  But the return has to be huge to impact the fund.  Fire the CEO, fire the founders, dilute you with nothing … they care less.  But they’ll give you more money to go big.  Both have pros and cons.  Pick the one that best matches how you want to grow.

7. Some other key facts you might want to know…

  • The VC industry is a drop in the finance ocean; its share is quite small
  • The IRR is, on average, is far from spectacular. Firms that do consistently are outliers (thus get more LP money than they can handle and downtrends)
  • Very few VCs invest seed stage. Those that do tend to invest mainly in their extended networks.
  • The majority of Inc 500 companies have not taken institutional funds.
  • The chance of getting VC investment through a cold contact is infinitesimal. Get a warm introduction if not, don’t even try.
  • Each partner and firm has specific investment criteria and stages despite saying otherwise on their sites and at conferences. Ask people who know them.
  • It’s more art than science – half-truth. There is an art to it, but again, they have their criteria and they have metrics – they’re just not telling you. Give a vision and a passion to them, yes, but don’t forget the business model.

So next time you go pitching a venture capitalist, remember those facts and most importantly make sure you pick the right “partner” or just forget about them altogether and try rather a “family office“.

  • Family Offices have money, and are looking for investments: this already makes them a good target for entrepreneurs.
  • They don’t advertise openly: this reduces their ‘deal flow’, which means if you get in front of them, you are competing against tens of other opportunities, not hundreds or thousands, as is the case with VC funds and angel groups
  • They invest their own money: this means they are willing to look at investments on their merits. They don’t have to ask themselves ‘does this investment fit my mandate’ or ‘how will it look to my limited partners’. They can just say ‘do I want to make this investment’.
  • They can often decide to invest very quickly: a family member with influence can simply decide to do the deal, on their own. Even if other family members disagree they often have a pool of money which belongs to them and they can control personally. Compare this to venture funds or angel groups where multiple people need to agree to every investment.
  • Family office money was often made by entrepreneurs: they can understand what it is like to run a business and may be able to empathize better than investors with a purely financial background

Now that you see the whole picture, share your thoughts…

Written by

Ziad K Abdelnour is a Wall Street Financier, Author, Philanthropist, Activist, Lobbyist, Oil & Gas Trader & President & CEO of Blackhawk Partners, Inc.,