Venture Capital has changed a lot since the late 90s.
Capital was hard to come by, and the founders practically had to beg venture capitalists to back their company. Our funding options were limited to a handful of blue chip companies and networks of successful angels. Two decades later, more money is flowing from more sources than ever before, and social capital has become a commodity.
In today's market, it's not uncommon to hear the sentiment that venture capitalists have to work to sell their money. We are now in the age of "value-added venture capital," where investors must show founders that they will do more for them than just write a check. It's a power shift, and the selling point these VCs offer to founders is that they will be true partners who are with them every step of the way.
But all too often, founders discover, in a very negative way, that these value-added services have a short-term expiration date.
When founders are asked, they reply that even the best-intentioned investors rarely add much value beyond 90 days from signing. At that time, the investor's commitment is limited to his attendance at the quarterly board meeting.
While many venture capitalists may think of themselves as financiers, they ultimately provide a service to their founders.
Many of the other participants don't provide any additional value beyond your paycheck other than the occasional performance. According to founders, a whopping 20% of investors don't even help their founders make strategic connections. They put the money and disappear.
In a world where investor money flows freely, VCs that don't add value are dead weight. However, they invariably invoke their contractually negotiated prorated rights when it comes time to raise a new round. Their mere presence on the cap table discourages other venture capitalists from proactively working for the founders.
After all, why should they do more for founders than their peers if they're both guaranteed to keep a seat at the table?
“This is how it has always worked” is not a good excuse. It's time for founders to hold their investors to a higher standard and insist that they provide ongoing support as their company scales in the market. It is time to abolish traditional apportioned rights.
In a term sheet, the pro rata clause guarantees an investor the right to maintain (or increase) their shareholding in the company by investing in future rounds. There are no strings attached, there are no KPIs that the investor needs to achieve for the founders. The prorated rights are simply part of the deal.
In truth, pro rata is a huge privilege that venture capitalists take for granted. Now that capital is a commodity, founders can and should demand that the right to invest in future rounds depends on demonstrating value added to the company. You can think of it as a "performance fee," a new type of proration awarded only to investors who contributed more to the company than just capital.
Andrew Horowitz He got ahead of the trend by recognizing that money is not enough to attract the most talented founders. They recruited more than 100 professionals to help their founders excel in core business functions such as merchandising, talent, people practices, marketing, and operations.
A company does not need billions of AUM (Assets Under Management) to add serious value to a company. Just look at investment shops like Signalfire y NFXMore, which offer clearly defined internal services to help their founders succeed in differentiating themselves from other investors.
Rate of return vs proration
The death of pro rata begins when founders hold their investors to the same standards as a highly engaged team member.
A rate of return clause will be different for each investor in a founder's capitalization table. Larger companies may offer a suite of services, while individual GPs and smaller funds may specialize in a particular business function, such as marketing, sales, design, engineering, or public relations.
Some ideas founders can use to identify and reward investors who work for their proration include:
- Identify three support functions that major investors must complete each quarter. Before each board meeting, these requirements are reviewed and updated for the next quarter.
- Conducting a request from non-lead investors each quarter, but insisting that every investor at the cap table, regardless of size, complete some mutually agreed-upon task each quarter.
- Provide the goals to your sales manager or equivalent. Ask them to add all of their investors on LinkedIn and identify mutual connections that can become qualified leads. Keep track of investors making introductions to those leads.
- Provide the goals to the HR and recruiting manager so they can work directly with each of their investors on potential hires. Track investors who don't engage and those who make qualified pitches within their network.
- Inviting investors to internal company events, such as hack-a-thons, email updates, board meetings, or company meetings. Measure attendance and engagement. If you want to have detailed information, you can even measure the open and read email rates.
That last suggestion is not so outlandish. In fact, the CEO of TailShishir Mehrotra maintains an open business by making all board meetings open to all employees and investors.
“The way our company operates involves a lot of our investor group,” Mehrotra said. “We have more than 100 investors on a personal level, and some donated small amounts to the company. But it's amazing how many different skill sets each can bring to the table with their various channels and ideas."
The particular deliverable that each investor offers does not matter as much as the fact that each of them in your capitalization table is empowered to deliver quantifiable value to the company beyond capital. It holds investors accountable and makes startups more effective by enabling its broader management team to leverage investors rather than just the founders and CEO.
The abolition of conventional pro rata rights is a radical and almost sacrilegious concept for venture capitalists, but it is not without precedent. It reflects a model of customer interactions familiar to most service companies. Money does not change hands in these industries without a clear understanding of what the customer can expect from the service provider.
While many venture capitalists may think of themselves as financiers, they ultimately provide a service to their founders. In the past, that service may have been limited to capital. Today, it must include the full range of support functions needed to successfully launch and grow a business.
It is understandable that many venture capitalists have an allergic reaction to the concept of apportionment based on value delivery. No one likes to work for something they used to get for free. But it is a mistake to see it this way.
It's easier than ever for anyone to launch a software company today, which has created a hyper-competitive startup environment. Companies that receive significant and ongoing support from their investors dramatically increase their chances of success and, by extension, improve the results of their investors. It is a true win-win scenario, including the clients, of course, who get more value for the service by adding all the knowledge derived from the experience and connections of the investors.
We can already see smart venture capital firms transitioning to a quantified value-added deliverables model. For example, Alexis Ohanian's venture company, 776, provides monthly receipts or liability reports to its founders detailing all the work the company has done for them over the last 30 days.
This creates transparency, holds the company to high standards, and fosters a sense of common purpose between the company and the rest of its portfolio companies. Unsurprisingly, founders working with 776 they love this approach.
Performance ratio is ultimately about giving founders control and choice. Some investors may argue that they are providing capital for the startup to hire its own people for these types of actions. That position is correct, and thus the founders will be clear about the position of those investors in terms of added value.
The purpose of abolishing conventional apportioned rights is to create what might be called a "binding boundary box." It's a situation where the investors who work the hardest for a founder are the ones who are rewarded with the privilege of working with the company in the future.
It is a very powerful means of aligning incentives between builders and their investors. Venture capitalists ignore the volatility and evolving needs of supply in their own investment. Time always produces more or less critical changes in trends, and the rights you took for granted, along with the best business opportunities, are lost to a new way of doing business.
