Dharmesh Shah over on OnStartups has a terrific post titled 9 Pithy Insights on Venture Capital. The post covers many of the key points that should be in the new entrepreneur’s handbook on getting venture capital. I found myself nodding my head as I read each one.
I’d add to the list (in a way that’s not nearly as pithy or concise as Dharmesh) that it is very important to realize that all VC firms are NOT created equal and the dynamics that those inequalities bring will, most likely, have a big impact on how your company gets it’s current round of capital as well as each subsequent round. While I’m not a venture capitalist, my view from the outside, having been the beneficiary of more investment rounds than I can count, is that there are at least two tiers of venture capital firms. There may be more than two, but for the sake of simplicity from the entrepreneur’s standpoint, tier 2 through tier n appear to be regarded similarly and, generally speaking, act similarly. I’m not counting angels or angel funds here. The former are almost always subordinated by venture capital firms and the latter act more like nth-tier VCs than they do like angels.
Top-tier funds are generally larger (in terms of money being managed and number of partners), more established, have more experienced partners on the whole and are better known in their areas of focus. This is not to say that top-tier funds aren’t sometimes smaller or that second-tier funds don’t have uber-experienced partners, but the generalization does fit most often (as generalizations should).
Here are some actions that are indicative of a top-tier firm:
- They do larger initial deals
- More partners and more money means that they do more deals
- A relatively high percentage of their investments are in later rounds
- They frequently do M&A type investments along with pure venture deals
- They don’t usually mention the 2nd-tier funds they have worked with
- While they’ll jump quickly for certain investments, deals on the fringe of their expertise or that are otherwise not a slam dunk may take a while to close
Here are some actions that are indicative of 2nd-tier firms:
- They look to do highly-leveraged, smaller initial deals
- They’ll often move faster than larger firms to get a deal they find exciting
- Since they are often squeezed out of popular deals, they tend to jump at the opportunity to get into or even lead a deal they think will be desirable by top-tier firms.
- They almost always mention the top-tier funds they have worked with
- They are often more likely to nurture a deal that they feel has promise, although resource limitations can make this difficult for them
None of this is shocking, of course, and if you’ve shopped a deal around before, you’ve probably already drawn similar conclusions. In my experience, though, there is an added point that appears to be virtually unspoken: top-tier and 2nd-tier VCs often don’t play well together. Why does this matter? Because many venture deals involve investment from both types of firms and if an entrepreneur seeking funding isn’t aware of the potential pitfalls, they may find themselves wasting loads of extra time capitalizing the company instead of running it or potentially giving up more equity than is necessary.
As I see it, the problem manifests itself in two ways:
- Startups that do their A-rounds with 2nd-tier VCs often have trouble bringing in top-tier VCs in subsequent rounds. Top-tier VCs like being in control and, therefore, don’t like being subordinated to the smaller A-round investors. This means that later rounds of funding may have to rely on 2nd-tier VCs that are generally not as deep-pocketed as their larger brethren.
- Top-tier VCs often want to be the lead in a round that has both top-tier and 2nd-tier investors. In my experience, this can result in a large amount of time and money spent on negotiating terms with the lawyers. Because of the relationship, this can obviously happen when the 2nd-tier firm takes the lead as well.
This is not a science, of course, and your mileage may vary. There are, I’m sure, many venture capital firms, both large and small that work together seamlessly. However, having witnessed the problems of mixing oil and water many times and having heard about it from others plenty more, I believe that such problems are far from rare. In the end, these factors only come into play when you have funding choices which many startups don’t have. Most startups will end up taking money from the best (or only) available source. This is absolutely the right thing to do, regardless of the factors mentioned here. If you have a choice, though, these factors should be considered. Even if you don’t, they’re good to know ahead of time.