I had dinner a few weeks ago with some entrepreneurs, and it got me thinking about how a VC manages potential conflicts of interest. In short: does a VC give advice that is best for the entrepreneur or himself?
To start, let’s talk about how a VC is a business just like any other. The firm has stakeholders:
- The entrepreneur
- The investors, called “limited partners”
- Partners of the firm
- Non-partners of the firm
I think that venture capital does best when there’s clear alignment among, and with, a firm’s stakeholders. The four stakeholders noted above are like legs in a chair. When there’s dis-alignment with one of the legs, the whole machine teeters.
So, with that prelude, I’ll focus on a VC’s alignment with an entrepreneur, and why that matters. In particular, I’ll write about our approach to entrepreneurs. It isn’t perfect, I suspect, but it’s a situation about which I can comment with full knowledge.
Here’s our view: we think the entrepreneur is our customer. We have this as one of our Operating Principles of the firm (more here), and it’s one about which we discuss often. There is a major implication for us regarding this Principle: like any business, there are customers that fit, and there are those who do not.
For example, I’ve been advising a MIT undergrad since the winter. In the beginning, it was just he and an idea, and today, he has a founding team and they’ve done very well in getting initial traction (and tons of good press). I took two of the founders out to dinner to congratulate them. They were debating whether to stay in Boston or move to Silicon Valley.
My advice? I told them to move west. One founder’s comment: “You’re the only Boston VC who has told us that.”
Now, I know this won’t make me popular with those who want students to stay in Boston. But, remember that our firm invests 90% of its dollars locally, and so, we have a huge interest in having student talent stay after graduation.
So, why did I say what I did? Simply put, I thought it was the best advice for those founders. They want to settle long-term in Silicon Valley. One founder is from there and wants to go back home. The other founder wants to make his tech career happen there long-term. It would have been terrible if Kepha had invested in them, and all along, they were looking for a quick exit to end up in Silicon Valley anyways.
I also think most people are smart enough to the know the difference between “advice” and “self-serving comments disguised as advice.” So, why play the charade? Why not tell folks what you think, and if you’re in a conflict situation, alert them to it?
Towards the end of the dinner, they revealed a very interesting fact: they would be happy to sell to a Google quickly at a price that wouldn’t be interesting to VCs. Now, that type of exit scenario doesn’t work for a fund like Kepha. We want to build huge companies. So, their aspirations didn’t align with ours.
So, by being honest with them, they were being honest with me. And, in the end, it was a win-win discussion for Kepha and those guys.
Let me give another example. We seeded a company out of MIT and worked with them. Our CFO became their part-time CFO. He helped them apply for a few million dollars of free U.S. grant money. The group then became very focused on pursuing a customer vertical about which we were extremely bearish. We gave them a lot of evidence on our thinking. They chose to disagree.
So, we agreed to bow out. We had the power to shut down the company and block a financing. We didn’t.
We wanted them to succeed in the business they wanted to be in. We served as references during their fundraising. In the end, they raised a large Series A from a prominent firm. We sold our seed investment for a gain. What happened later? They abandoned the vertical we hated.
Some customers are right for Kepha and some are not. By being up-front and honest with entrepreneurs, we think that’s the best way to figure out if we are aligned with them. It does not do our fund and investors any favors to “sell” entrepreneurs into a situation where they’re not going to be happy.
To finish up, I think alignment is critical. When it exists, real magic can happen. When it doesn’t, dysfunction eventually takes root.