When startup founders bring venture capitalists (VCs) on board, they unlock opportunities for accelerated growth and access to invaluable expertise. However, they also enter into a dynamic where VCs’ goals may not always align with their own. For founders, understanding how VCs operate and their approach to exits is critical for managing expectations and making informed decisions.
The VC Growth Imperative
Venture capitalists are driven by one thing above all: growth. VCs must deliver outsized returns to their Limited Partners (LPs), who expect annual returns of 20%–30% on a typical 10-year fund. To meet these expectations, a VC fund needs to generate returns equivalent to 12.8 times the initial investment.
Given the high risk of investing in early-stage companies—where only 10%–20% may succeed while others fail or limp along—the pressure is immense. To make the math work, VCs rely on one or two portfolio companies to achieve exponential growth, delivering returns of 10x, 20x, or even 100x. This strategy compensates for the majority of investments that don’t perform as hoped.
Why “Swing for the Fences” Impacts Founders
The need for grand-slam successes shapes how VCs advise their portfolio companies. General Partners (GPs) in VC funds don’t know in advance which investments will become the winners, so they encourage all investee companies to prioritize aggressive growth. For founders, this approach can mean doubling down on risky strategies and delaying exits that might otherwise provide a comfortable return.
For example, founders or early investors might see an offer that provides a 2x or 3x return as a solid outcome. However, VCs—focused on their fund’s overall performance—may view such an exit as suboptimal and push to hold out for higher returns, even if it takes years.
The VC’s Power to Block Exits
Venture capitalists often wield significant influence over a company’s major decisions, even with a minority stake. This power stems from the terms negotiated during the Series A financing round. Typically, VCs acquire 25%–40% of a company’s stock in the form of preferred shares, which come with special rights and protections.
Among these rights, two stand out for their impact on a company’s ability to exit:
- Share Issuance Rights: VCs often retain approval rights over the issuance of new shares. Without their consent, the company cannot raise additional funds, giving the VC significant leverage.
- Change of Control Veto: Even with a minority stake, VCs can veto a company’s sale to an acquirer. If the exit doesn’t meet their minimum return threshold—often around 10x—they may block the deal, frustrating founders and early investors.
Navigating the Challenges of Misaligned Exit Goals
Disputes between founders, angels, and VCs often arise when exit strategies are not aligned. For instance, a VC’s decision to veto a seemingly lucrative exit can create lasting tension, harm the company’s morale, or even jeopardize its survival.
To avoid such pitfalls, founders should:
- Clarify Alignment Early: Before accepting VC funding, ensure alignment on exit strategies. Discuss potential scenarios and agree on what constitutes a “win” for all parties.
- Understand Investment Agreements: Carefully review the terms of the investment agreements, including the Articles of Incorporation and shareholder agreements, to understand the rights and restrictions VCs hold.
- Prepare for Negotiations: During the exit process, anticipate potential objections from VCs and work proactively to address them. Having a well-prepared case for an exit can make it easier to secure buy-in from all stakeholders.
- Consider Alternative Financing: If the relationship with VCs feels too restrictive, founders might explore other funding options, such as angel investors or strategic partnerships, which may offer more flexibility.
Final Thoughts for Founders
Bringing VCs on board is a significant step for any startup, providing capital and expertise to scale. However, founders must remain vigilant about the potential for misalignment, particularly regarding exit strategies. By fostering open communication, aligning expectations, and understanding the mechanics of VC agreements, founders can navigate these challenges and position their company—and their stakeholders—for success.
David Rowat is a Partner at Strategic Exits Partners, a boutique investment bank, specializing in the sale of technology companies. David recently published Your Company, Their Money: What tech founders need to know about finance. It describes the structure of the angel and venture capital systems, and how they finance early stage tech companies.
Good advice from David Rowat. The entrepreneur and the investor must have compatible goals.
When I was looking for VC investment I spent months making pitches all over North America, received two offers, and declined both when I realized how different were my objectives from those of the VCs. My company no doubt grew more slowly, but at the same time I continued to own more of it, so who knows, in the long run I may have ended up better off.
Good article.
The key point is that VC is just one source of capital that has its advantages and disadvantages, just like every other form of outside capital. At every stage of a company’s life, various sources of capital should be considered as to what is the best fit for the company to achieve its objectives at that time.
Excellent advice! A lot of wisdom packed into a few paragraphs! As with everything in business (and almost all of life…), founders and CEOs have to consider the tradeoffs involved in any financing arrangement. Ideally, venture capitalists bring “smart money” and true partnership to owners and management. Their extra resources can be the difference between success and failure, or modest and epic success. But it is very important that investors and founders fully understand and appreciate each other’s abilities and goals as they evaluate the investment opportunity. It is in no one’s interest to create a mismatch from the beginning.
David: Alignment of interests is key to a successful financing or exit. Founders need to spend a lot of time testing that the stakeholders are in aligment.
David’s advice with respect to VC investments into start-up companies is very helpful to entrepreneurs. VC’s can and do definitely help companies create the ability to succeed, but during the conversations between the start-up founder and the VC firms understanding VC medium and long-term vision and priorities is critical. Aligning not just the money but also the vision for the company by the VC firm is just as important. I also found David’s book to be very helpful to entrepreneurs at all stages of a start-up company’s life cycle and highly recommend the book as an excellent read.