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90 Academy of Management Perspectives August

An Entrepreneurs Guide to the Venture Capital

Dirk De Clercq, Vance H. Fried, Oskari Lehtonen, and Harry J. Sapienza*

Executive Overview
This article provides a foundation for an understanding of the dynamics of venture capital from the
entrepreneurs point of view. An important aspect of understanding venture capital involves the different
sources of risk capital for the entrepreneur, i.e., (classic) venture capitalists (VCs), business angels, and
corporate venture capitalists. Furthermore, whatever source of risk capital entrepreneurs choose, they have
to take into account the different phases of the investment cycle, i.e., the pre-investment, post-investment,
and exit phases. We discuss some of the key issues of which entrepreneurs need to be aware when dealing
with venture capitalists during each of these three investment phases. Furthermore, we provide hands-on
advice to help entrepreneurs maximize the value of their relationship with VCs throughout the investment
cycle, and we point to trouble spots which can endanger value creation. For instance, in the pre-investment
phase, the challenges of finding an (adequate) investor, obtaining the right amount of money, and
structuring a fair deal are paramount for entrepreneurs. During the post-investment phase, entrepreneurs
must attend to managing the relationship with the VC via the creation of effective communication, mutual
trust, and the establishment of objectivity and consideration towards the other party. For the exit phase,
we discuss the importance of establishing a timely and harmonious exit for the VC. We begin with a brief
comparison of venture capitalists in classic venture capital firms with business angels and corporate venture
capitalists. The focus of the article, however, is on classic venture capital.

he venture capital (VC) industry has grown rad- Next, follows a discussion of the different phases
ically in size and sophistication over the last 40 of the investment cycle (i.e., the pre-investment,
years. In 1978, $424 million was invested in VC post-investment, and exit phases) with a focus on
funds, while in 2004 almost $21 billion was invested the dynamics of the relationship between the en-
(Gompers & Lerner 2001; MoneyTree Survey trepreneur and one specific type of equity inves-
2004). The result is a dynamic, often confusing, and tor, the (classic or professional) venture capitalist
at times intimidating world for the uninitiated en- (which will be labeled hereafter as the VC).
trepreneur. This article provides an overview of VC Finally, the authors use the three phases of the
from the entrepreneurs perspective. It is intended (venture capital) investment cycle to organize a
primarily for aspiring entrepreneurs who are in discussion of how entrepreneurs can maximize the
search of risk capital and secondarily for those aspir- value from their relationship with a VC.
ing to be venture capitalists or angel investors.
The article opens with an overview of the Sources of Capital

potential sources of equity capital to the entrepre- ntrepreneurs rely on different sources of capital
neuri.e., the different options of risk capital and in order to finance their ventures. Often an
types of venture capitalists available for an entre- important source of capital is the entrepre-
preneur in search of funding for his or her venture. neurs own capital, or personal savings (Aldrich
* Dirk De Clercq (ddeclercq@brocku.ca) is an Assistant Professor of Entrepreneurship at Brock University.
Vance H. Fried (vhfried@okstate.edu) is the Brattain Professor of Management at Oklahoma State University.
Oskari Lehtonen (oskari.lehtonen@hanken.fi) is a Doctoral candidate at the Swedish School of Economics and Business Administration,
Helsinki Finland.
Harry J. Sapienza (hsapienza@csom.umn.edu) is a Professor of Strategic Management and Organization and the Curtis L. Carlson Chair
of Entrepreneurial Studies at the Carlson School of Management, University of Minnesota.
2006 De Clercq, Fried, Lehtonen, and Sapienza 91

1999). Alternatively, serial entrepreneursi.e., capital and informal investors on the one hand,
individuals who launch several ventures over and bank loans on the other), there are three
timemay liquidate their stakes in their earlier major sources of equity finance available to entre-
ventures and re-invest their money in a new ven- preneurs: (1) classic or professional venture capi-
ture (Wright, Robbie, & Ennew 1997). A second talists (VCs); (2) business angels (BAs); and cor-
source of capital may come from informal investors, porate venture capitalists (CVCs). These three
often referred to (somewhat disdainfully) and col- investor types differ according to the source of
lectively as the 3Fs (family, friends, and fools) of investment funds, typical scope and size of invest-
new venture financing. Relatively speaking, the ments, primary motive(s) for investing, invest-
investment amount available or provided via ment criteria, reporting requirements, and exit
these sources is limited, and these investors ex- issues. Table 1 compares these three venture cap-
pectations about a good return are set in an infor- ital investor types.
mal way. In many cases, existing personal relation-
ships with the entrepreneur will play an important Venture Capitalists
role in the informal investors decision to provide Venture capitalists (VCs) invest outside equity
financing (Harrison & Dibben 1997). Another from professionally managed pools of money. VCs
source of funding, at the other end of the spec- raise funds from various parties (primarily institu-
trum, are banks as providers of capital in the form tional investors) who function as limited partners,
of loans. However, banks do not wish to assume in an investment pool referred to as a venture
the high levels of risk associated with equity in- capital fund. In order to maintain limited liability,
vesting in entrepreneurial ventures. In between limited partners are not directly involved in spe-
these two extremes (i.e., an entrepreneurs own cific investment decisions. The VC therefore
Table 1
Characteristics of VC Providers
Professional Venture Corporate Venture Capitalist
Capitalist (VC) Business Angel (BA) (CVC)
Source of funds Investing funds of outside Investing their own money Investing corporate funds
limited partners
Legal form General partnership Private individual Subsidiary of a large firm
Typical size of investment $210M $50100K $220M
Financing stages All stages Seed & Startup All stages, later preferred
Geographic proximity Preferences Close proximity is Very close proximity is preferred Proximity less important
Motive for the investment Equity growth only Equity growth and personal Strategic and equity growth
Investment criteria Growth prospects Growth and mentoring prospects Strategic value and fit
Great management
Finding investors Easy to find Hard to find Few but easy to find
Reaching agreement Lengthy and extensive Relatively quick to reach Hard to meet fit requirements
due diligence agreement when fit
Reporting requirements Regularly timed reporting Varies by individual Regularly timed reporting
requirements requirements
Financially focused Generally light Strategically focused
Involvement level Method Moderate Low to extremely high, informal Low to moderate
Board membership direct Informal or board
or through syndicate
Exit planning Method Planned Often unplanned Often unplanned
IPO/trade sale Trade sale Acquisition/trade sale/IPO
92 Academy of Management Perspectives August

manages the fund for his or her limited partners by financing. Table 2 provides some background in-
making investments in a portfolio of entrepreneur- formation in comparing financing stages in terms
ial ventures (Sahlman 1990). of the ventures characteristics, the purpose of the
A group of VCs who co-manage one or more funding, the typical VC investor, the benefits
VC funds is referred to as a venture capital firm. provided by the VC, and the major trouble spots.
Because of the limited life (typically 10 years) of a Where appropriate, Table 2 points out differences
venture capital fund, venture capital firms com- by stage among VCs, BAs, and CVCs.
monly have more than one fund under manage- VCs are interested in growth and increasing
ment at all times. Some very large firms even have the value of the venture when making invest-
multiple funds, each of which may be specialized ments. Therefore the growth potential of entre-
by industry sector or stage of development (Nor- preneurial ventures and the capability of the man-
ton & Tenenbaum 1993). The total amount of agement team to realize this growth are
money a venture capital firm has under manage- paramount to VCs. VCs typically focus on the
ment in its various funds varies with firm strategy track records of the entrepreneurs. In the earliest
and reputation. Most venture capital firms have stages, the world-class status of the entrepreneurs
between $100 to $500 million in capital under is especially important. As time goes on, the dem-
management. Investment decisions are made col- onstrated ability of the CEO to bring venture to
lectively by the individual VCs who act as part- the market increases in importance. It is not un-
ners of the venture capital firm (for convenience, usual for the CEO to be replaced as the venture
we refer to the venture capital firm itself as firm growth explodes (Tybee & Bruno 1984; Wright &
and to the investee as venture). These partners Robbie 1998). In order to assist in growth and to
are also involved in the venture capital firms monitor progress, VCs stay highly involved with
day-to-day operations. Venture capital firms are their portfolio companies and expect regular re-
small, flat organizations (Wasserman 2005; 2003). porting from the entrepreneur (Busenitz, Moesel,
The firm receives an annual management fee (typ- & Fiet 2004). Whereas entrepreneurs are espe-
ically 1 to 2.5 percent of the funds committed cially interested in maintaining ownership control
capital) from its limited partners; this fee covers of the venture, this issue is only of indirect interest
expenses of managing the fund, including the to the VC. VCs want to make sure the entrepre-
salaries for the VCs. The venture capital firm also neur stays motivated; the VCs do not want to run
receives a share (commonly 20 percent) of the the entrepreneurs business. However, although
profits of the fund (typically called carried inter- an individual VC rarely takes a majority stake in
est or simply carry) that is divided up among the the venture, VCs often insist that control of the
VCs. Because the most successful of ventures may board of directors and of future equity dilution
generate more than $100 million in return at exit, decisions be in the hands of a syndicated group of
a VC can become wealthy with but one highly venture capital investors. These preferences imply
successful venture investment. that entrepreneurs should not come across as be-
As an industry, classic venture capital firms ing obsessed with ownership percentages. Rather,
invest in all stages of venture financing, although entrepreneurs should portray themselves as want-
some individual firms focus on particular venture ing a fair deal for all.
stages. Among other names, these stages are some- The preferential exit mechanisms for the VC
times referred to as seed, start-up, expansion, and are an initial public offering (IPO) and trade sale.
buyout. Compared to BAs (see below), VCs in- The route to exit is preferably planned before the
vest, but modestly, in seed financings (Wright & investment is made. VCs have developed highly
Robbie 1998). Seed financings are where the ven- standardized terms of agreement and prefer to let
ture is still developing its technology and/or busi- their lawyers hammer out the details of the agree-
ness concept. Funds for a seed financing are used ment with the entrepreneurs lawyers so as to
to develop the technology and business concept to minimize last minute personal acrimony between
the point where the venture can attract start-up themselves and the entrepreneurs.
2006 De Clercq, Fried, Lehtonen, and Sapienza 93

Business Angels mentor the development of a promising young

Business angels (BAs) are individuals who invest entrepreneur. As a result, BAs are inclined to
their own capital in new ventures. BAs are often invest in businesses where they have knowledge
either entrepreneurs (who have sold their compa- and experience (Harrison & Mason 1996). An
nies and wish to invest their money) or retired important issue for the entrepreneur will be to
senior executives of large companies. BAs share determine whether the BAs primary interest is to
the VCs interest in equity growth, but many are generate a profit or to mentor as well. The former
also drawn to venture capital investing by the type of BA will resemble the VC in many ways
chance to be heavily involved in an exciting ven- and the latter will want closer ties and involve-
ture where they have the opportunity to leverage ment with the entrepreneur; in this latter case,
their industry contacts and expertise and/or to meddling can become an issue for the entrepre-

Table 2
Issues Related to VC Investing by Venture Stage
Seed Financing Start-up Financing Expansion Financing Buy-out Financing
Characteristics of the venture 12 entrepreneurs Management team in place Marketing has been started Established company
Undeveloped technology and Product ready for marketing Venture is ready to start growing
business concept and expanding
Business plan is not validated A pilot and other information
about the product are available
Main purpose of the funding Enabling research and Establishing the marketing and Launching full scale marketing MBO
development sales activities activities
Developing business concept LBO
Typical venture capital Business angel (BA) VC VC VC
Sometimes corporate CVC CVC
venture capitalist (CVC)
Sometimes BA
Main expertise or benefit Structure, discipline, Marketing experience, recruiting Marketing experience, recruiting Legal and other expertise how
beyond money provided sounding board and attraction help, contacts, help with follow-on help, contacts, help with follow-on to execute a buy-out deal (VC)
by the venture capitalists of additional (external) financing (VC) financing, help to plan and execute
funding (BA, VC, CVC) the exit (VC)
Insights how to establish the Technological insights, test Technological insights, test
ventures legal form (VC) marketing and piloting possibilities marketing and piloting possibilities
Technological insights (CVC) Reputation benefits (VC, CVC) Reputation benefits (VC, CVC)
Major trouble spots of Time consuming to locate, Time consuming to locate, Time consuming to locate, Time consuming to locate,
venture capital funding negotiate and close the deal negotiate and close the deal negotiate and close the deal negotiate and close the deal,
from entrepreneurs
point of view
Involvement (e.g. reporting Involvement (e.g. reporting Involvement (e.g. reporting Involvement (e.g. reporting
requirements and governance) requirements and governance) requirements and governance) requirements and governance)
with a VC requires a lot of time with a VC requires a lot of time with a VC requires a lot of time with a VC requires a lot of time
Early stage company does CVC might want to direct the CVC might want to direct the
not have very much to back up strategy of the venture strategy of the venture
the valuation of the venture
and the valuation might be
very low
94 Academy of Management Perspectives August

neur. Typically, BAs will take modest levels of parents existing business. Entrepreneurs should be
ownership in the new venture, averaging 10 to 15 aware that a CVC whose parent is well-recognized
percent of ownership in initial deals. in the marketplace can provide substantial bene-
BAs rarely compete with VCs for deals. Rather, fits such as access to distribution channels, R&D
they either invest in seed stage deals that they support, and direct sales to the mother company.
hope will develop into ventures that attract Furthermore, the reporting requirements expected
start-up financing from VCs, or they invest in by the CVC are rather strong for the entrepreneur
ventures whose growth prospects are too small to and often focus on the strategic fit between the
be of interest to a VC. In the case of the lower investor (corporate parent) and investee (entre-
growth potential ventures, the BA still seeks good preneur). A common exit method for the CVC is
returns, but the absolute value of the potential acquisition or trade sale, and the exit route is
return can be much smaller than the VCs because often unplanned.
the amount invested is significantly less. For en- From the entrepreneurs point of view, a major
trepreneurs who favor informal relationships with danger with CVCs is the appropriation of tech-
their investors and prefer light reporting require- nology secrets or know-how by the CVC. Also, if
ments, BAs may represent an appropriate source the venture is acquired by the CVC, entrepre-
of risk capital. Furthermore, because extremely neurs are likely to lose operating control of the
high growth is rare for BA-backed ventures, the venture, and the entrepreneurial culture of the
main exit mechanism is trade sale. Oftentimes, venture is also threatened. CVCs are less con-
the specific exit type is unplanned. Agreements cerned with venture exit; instead they leave the
will be much less formal and standardized than conditions open to their evaluation of the strate-
with VCs. And, while lawyers are typically in- gic usefulness of the venture to their parents core
volved in capturing the final agreement, the terms operation. Terms tend to be standard and formally
are usually directly negotiated between the BA negotiated.
and the entrepreneur. Entrepreneurs should be aware that VCs, BAs,
and CVCs represent partially complementary and
Corporate Venture Capitalists partially overlapping sources of finance. The com-
Corporate venture capitalists (CVCs) are another plementary involves two dimensionsnamely,
source of equity finance for the entrepreneur and the timing and amount of capital provided. BAs
reside at the other end of the venture develop- tend to be more willing than VCs to invest at the
ment spectrum from BAs. The CVC acts as a very earliest stages; however, the amount of fund-
financial intermediary of a non-financial company ing available for a single infusion is much larger
(Siegel 1988). While CVCs are interested in eq- from VCs and CVCs than from BAs. In general,
uity growth on their venture investment, their VCs are more risk averse and prefer shorter in-
primary interest is in securing strategic benefits for vestment horizons. Furthermore, BAs are more
their parent operating company. CVCs seek to highly motivated by the intrinsic reward of their
make money indirectly for their corporate parent involvement in the management of the venture.
by investing in ventures that add value to their Since CVCs emphasize technology and the line of
parent. For example, the CVC of a pharmaceuti- the business of the venture, they make invest-
cal company may invest in a start-up that is de- ments of varying size, often in conjunction with
veloping a new drug that its parent company will BAs and VCs. The strategic interest CVCs take in
ultimately distribute. Other times the CVC may the venture means that they are often willing to
invest in the hope that if the venture is successful, pay higher prices for equity but also present a
then the CVCs parent company will have the significant threat of using the ventures knowledge
inside track on ultimately acquiring total owner- to create direct competition for the venture.
ship of the venture. As a result, corporate venture Entrepreneurs should be interested not only in
capital investments are primarily made in ven- the money a potential investor can provide, but
tures whose line of business is closely linked to the also in their potential to add value beyond cash.
2006 De Clercq, Fried, Lehtonen, and Sapienza 95

In fact, in some cases, the potential value-adding classic venture capitalists are popularly believed to
services can be the primary reason for entrepre- have developed the most sophisticated and best
neurs to seek venture capital, as illustrated by the practices in nurturing new ventures. In short, both
notable example of Microsoft in its pioneer years entrepreneurs and other investor types can learn
(Wilson 1985): much by understanding classic venture capital
Money alone was certainly not what won David
(Wright & Robbie 1998; Bruton, Fried, & Mani-
Marquardt (a VC at a firm called TVI) a chance to gart 2005; Kummerle 2001; Sapienza, Manigart, &
put $1 million into Microsoft Corp. . .. The company Vermeir 1996; Wright, Lockett, & Pruthi 2002).
. . . was generating more cash than it could use when
Marquardt heard in the Fall of 1980 that Gates was Pre-Investment Phase
interested in lining up his first outside investor. They The VCs goal in the pre-investment phase is to
absolutely didnt need our money, but they wanted
outside counsel and I was the first venture capitalist
make an investment in a venture that offers the
they had talked to who understood their business. potential for significant long-term capital gains.
Marquardt, who had been a computer hobbyist for Their target rates of return are about 30 to 60
years, spoke Gates language well enough to win a percent per annum; thus, to qualify, a venture
place on the Microsoft board of directors. must have a realistic chance of achieving signifi-
cant growth in sustainable earnings and offer an
The Venture Capital Investment Cycle exit opportunity in three to seven years after the

egardless of the type of venture capital the investment (Sahlman 1990).
entrepreneur has chosen to seek, entrepre- For the entrepreneur, it is crucial to understand
neurs will have to take into account the phases what VCs are looking for when making invest-
of the investors investment cycle and the impact ment decisions. In essence two aspects are impor-
of these phases on their financial and social rela- tant. First, the venture needs to offer an excellent
tionship with the investor. Overall, three phases business opportunity. More specifically, a VC
can be distinguished in the VC investment cycle: would define such opportunity as huge market
the pre-investment, post-investment, and exit potential; appropriate venture strategy with a goal
phases (Tyebjee & Bruno 1984). These phases of establishing and maintaining uniqueness; ade-
will be used to organize the discussion for the quate protection of intellectual property from im-
remainder of the article. The flow chart in Figure itation; and a well-developed and integrated mar-
1 summarizes the different steps included in the keting, production, and financial plan (Shane
investment cycle. Whenever possible, we will pin- 2003). Furthermore, VCs look for a concept that
point what the implications are for the entrepre- can be implemented in a reasonable time with a
neur when discussing the investors activities and reasonable amount of capital. VCs are not inter-
preferences in the different phases. ested in funding basic research. The concept must
Because entrepreneurs motives for attracting offer a sustainable competitive position that will
venture capital differ, they should keep in mind generate a significant level of absolute profit if
that different types of investors can play different successful. This means that VCs are generally
and complementary roles in their venture. Table 3 looking for concepts that address markets of at
compares the different investor types across the least a half-billion dollars in size.
different phases in the investment cycle. In the Second, the venture should be led by an excel-
remainder of the article, the focus is on VCs, only lent entrepreneur and management team one
(although Table 3 can be used throughout to that shares the VCs growth and value maximiza-
compare the investor types in different phases of tion goals. VCs want management that is honest,
the venture capital cycle). An emphasis on this trustworthy, motivated, and passionate about the
sector was chosen for two reasons: (1) the longer venture. However, as many entrepreneurs may
history of the professional venture capital sector have (or pretend to have) these characteristics,
has resulted in a common set of practices from the most critical distinguishing factor is the en-
which lessons and insights can be drawn; and (2) trepreneurs experience. A variety of types of ex-
96 Academy of Management Perspectives August

perience are critical: experience in the start-up aspects in the VCs decision-making process: the
process itself (including selecting and motivating entrepreneurs educational capacity (i.e., the
a high-quality team); experience in the target availability of general skills that enable the per-
industry (including understanding key success fac- ception of, and enactment upon, market opportu-
tors and crucial value chain activities, as well as nities) and industry-related experience (i.e., the
possessing reliable and venture-friendly access to presence of considerable experience within the
distribution channels); and cutting-edge technol- management team in terms of the industry that is
ogy experience (including knowledge of and ac- being entered by the venture) (Shepherd 1999a).
cess to the key people and techniques in the field). Another study pointed to the importance of the
One study referred to the following two key entrepreneur having successfully completed a
Figure 1
Steps in the Investment Cycle
2006 De Clercq, Fried, Lehtonen, and Sapienza 97

product development project or funding round; going from early stage to exit, in a successful
still another examined the different kinds of ex- company. If the VC is interested in an emerging
perience needed in different phases of the invest- venture, but views the entrepreneur as too inex-
ment cycle (Wasserman 2002). Interestingly, perienced, a VC might still offer seed investment
what many VCs perceive as the necessary extent with the explicit understanding that more experi-
of experience has varied over time. At the height enced management must be in place before start-up
of the Internet bubble, many VCs invested (often financing is provided. In short, entrepreneurs should
to their deep regret) in ventures headed by entre- be aware that investors want to know whether the
preneurs with just a few years of experience. Now, entrepreneur is as interested in growing the venture
even early-stage investors want to see a CEO in as are the investors themselves, and is willing to step
place whom they feel is capable of managing the aside if doing so will improve the ventures prospects.
company all the way to exit. The current prefer- VCs select investments through an informally
ence is for someone with top management expe- structured (but relatively uniform) process usually
rience (or at least full profit-center responsibility), contain the following phases: deal origination,

Table 3
Issues by VC Type and Investment Phase
Professional Venture Capitalist Corporate Venture Capitalist
(VC) Business Angel (BA) (CVC)
Pre-investment phase
Deal origination VCs tightly knit community BAs hard to locate CVCs usually tag along with
Referrals are highly valued Internet, informal networks and May be best to find VCs that
university groups may be used regularly partner with CVCs
Deal screening Defined targets Difficult to know a priori what Multiple strategic foci
investors preference is
Check stage, industry, location, Typically informal pitch Formal pitch
and capital needed
Formal pitch
Deal evaluation Extensive due diligence Criteria/process investor Extensive due diligence
specific (proprietary knowledge at issue)
Deal structuring Valuation Fewer restrictive terms Follows VC lead
Formal control by the VC Lack of sophisticated terms may Intellectual property rights are
cause later financing problems key issue
Use of term sheet
Staged investing
Post-investment phase
Monitoring Milestones Informal control Corporate control
Board representation
Reporting requirements for
Value-adding roles High to moderate Low to moderate High to moderate
Roles: strategic, financing,
networking, interpersonal,
reputational, discipline
Exit phase
Exit planning Planned Often unplanned Often unplanned
Exit mode IPO/Trade sale Trade sale Acquisition/Trade sale/IPO
98 Academy of Management Perspectives August

deal screening, deal evaluation, and deal structur- added contributions. For example, a VC may in-
ing. The process generally takes the VC in excess vite a BA to invest in a start-up in an industry
of 100 hours of work over about a three-month where the BA has significant experience. The VC
timeframe before making an investment. Less does not want the BAs money; rather, the VC
than 2 percent of the deals that enter the process wants the venture to benefit from the BAs indus-
ultimately receive an investment from the VC try expertise and contacts. Often two or three
(Fried & Hisrich 1994). such investors may require seats on the venture
In the deal origination phase, the entrepreneur board in order to do the deal. However, filling up
and the VC initiate contact with one another. the board with investor-types can be burdensome
VCs make themselves known through active par- and redundant. Entrepreneurs should seek infor-
ticipation in entrepreneurial networking events mation both on the potential value-added contri-
and their websites (e.g., NVCA.org has a list of all butions of the investors in their investment syn-
member firm websites). The entrepreneur can also dicate and on the style of governance in which
learn about VCs through published industry they typically engage.
guides (e.g., Pratts Guide to Venture Capital or In the deal screening phase, the focus is on
West Coast Venture Capital) and more in-depth whether the venture meets the VCs interest in
information services (e.g., VentureOne Corpora- terms of industry sector, investment stage, geo-
tion, Venture Economics, and Securities Data Cor- graphic location, and amount of capital needed
poration). Some VCs like to identify potential (Shepherd 1999b; Zacharakis & Meyer 2000). As-
deals and then initiate contact with the entrepre- suming a potential fit, the VC then makes a quick
neur. However, most VCs focus their efforts on
evaluation regarding whether the venture has a
developing and maintaining a broad network of
realistic chance of being a worthwhile investment.
people who refer deals to them. VCs are much
Because the subsequent evaluation phase requires
more apt to invest in deals that are based on
a great deal of VC time, the VC tries to limit the
referrals, rather than in deals that come in cold.
number of investments entering that phase. As a
Referrals come from a variety of sources, such as
result, most investment proposals are eliminated
commercial bankers, lawyers and accountants,
by the VC, based solely on a cursory reading of the
consultants, managers of success entrepreneurial
companies, and personal friends (Shane & Cable plan or a brief chat with the entrepreneur. An
2002). Referrals give the VC some confidence important step in the screening process typically is
that the entrepreneur is a trustworthy party, espe- a personal meeting by the entrepreneur with the
cially if the entrepreneur has little history or rep- VCs in the venture capital firm. This meeting
utation in the VC community. often takes about an hour and involves a pitch by
In fact, often the referral comes from another the entrepreneur and extensive questioning by the
potential investor. It is a common practice for VCs. The meeting may result in the exchange of
deals to be syndicated among multiple investors knowledge useful for both parties, as well as the
(Bygrave 1987). Syndication allows both different development of a feeling as to whether there is
investor types (i.e., VCs, BAs, and CVCs, see good chemistry between the parties.
Table 1) or all of one type to share the risk of an If the entrepreneur is still under consideration,
individual investment and increase the number of the critical third stage is begun. In the deal eval-
quality investments they can make. Syndication uation phase (also called due diligence phase), the
also allows investors to pool efforts in the deal VC engages in a very in-depth evaluation of the
screening, evaluation, and structuring phases venture. The VC engages in a variety of informa-
(Brander, Amit, & Antweiler 2002). For instance, tion gathering and background checks, generally
one reason professional VCs may bring a deal to through informal methods, to determine if the
corporate VCs is for the latter to provide help in business plan presented by the entrepreneur is
evaluating the technology. Once the deal has realistic and achievable by the ventures manage-
been made, investors often make different value- ment. This phase also includes the interviewing
2006 De Clercq, Fried, Lehtonen, and Sapienza 99

of, and extensive reference checking on, all mem- preneur from an income tax standpoint (Gilson &
bers of the management team. Schizer 2003). VCs may also include a variety of
Finally, in the deal structuring phase, the en- covenants in their agreements with entrepreneurs.
trepreneur and VC negotiate the valuation of the For instance, they may prohibit the entrepreneur
venture to be used in pricing the equity securities from purchasing assets or issuing or selling shares
the VC is purchasing. In determining the price, without their permission. They may also demand
the VC is driven by his or her expectations of the mandatory redemption rights that require the
likely value of the venture at the time the VC venture to purchase their investment back. Fur-
anticipates exiting. Theoretically, valuation is de- thermore, VCs may employ forfeiture provisions
termined based on projected earnings and market- that cause entrepreneurs to lose ownership if their
comparable PE ratios at the time of exit. However, performance falls below target goals. Interestingly,
in early stage ventures, the actual equity received there may also be informal control mechanisms
for a given level of investment is much more likely within the ventures management team. This is
to be determined by prevailing norms than any illustrated by the Cisco case in which the
actual calculation of realistically expected future founders, Sandy Lerner and Leonard Bosack, had
cash flows. In essence, the VC needs to believe to step down (Fortune 1995):
that the target rate of return has a reasonable
chance of being reached within her required time After Cisco had made a successful IPO, Sandy Lern-
ers role had made her rich, but with her role dimin-
to exit. With multiple investors involved and with ished and her company moving further away from its
great future uncertainty, the end result is that VCs roots, she was deeply unhappy. Increasingly, she be-
generally receive significant ownership stakes in gan lashing out. The other executives, however, be-
their ventures, especially in those receiving lieved that her behavior had become a huge, unnec-
money in early stages. For instance, Moneytree essary distraction. At some point, they went to the
reported that the average early stage deal size VC (i.e., Don Valentine) and told him, in essence,
either she goes or we go. In December 1990 both
equaled $4.6 million in 2004, with VCs receiving founders sold every share of their stock in the com-
approximately 50 percent ownership (i.e., pany.
summed across VC members of the syndicate) of
the venture in early-stage deals (MoneyTree Sur- In short, given the high risks to which they are
vey 2004). exposed, VCs typically include tough provisions
In addition to price, many issues are involved that give broad powers to ensure participation in
in structuring the deal. Particularly important to the upside and minimize exposure to malfeasance.
the entrepreneur is the extent of control that the Clearly, many restrictions are harsh and perhaps
VC can exercise, e.g., the composition of the even unfair, leaving great room for potential dis-
board of directors, types of spending that require agreement over the deal structure, particularly as
VC approval, the mechanisms given to the VC to to valuation and control. Often a VC very inter-
force a future exit event, or the terms of the top ested in a deal will choose not to invest because he
managements employment contracts (Bouillet- or she cannot agree upon the terms with the
Cordonnier 1992; Kaplan & Stromberg 2003; Tri- entrepreneur.
antis 2001; Sahlman 1990). For instance, VCs Since the evaluation process is time-consuming
often require entrepreneurs to issue convertible for both parties, it is common to negotiate the
preferred stock that gives the VC a liquidation major terms of the deal before the VC starts ex-
preference if the venture does not perform well, tensive due diligence. Thus, terms that are deal-
but also common stock ownership in the event breakers are identified and negotiated before ei-
that the venture succeeds. Such provisions effec- ther side gets too far into the process. The result of
tively ensure that entrepreneurs whose ventures this negotiation is a written document, commonly
do not succeed will be able to salvage very little referred to as a term sheet. It summarizes the
from the venture. However, in the U.S. this struc- major terms of the potential VC investment. If
ture is also extremely advantageous to the entre- the outcome of the due diligence process is favor-
100 Academy of Management Perspectives August

able, then the VC will make an investment sub- rounds as the level of risk decreases (i.e., the
ject to the terms outlined in the term sheet. The valuation of the company goes up in subsequent
actual closing of the investment transaction re- rounds), thus shifting investment to a later round
quires a plethora of detailed legal documents that lowers dilution. The key for the entrepreneur,
are negotiated in detail at the end of the selection therefore, is to receive adequate money to get to
process. As mentioned earlier, because many of the next stage and to set hurdles that are measur-
the term sheet issues have been difficult and emo- able and achievable. Many entrepreneurs have
tional, often the details of closing are handled by learned that setting huge growth targets to impress
the parties lawyers with little direct involvement investors can be self-defeating. It is best to under-
from either entrepreneur or VC. While the term promise and over-deliver. In short, from the dis-
sheet is not binding on any party, it is unusual for cussion above, it follows that entrepreneurs are
deal breakers to arise when the final legal docu- faced with conflicting objectives when negotiat-
ments are drafted. ing a deal structure with an investor, i.e., to give
A particularly important issue for many entre- up as little equity as possible, to get as much cash
preneurs is the common practice among VCs to as possible, and to set milestone hurdles as low as
stage their investments across multiple rounds of possible. Entrepreneurs should be aware that the
financing. VCs prefer to stage their investments simultaneous accomplishment of these goals may
because this reduces the amount of money in- not be possible.
vested at the earliest stages of development when
risk is highest (Sahlman 1990). If the venture Post-Investment Phase
develops properly, more money is invested back- In terms of the post-investment phase, the VC is
ing this potential winner. If the venture does not essentially engaged in two types of activities: mon-
develop as desired (i.e., the milestones are not itoring and providing value added. As with any
met), the VC either cuts losses by simply not investor, the VC spends time monitoring the per-
funding the next financing round or alternatively formance of the investment. These monitoring
invests at a lower valuation of the venture. For the activities reduce the agency risks associated with
entrepreneur, a staged practice approach poses an VC-entrepreneur relationships (Sapienza &
obvious risk. If the venture does not develop as Gupta 1994). However, the VC is a much more
planned, the venture will soon be out of money active monitor than are other investors (such as
and in a very poor position to raise more money. banks) for several reasons. First, the VCs invest-
In addition, when negotiating an early round the ment is illiquid. Unlike the public market inves-
entrepreneur must be aware that his or her per- tor, the VC cannot sell his or her investment on
centage ownership in the venture will be signifi- a moments notice (Sahlman 1990). Second,
cantly diluted in subsequent rounds even if the there is much uncertainty involved with a venture
venture develops as planned. One study found receiving venture capital, so the VC has to spend
that founder ownership decreased from 28.9 per- more time determining what is happening now
cent immediately after the first round of VC fund- and what should happen in the future (Sapienza
ing to 12.4 percent immediately before the IPO, & Gupta 1994). Third, the VC is paid by his or
then to 8.8 percent immediately after the IPO her own investors to monitor the funds invest-
(Kaplan, Sensoy, & Stromberg 2005). However, a ments. The VCs ability to raise future investment
staged approach to financing also offers a major pools is heavily impacted by the investment per-
advantage to the entrepreneur. If the venture de- formance of earlier pools that he or she managed
velops as envisioned (or better), the entrepreneur (Sahlman 1990). Finally, VCs often have a signif-
will end up with a larger share of the company if icant personal investment in the fund and much
investments are delayed than if all the money is of their compensation is directly tied to the funds
invested in the first round. Entrepreneurs will end investment performance (Gifford 1997).
up with a larger share because the required IRR for In order to facilitate monitoring activities, VCs
the VCs investment is typically lower in later receive strong control levers. As mentioned ear-
2006 De Clercq, Fried, Lehtonen, and Sapienza 101

lier, VCs often engage in staged investing, and fund, and its portfolio companies as reported in
generally invest in convertible preferred stock Pratch (2005).
that carries the same voting rights as if it had
already been converted into common stock Strategic Role
(Gompers 1998). Furthermore, a significant board The VC serves as a sounding board to the entre-
representation allows for the replacement of the preneur and the ventures top management on a
entrepreneur as chief executive officer if perfor- variety of key decisions in the life of the venture.
mance lags. Also, entrepreneurs should be pre- Rather than making decisions for the entrepre-
pared to provide regular reports to their VC, ones neur, the VC prefers to provide advice to the
to which VCs will pay close attention and upon entrepreneur, reflecting on the entrepreneurs
which they will rely in board meetings, as illus- ideas and making suggestions (Sapienza 1989).
trated by the following quote from an entrepre- Entrepreneurs can often expect helpful advice on
neur (Fried & Hisrich 1995): strategic and marketing issues as well as on issues
related to organizational development based on
They [VCs] know general types of goals that we the VCs understanding of the entrepreneurial
might have. An example would be an average days
outstanding on accounts receivable. They might call
process (Pratch 2005):
up and say: You know, at the last board meeting you Vesbridge Partners strategic support and insight led
thought you could get average days outstanding one of its portfolio company, Granite Systems, to
down to so and so. How do you think youre doing? rewrite its software. The software was marketed to
carriers that used it to digitally maintain network
However, entrepreneurs should also understand inventory. Vesbridge used its deep telecom industry
that most VCs do not want to tell entrepreneurs knowledge to guide the change which was necessary
to ensure long-term success of the portfolio company
how to make day-to-day operations nor have them
though it was a very risky move.
report on a daily basis. They basically want the
entrepreneur to run the venture profitably; they Financing Role
want merely to be consulted on any major deci-
The VC is often very active in developing capital
sion (Gifford 1997).
strategies for the venture, arranging financing
VCs post-investment activities often go well
from other investors such as VCs, banks, and
beyond monitoring the investment. VCs are val-
others (Lerner 1994). Furthermore, VCs play a
ue-added investors; that is, they add value to their
significant role as a venture moves toward an
ventures (Busenitz, Moesel, & Fiet 2004; Dimov
initial public offering or acquisition (Gladstone &
& Shepherd 2005; Edelman 2002; Sapienza
Gladstone 2003; Megginson & Weiss 1991). En-
1992). From the entrepreneurs point of view, the
trepreneurs can also benefit from VCs assistance
presence of added value beyond cash may more
in developing strong internal financial manage-
than compensate for the high cost of VC financ-
ment procedures (Pratch 2005).
ing. From the VCs perspective, the provision of
value-added services increases the average return In case of Canadian Metconnex, Vesbridge Partners
on investment. For example Vinod Khosla, an put together a very complicated dual stock structure
by creating a parallel legal U.S. entity. The arrange-
early-stage investor and general partner at ment ensured that the portfolio company simulta-
Kleiner, Perkins Caufield & Byers, indicated that neously enjoyed Canadian tax breaks and attracted
when he took on an active role in portfolio com- U.S. investors which could become essential in the
panies his aggregated returns were approximately future if the company would decide to go public.
70 percent, while when he was a passive investor
his aggregated returns were only around 8 percent Networking Role
(Pratch 2005). Below we discuss in some detail The VC often has a very large network of contacts
these contributions (also see Table 3) and present with expertise in start-up problems, issues, and
some illustrative examples from Vesbridge Part- solutions. Entrepreneurs benefit from these net-
ners, an early-stage technology venture capital works when looking for external managers, addi-
102 Academy of Management Perspectives August

tional financing opportunities, key service provid- the VCs were pulling out of the telecom industry. As
ers, acquisition candidates, or customers (Pratch a sign of commitment, Vesbridge acted as one of the
leading investors in Mahis financial round. Because
of Vesbridges strong support Mahi was able to raise
A well connected general partner from Vesbridge altogether $75 million of VC funding.
Partners introduced Mahi Networks, one of the firms
portfolio companies active in the telecom sector, to Discipline Role
Bell South, British Telecom and AT&T, all major
carriers that could become significant customers for
A major role of the VC is in the evaluation and,
Mahi Networks if necessary, replacement of management. The
entrepreneur may dispute the value added aspect
Interpersonal Role of this discipline. But such a role may represent
value added to the venture as whole, not the
The VC often serves as a mentor, friend, and
entrepreneur individually. Replacing a CEO who
confidant to the entrepreneur. Running a fast-
is performing poorly is a vital, if unpleasant, way
paced, high-potential venture is demanding,
in which VCs add value (Fried, Bruton, & Hisrich
stressful, and uncertain. On sensitive internal is-
1998). VCs also contribute discipline in less in-
sues, the entrepreneur may be more comfortable
trusive ways. A hallmark of the VC is continual
talking with the VC than with members of his or
pressure on the entrepreneur to focus on attaining
her own top management team, fearing to share
agreed objectives. While at times unpleasant,
misgivings and doubts with other top managers.
many entrepreneurs view this disciplinary contri-
At times even a spouse or close friend cannot
bution as vital to their success (Pratch 2005; Sa-
understand what the entrepreneur is going
pienza 1989).
through or give any kind of useful advice. The VC
often can provide the type of moral support in In the case of Aegis Semiconductor, one of Vesbridge
times of crisis unavailable anywhere else (Pratch Partners portfolio companies, the venture capital
firm considered the CEO to be too interested in
technology (rather than sales). The VC convinced
Vesbridge Partners provided a lot of organizational the CEO to step aside and a new CEO was recruited
and management experience to a 28 years old CEO who was able to concentrate on sales and other needs
with scientific background who was in charge of one of the company.
of its portfolio companies. This support as mentor
helped the CEO avoid many beginners mistakes. Exit Phase
VCs insist on a clear exit strategy that enables
Reputational Role them to convert their non-liquid equity position
The involvement of a VC, particularly one with a in a private company into cash or publicly traded
history of backing successful ventures, can signif- stock. The investment funds they manage are gen-
icantly enhance the reputation of the venture. erally not operated on a going concern principle,
This can be vital for the entrepreneur in persuad- but instead have a pre-determined liquidation
ing a variety of potential stakeholders to get in- date. Exit generally occurs by: (1) the venture
volved. A venture with VC involvement is much going public (IPO) and the VC selling his or her
more likely to be viewed as a potential winner by stock in the public stock market; (2) the venture
these stakeholders. This reputational benefit can being sold (trade sale) in its entirety; (3) the
come into play in the recruiting of top manage- venture buying back the VCs stock; or (4) the
ment, getting initial sales from key customers, venture being liquidated and the proceeds, if any,
attracting other investors, attracting investment going to the VC after creditors have been paid off.
bankers, and winning acceptance in the public For many VCs, the preferred exit route is the
market for an IPO (Pratch 2005). IPO, because the public market tends to value
Vesbridge Partners made it clear during 2001 that it companies higher during an IPO than in trade
believed in Mahi Networks, regardless of the telecom sales. In fact, VCs often use the potential for a
industrys downturn and the fact that the majority of company to go public as leverage in extracting the
2006 De Clercq, Fried, Lehtonen, and Sapienza 103

highest price possible in a trade sale. However, a control over the company, and likely his or her
negative outcome of an IPO compared to a trade job as CEO. If the venture is strategically impor-
sale is that the VC does not achieve instant li- tant to a large company, the prices realized
quidity in an IPO. In part, this delay is caused by through trade sale can compare favorably with an
the VC staging exit in order not to depress the IPO. In general, when the IPO market is good,
stock price by hitting the market with a large sell trade sales values are high and vice versa.
order. Gradual exit may also be legally required by Another exit means is a buyback of the VCs
a lock-up agreement with the IPO underwriters or stock by the venture. A buyback differs from a
securities laws limiting sales of securities by pre- trade sale in that the VC exits, but the entrepre-
IPO insiders. In either case, however, holding this neur remains. The entrepreneurs control in-
stock for a long period after IPO means facing the creases by eliminating the VC as a shareholder.
risk that the valuation of the venture may plum- However, it often results in much of the ventures
met before VCs can exit (Bartlett, 1995). This future cash going to reduce debt incurred to fi-
scenario occurred with breath-taking results and nance the buyback.
devastating regularity during the IPO bust in Finally, liquidation is not a happy route for any
2000. party. A liquidation is the sell-off of the assets of
The IPO exit also tends to be favored from the the venture for their salvage value. Proceeds go to
entrepreneurs perspective. An IPO is a way to security holders (after paying back taxes, accounts
raise equity capital to fund current and future receivable, etc.) in the order of seniority of the
operations without giving up operating control of debt and equity instruments. It almost always re-
the venture. For instance, Amazon.com went pub- sults in the VC losing some, often all, of the
lic in May 1997 and raised over $40 million by original investment. This scenario is even worse
selling stock to the public, with management still for the entrepreneur, who rarely gets any money
firmly in place. To the entrepreneur, the IPO back, loses a job, and watches a dream die
provides a high valuation, but limited liquidity. In (DAveni 2005; Cumming & MacIntosh 2003).
addition to being subject to the same legal con-
straints on selling stock as the VC, public markets Maximizing the Entrepreneur-
are highly adverse to any large stock sales by the VC Relationship

entrepreneur. It is viewed as a signal that the aving a VC on board for a venture may be a
company is not doing well. However, limited li- huge benefit to an entrepreneur, yet there is
quidity is not a problem to many entrepreneurs. also the potential for major problems. The
They want to remain with the company long- remainder of this article focuses on hands-on ad-
term. Besides keeping his or her job, entrepreneurs vice regarding how the relationship between en-
can actually increase their control over companies trepreneur and VC can be maximized from the
through an IPO. While the entrepreneurs per- entrepreneurs perspective, organizing the discus-
centage ownership will go down as a result of the sion according to the three investment phases and
IPO, the entrepreneur is trading a large, powerful pointing out likely trouble spots along the way.
and active shareholder (the VC) for the highly Table 4 provides a summary of the major points
fragmented, nearly powerless, shareholders of the presented.
public market (Black & Gibson 1998).
While the IPO may be the preferred route for Pre-Investment Phase
many VCs and entrepreneurs, realities of the pub- In the pre-investment phase the entrepreneurs
lic market place make the trade sale by far the first and most difficult task is locating a VC who
most common route (Relander, Syrjanen, & Mi- is willing to invest. However, more is involved
ettinen 1994). Although the trade sale may result than just getting venture capital. The entrepre-
in a lower value, it does provide immediate, full neur should also find the right investors, secure the
liquidity to both entrepreneur and VC. It also right amount of money, and obtain a deal struc-
means, however, that the entrepreneur loses all tured in an equitable manner.
104 Academy of Management Perspectives August

Getting Venture Capital investment banker is sometimes helpful. How-

Just getting the VC to spend time seriously eval- ever, investment bankers are rare in early-stage
uating a deal is often a challenge for the entrepre- investing, as early-stage VCs generally balk at
neur. The VC starts with a limited knowledge of cash fees being paid out by an early-stage com-
the deal. To gain the level of knowledge necessary pany.
to make a positive investment decision requires Write a Good Business Plan. Most proposals
time, yet VCs time is limited and many potential are eliminated based upon a reading of the
deals vie for it (Gifford 1997). VCs want to invest business plan. Without a good business plan it is
only in the very best of deals. Investing in a difficult even to get a personal meeting with
mediocre deal is a bad decision from the VCs most VCs. The business plan is an important
point of view. On the other hand, the entrepre- communication mechanism. It tells the VC
neur of a mediocre deal has great incentive to get why the business can make the investor a lot of
the VC to invest. Furthermore, the quality of a money in a relatively short time span; it suggests
deal is uncertain and highly subjective. VCs ex- how the investor can exit and what the venture
perience a high variance in returns from their will be worth at that point. The quality of the
investments (Cochrane 2005). What the VC in plan also tells the VC about the quality of
good faith views as a weak deal, the entrepreneur management. Numerous works have been writ-
may in equally (and often very passionate) good ten about the effectiveness of business planning
faith view as a great deal. There are several things (Delmar & Shane forthcoming; Prince 1997).
an entrepreneur can do to increase his or her There are also many consultants who will help
chances of attracting venture capital (Fried, Bru- write a plan. Their quality varies vastly. The
ton, & Hisrich 1998). entrepreneur should remember, however, that
Secure a Good Referral. As discussed earlier, he or she must really be the architect of the
referred proposals are much more likely to get plan and must know, from top to bottom, what
funded by the VC than proposals that come in makes it tickwhat its key assumptions are,
cold. Both the entrepreneurs lawyer and CPA where the risks and weaknesses lie, and what
may be able to help, as well as friends and the key leverage points in the work are. Venture
industry contacts who may know VCs (Shane capitalists are apt to ask questions, such as
& Cable 2002). For a later stage transaction, an Where did you come up with the price points

Table 4
Maximization of Value in Entrepreneur - VC Relationships
Pre-investment phase Post-investment phase Exit phase
Getting venture capital Respect the VC Avoid pre-mature exit
Secure a good referral Formal legal power Exit harmoniously
Write a good business plan Money power
Be prepared for the meeting Deserve VC attention
Dont (over) shop/dont (over) rely Respect yourself
Be honest, but sell Communicate
Have patience Be trustworthy
Get the right venture capitalists Remain as objective as possible
Complementary skills
Trusting relationships
Obtain the right amount of money
Structure a fair deal
2006 De Clercq, Fried, Lehtonen, and Sapienza 105

you used? or What will be the effect on earn- is to let the venture capitalist know who else
ings if a customer does not renew the contract? you will talk to and when. Some negotiation
The entrepreneur must know the business and may occur around these issues.
financial models inside and out. Thus, the con- Be Honest, but Sell. The entrepreneur should
sultants role (if any) is to help develop the be honest with potential investors. The rela-
presentation, nothing more. tionship between the parties will only work if
Be Prepared for the Meeting. The initial meet- built on trust. If the VC does not trust the
ing between the entrepreneur and VC is impor- entrepreneur, he or she will not invest. In ad-
tant. The entrepreneur should find out how the dition, the entrepreneur should not be exces-
meeting will be structured. Usually such meet- sively optimistic. Excessive optimism causes
ings are quite informal. However, the entrepre- VCs to question the entrepreneurs competence
neur should be prepared to give about a 30- (Forbes 2005). On the other hand, the entre-
minute overview and have ready answers for the preneur must remember that the objective is to
questions that the VC is likely to ask (Glad- persuade the VC to invest. VCs want to see that
stone & Gladstone 2003). The entrepreneur the entrepreneur understands the risks involved
must guard against becoming angry or defensive but is confident that they can be conquered.
when asked tough questions and should remem- The entrepreneur should present the ventures
ber that the VC is trying to assess both the risk and uncontrollable factors honestly, and if
value of the deal and the poise and honesty of possible, fairly early in the presentation, or at
the entrepreneur. The entrepreneur should also least, not as an afterthought. At the same time,
understand the main contingencies underlying if the entrepreneur cannot convince the VC of
the business plan, in case the VC questions the the ventures potential and her own confidence
assumptions underlying the proposal. and will, no money will be forthcoming.
Dont (Over) Shop/Dont (Over) Rely. If the Have Patience. Generally the only thing that
entrepreneur is dealing with only one VC for ever happens quickly in the venture capital
several months and the VC ultimately turns the process is rejection. Sometimes even rejection
deal down, the entrepreneur will have to start comes slowly. Actually securing and closing on
from scratch with another VC. Delays of this an investment usually takes months of calendar
nature can be deadly for a thinly capitalized time. The process involves out-of-pocket legal
venture. In addition, a little competition be- and travel expenses that can be significant for a
tween financial sources can improve the terms new venture. Most importantly, the process
of the deal for the entrepreneur. Thus, the takes a lot of management time. The entrepre-
entrepreneur should try to develop more than neur must remember that she is asking for a yes
one source of financing. However, this is a in a no business. A rejection, and the feedback
delicate matter. VCs dont like to look at deals associated with it, should be used constructively
they think are being shopped around indiscrim- when approaching another potential investor
inately; they want to feel that they have a good (Gladstone & Gladstone 2003).
chance of getting the deal if they like it. Oth-
erwise, why should they spend a lot of time
looking? If too many VCs have already seen and Get the Right Venture Capitalists
rejected the proposal, word will get around. On Given the potential contribution of VCs to the
the other hand, if an entrepreneur relies only on entrepreneurs success or failure, the entrepreneur
one possible investor, he or she is subject to should take steps to find the right VCs as inves-
having very little bargaining leverage. Further, tors, if he has a choice. Before spending time
if the deal falls through with this investor and pursuing a specific VC firm, the entrepreneur
no other prospects have been contacted, the should check to determine whether the firm is
entrepreneur will have to re-start this lengthy currently looking for new investments, the indus-
prospect more desperate than before. The ideal tries in which the firm will invest, their stage
106 Academy of Management Perspectives August

preferences, and general track record. Other im- some VC firms began to assign their board seats
portant dimensions should be considered. The to inexperienced associates in their firms, rather
foundations for a good match between VC and than to their more experienced general part-
entrepreneur relate to complementary skills, a ners. Entrepreneurs complained that they were
strong commitment, and the potential for the not getting the level of value added that the VC
entrepreneur and VC to have an open, trusting had promised (Wasserman 2003).
Trusting Relationships. The entrepreneur
Complementary Skills. Complementary skills should seek a VC with whom it is possible to
mean that each party should have expertise that develop an open, trusting long-term relation-
the other needs. The VC needs an entrepreneur ship. Ventures operate in complex and turbu-
that provides product and market expertise lent environments. When things do not go as
along with general management skills. The en- expected, it is important that the pair can work
trepreneur needs a VC who can add value be- constructively and efficiently together. Often
yond money (Sapienza 1992). In many cases, important decisions have to be made swiftly and
VCs specialize in certain type of ventures, e.g., without verified facts, and there is no time to
in industry sectors or investment stages in evaluate the other parties real motives or hid-
which they have significant knowledge and ex- den agendas. Early development of trust is
pertise (Norton & Tennenbaum 1993). In ad- therefore important for both parties. It is par-
dition, there are quality differences among VCs. ticularly important to the entrepreneur since
Some VCs are simply better than others the VC will likely have the right to fire the
(Kaplan & Schoar 2005; MacMillan, Kulow, & entrepreneur if things do not go well. The en-
Khoylian 1989). In short, entrepreneurs should trepreneur should thus pick a VC with a history
know the specific competencies they are look- of fairness in performance evaluation (Sapienza
ing for in potential VCs. The importance of VC & Korsgaard 1996). Referrals from colleague-
expertise for the entrepreneur is illustrated by entrepreneurs who have been funded by the VC
the following quote from a Midwestern-based in the past are useful in this regard.
VC (De Clercq & Sapienza 2005): In short, in the pre-investment stage both sides
should seriously evaluate the other. VCs tradition-
Our focus is very much oriented towards early-stage
investments. Therefore, our people are specialized ally perform due diligence on the entrepreneur,
in providing support for seed stage investments. yet many entrepreneurs do not perform extensive
Since you have little information to make decisions due diligence on the VC. Certainly the entrepre-
and predict the future for this type of ventures, you neur should pay attention to his or her own im-
also need to be a company builder. Therefore, we pressions of the VC. But these gut feelings are not
have built an expertise in helping early-stage firms
sufficient. Entrepreneurs should talk about their
to put together a top management team, or to find
strategic partners. potential VC with other entrepreneurs (both suc-
cessful and unsuccessful) with whom the VC has
Commitment. Both parties need to be commit- invested.
ted to the venture. An investment deal is struc-
tured to impose harsh penalties on the entre- Obtain the Right Amount of Money
preneur if commitment should waiver. On the Venture capital, even for expansion and buyout
other hand, while the VCs capital is committed stages, is an expensive form of financing. At seed
at the time of investment, the VC is not legally and start-up stage, it is especially expensivein
obligated to provide any value-added after the that the amount of equity a venture must sell for
investment. Therefore, entrepreneurs should a given level of investmentthe ideal is to gain
seek to deal with VCs who have a track record enough money to reach the next investment
of staying committed to their ventures. During stage, taking into account the fact that needed
the height of the Internet investment boom, time and money are both usually under-estimated.
2006 De Clercq, Fried, Lehtonen, and Sapienza 107

The entrepreneur can usually proceed on the as- pre-investment phase, the relationship continues
sumption that, if successful, he or she can raise through the post-investment phase to exit. This
more money later. This money can be raised at a results in a dilemma at the pre-investment phase.
lower cost if the venture has progressed well. This On the one hand, during deal structuring negoti-
logic is what underlies the milestone financings ations the entrepreneur and VC are opposed to
discussed earlier. However, if the venture is not as one another on major issues like valuation and
successful as anticipated (i.e., if the entrepreneur control. On the other hand, once an investment
has severely missed targets), the entrepreneur may deal has been agreed upon, the two parties become
enter into an even more expensive, distressed fi- partners and have a mutual interest in co-operat-
nancing, or worse go out of business (Fried 2005). ing openly with one another (Cable & Shane
In short, the entrepreneur must balance the 1997). Therefore, both entrepreneur and VC have
risks associated with keeping more equity but run- to be aware that the quality of their future rela-
ning out of cash, against the risk of taking more tionship may be heavily damaged from overly ag-
cash than needed and selling a larger portion of gressive negotiations in the pre-investment phase.
the venture than was necessary. The ideal spot is
somewhere in between, where the venture can
meet its needs but the entrepreneur retains as Post-Investment Phase
much equity as possible. The post-investment phase of the relationship is
the longest and most crucial phase. It is here that
Structure a Fair Deal
the VC can add or detract the most value. It is
Deal structuring is often a major problem area, also in this phase that the VC may replace the
particularly in terms of valuation. In this regard entrepreneur. One study showed that 47 percent
the relationship between the two parties will al- of CEO firings by VCs occurred when the CEO
ways be somewhat adversarial since setting own- had good ideas, but was unable to execute them;
ership percentages between entrepreneur and VC 37 percent when the CEO and VC had major
is largely a zero sum game. Early stage ventures are disagreements regarding what was best for the
the most difficult ones to place a fair value on.
company; and 16 percent when the CEO took
Without tangible proofs like pilots or prototypes it
actions in his or her own self-interest, knowing
is challenging to convince the VCs of the value of
that they were not in the ventures best interest
the business concept. Here, the best thing an
(Bruton, Fried, & Hisrich 2000). Experienced
entrepreneur can do is to try to use comparable
CEOs recognize that if VCs do take actions to put
ventures in the same or similar industry space at
comparable rounds of funding as a price guide someone else in the role of CEO it is done with
(Gladstone & Gladstone 2003). the belief that such action will bring higher value
Another common problem area in terms of to the venture. Indeed, founder-CEOs often exit
deal structuring is that significant control is trans- after completion of product development to make
ferred from the entrepreneur to the VC. For the way for someone with a broader skill set (Wasser-
entrepreneur it is often difficult to accept, for man 2003). Still, this move is significant and not
example, that the VC has a right to dismiss the to be taken lightly. In many cases, entrepreneurs
management of the venture or has a final say on actually feel relieved when they are replaced. Yet,
the budget of the venture. Yet, board seats and although they may know in their hearts that they
certain oversight powers may be non-negotiables are in over their heads, few can willingly leave the
for many VCs. The entrepreneur needs to be helm unless forced. On the other hand, many
educated in industry norms as well as VC-specific times it is far from clear that the CEO should be
norms in order not to be blind-sided by such issues changed. There are a variety of things the entre-
at the last minute. preneur can do to minimize the risk of being fired
Entrepreneurs should realize that, while their and at the same time maximize the positive im-
relationship with a VC is initiated during the pact of the VCs value-added activities.
108 Academy of Management Perspectives August

Respect the VC trepreneur has power because he or she possesses

The entrepreneur needs to respect the expertise important information that the VC does not. As
and experience of the VC. Yet the entrepreneur the VC is involved in multiple firms in an assort-
must recognize that the VC is not just a friendly ment of businesses, the entrepreneur will have
advisor. The VC has significant formal legal superior knowledge of the ventures product and
power (Cable & Shane 1997). VCs are frequently market. Particularly important is the power stem-
in control of the board. If they are not, they ming from the entrepreneurs operational control.
usually possess contractual rights that will place While the VC may have a significant amount of
them in control if the venture fails to meet ex- formal power, this power is present at the share-
pectations. However, the VCs formal legal power holder and board level. From a practical stand-
is generally not absolute. The entrepreneur also point, operational control is in the hands of man-
has some formal legal power through rights as a agement. It is impossible for the VC to dictate
corporate officer/employee and shareholder. In- managements every move (Cable & Shane
deed, a common board structure is a five-member 1997). Thus the VC routinely defers to the views
board consisting of two VCs, two entrepreneurs, of the entrepreneur who is responsible for day-to-
and an unaffiliated third party acceptable to both. day operations of the venture. As a result, there is
Because the use of formal power is highly confron- room for an entrepreneur to exhibit passive, and
tational, most VCs prefer not to use it. However, at times active, aggressiveness and recalcitrance in
the shadow of the VCs formal power always looms the exercise of operational control. Yet, defiance
over the relationship. to prove a point rather than to achieve a strategic
Monetary power is also frequently present, par- objective will lead entrepreneurs to hollow victo-
ticularly with staged investing. Any time the ven- ries. To maximize the value of the relationship
ture needs more money, those who can provide it between entrepreneur and VC and to avoid harsh
have powermuch like the aphorism, He who conflict, it is important that the entrepreneur does
has the gold makes the rules. The VCs money not misuse power.
power is strongest when the performance of the
venture is poor. On the other hand, good perfor-
mance will increase the availability of funds from In order to maximize the value of the relationship,
other sources. good communication between the two parties is
After an investment is made, the VC retains also mandatory. Communications should be regu-
the discretion to put in value-adding effort or not. lar and should include a mix of formal communi-
Since a major benefit of the relationship to the cation (e.g., the CEOs report to the Board of
venture is the VCs value-added contributions, it Directors) and informal communication (e.g.,
is important that the VC spends adequate time through phone calls, social lunches, etc.) (Glad-
providing these contributions. However, the VC stone & Gladstone 2003). Good communication
has a limited amount of time to allocate among does not necessarily mean incessant communica-
multiple companies. The VC may be tempted to tion. Asking about trivial matters and conferring
allocate time in a manner that maximizes the on non-essential issues may undermine the VCs
value of his or her overall portfolio rather than the confidence in the entrepreneur and reduce inter-
value of any one investment (Gifford 1997). est in further communications. In general, good
Therefore, the entrepreneur must continually social relationships between the two parties can
convince the VC that attention devoted to his or play a positive role in enhancing the quality of
her venture is time well-spent. communication, as illustrated by a Midwest-based
VC (De Clercq 2002):
Respect Yourself When we have a good social relationship with the
entrepreneur, the entrepreneur may be more open to
The entrepreneur also has sources of formal and talk about his problems. Thats why the social rela-
informal power (Fried & Hisrich 1995). The en- tionship is very important. So, do we talk about
2006 De Clercq, Fried, Lehtonen, and Sapienza 109

different things when there is a strong social relation- Remain as Objective as Possible
ship? We are more open, I would say. We dont have
to say things in a diplomatic way, we can talk to the
While mutual trust is usually beneficial, both en-
other in a very blunt way. We can say the same things trepreneur and VC need to remain objective
in a different way because you are close to each other. about the other. When the two parties have a very
For instance, we can pick up the phone any time we high level of confidence in each others honesty
want, or even can call them at home. and competence, there is a danger that they will
not scrutinize the others decisions. As a result,
Be Trustworthy the quality of decisions can be compromised (De
Clercq & Sapienza 2005). Therefore, entrepre-
Mutual trust is vital to any successful relationship.
neurs should maintain a level of skepticism in
All through the post-investment stage there is the
their analyses of the VCs actions and input.
potential for opportunistic behavior by the entre-
preneur (Cable & Shane 1997). The entrepreneur
Exit Phase
may take actions that actually hurt the venture,
e.g., hiring an unqualified relative, padding ex- To a great extent, a successful exit is caused by the
pense accounts, or even plotting to steal the entrepreneur and VC having built and main-
ventures technology and customers and take tained a good relationship in the foregoing pre-
them to another company. Clearly the entrepre- investment and post-investment phases. How-
neur should be scrupulous to avoid even the ap- ever, there are two important issues specific to the
pearance of this sort of behavior. exit phase: avoiding a pre-mature exit and exiting
More subtly, VCs are concerned when entre- harmoniously.
preneurs use their operational control of the ven-
ture to hide negative information from the VC. Avoid Premature Exit
One way to build trust is the use of fair procedures Liquidation is obviously an unpleasant event. Yet
in the relationship. The relationship between it happens frequently among early-stage venture
venture capitalists and entrepreneurs is intense investments. Until the venture reaches positive
and is embedded in a context of great uncertainty. cash flow, the venture is somewhat at the mercy of
If nothing else, the two parties need to be able to the VC. When the VC chooses not to re-invest,
believe in their partners fairness and goodwill. the venture can run out of cash and be forced to
Research has shown that both parties respond liquidate. The entrepreneur almost always wants
powerfully to perceptions of their partners fair- to avoid liquidation, as liquidation means a loss of
ness. In one study it was shown that venture job, face, and the potential for large financial
capitalists were more inclined to support entrepre- rewards in the near future. Still, the VC will not
neurs plans, to trust them, and to re-invest in want to spend more time and money on a venture
their ventures (even if short-term performance with little upside potential.
was lower) when the entrepreneurs did what was The entrepreneur should guard against the VC
procedurally expected and kept them well-in- pulling the plug too early. The better the relation-
formed. Another study showed that entrepre- ship in the post-investment phase, the less likely
neurs, for their part, were more inclined to listen this is to happen. VCs tend to be more patient
to what venture capitalists said and to be receptive with under-performing ventures when they have a
to their influence when the venture capitalists good, honest relationship with the entrepreneur.
treated them fairly (Sapienza & Korsgaard 1996; Yet there are clear economic limits to this pa-
Busenitz, Moesel, Fiet, & Barney 1997). These tience.
potent effects are understandable in this volatile The entrepreneur can also protect against pre-
context, where much is out of the control of the mature liquidation by developing other funding
partners. Both sides appear to respond strongly to sources. Then, if the VC does not want to pro-
actions that engender or undermine the sense of ceed, the venture has a fallback position. How-
fair play. ever, the entrepreneur must also consider whether
110 Academy of Management Perspectives August

a VC who does not want to invest more money is high (Lerner 1994). In addition, having well-
may be completely right. In fact, historically the known VCs as investors enhances the ventures
VC industry has erred by not pulling the plug fast image in the public stock market (Megginson &
enough on underperforming ventures (Guler Weiss 1991). Given their experience in exit trans-
2003). Indeed, if the future of the current venture actions and strong networks in the investment
is bleak at best, it may even be in the entrepre- banking world, the entrepreneur should expect a
neurs own best interest to quit. high level of value added by the VC in the exit
A less common form of early exit is VC grand- phase.
standing (Gompers 1996). Less experienced or
less reputable VCs may seek to create an IPO exit CONCLUSION
route early on in order to enhance their own

his article provided an overview of the dynam-
reputation. Similarly, a VC may jump at a profit- ics in entrepreneur-VC relationships, focusing
able trade sale to show some positive returns in his on different aspects of the relationship that are
or her current fund. These grandstanding VCs relevant to the acquisition and effective utiliza-
are less concerned about the optimization of exit tion of risk capital. The article was primarily writ-
timing from a valuation perspective, and more ten to provide aspiring entrepreneurs with more
concerned about the effects the exit has on mar- insights into how better to manage their relation-
keting their own services. The entrepreneur gen- ship with venture capital providers. We conclude
erally has the power to prevent grandstanding. that the life of both entrepreneur and VC is
Unlike liquidation, grandstanding is an issue for fraught with peril but can bring great rewards,
successful rather than unsuccessful ventures; both financial and non-financial. For many VCs
greater venture success gives entrepreneurs more and entrepreneurs, their mutual relationship itself
power to withstand potential grandstanding by is a significant non-financial reward, no matter
their investors. what the financial outcome. Even for those who
Exit Harmoniously
do not enjoy the journey, maximizing the entre-
preneur-VC relationship is important since it in-
An exit event is a given in the entrepreneur-VC creases the chances of the entrepreneurs venture
relationship. From the beginning of the relation- ultimately being successful.
ship, an important goal of the VC is to exit the
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