back to notes

Naive entrepreneurs at risk of losing out to venture capitalists

Jan. 20, 2016 | The Financial Times News: p6. | Murad Ahmed

Tech start-up financing is often structured to protect venture capitalists, not founders, says Murad Ahmed

Nicolas Brusson and Philippe Botteri met in 2003. They were "two Frenchmen in the Valley", both having relocated to California for jobs in the tech industry. A friendship was forged over several skiing trips.

In 2007, Mr Brusson announced he was returning to France to co-found BlaBlaCar, a ride-sharing service allowing motorists to offer their spare seats to passengers.

"My first reaction was 'this is never going to work,'" says Mr Botteri.

But, over the years, Mr Brusson continued to develop the concept . And when in 2011 Mr Botteri joined Accel Partners, one of Europe's leading venture capital groups, he invested in BlaBlaCar. Today, it is a rare European "unicorn" - a private tech company worth more than $1bn.

"The important part is that I got to know Nicolas over seven years before investing, and getting this trust . . . is really key," says Mr Botteri. The pair also still enjoy skiing trips together.

There is not always time to build a relationship over such a long period. In the fast-paced world of technology, large sums of capital are required quickly for a start-up to seize a market opportunity.

Funding decisions are therefore more often based on contracts rather than trust. Unfortunately the balance of power in contracts can be heavily weighted in favour of the investor. A venture capitalist is usually far better informed than the twenty-something founder seeking funding for a company.

Unlike new entrepreneurs, VCs know their way around a term sheet, which sets out the investment conditions, and they employ analysts to assess the potential of a start-up compared to similar existing companies.

Experienced investors say it is folly to use this knowledge to exploit entrepreneurs by, for example, demanding too much equity in a business or insisting on outrageously advantageous terms.

Tech investors are laying bets that will take years, if not decades, to pay off. To achieve healthy returns, investor and entrepreneur must work in a long-term partnership. But it is also folly to believe investors never try to pull a fast one.

Juan Lobato, a prolific angel investor and co-founder of London-based fintech group Ebury, said recently that he often sees cunning investors insist on funding terms, such as preferential share classes and priority liquidation rights, that prey on inexperienced founders' naivety.

The desire to be a unicorn is making the problem worse. Entrepreneurs aim to raise huge sums and push to gain a headline valuation of over $1bn quickly so they can join this mythical club.

But, as the FT reported recently , such funding deals are increasingly structured with heavy investor protections. In effect these provide VCs with guaranteed returns and a degree of protection against any losses.

If a start-up grows into its high valuation, all will benefit. However there are already signs that high-profile companies such as Square, Dropbox and Snapchat are struggling to live up to their large valuations.

In such cases, those who lose out most are likely to be the entrepreneurs and early employees, who will see their stakes increasingly diluted.

By Murad Ahmed