Inside the Black Box of VC Behavior

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HEIDI: Welcome to The Startup Solution, I’m Heidi Roizen from Threshold Ventures.

In the last episode, I unpacked the ‘investor’s zone of indifference’ – a range of outcomes where, even if the sale price goes up, your investor’s payout won’t change. And clearly, that’s going to influence how they behave during M&A processes – in ways that might not make sense to you until you understand it.

But when I got to the end of that episode, I realized that there are many other VC behaviors that may not make sense to you either, until you understand even more about the VC model, including the internal dynamics of the fund and the firm that your money comes from.  

Much, if not all, of that may be an unknowable black box to you. But even so, you can still develop a pretty good sense of what may be happening inside a fund based on how your VC behaves if you understand how funds and firms work. And that in turn might help you better manage through whatever is happening.  

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Let’s start with something you should already know, because it’s documented in your fund paperwork – and that is, what fund your investment came from. Even if they’re all under the same VC firm’s roof, different funds will have very different dynamics, and those dynamics may in turn impact you down the line in future fundraises or even when negotiating exits.

Let me explain how a VC fund works. It’s usually a pool of money raised at a specific time from a specific set of investors, called limited partners. That fund will usually have about a ten-year life cycle – three years to make new investments, and seven more years to manage and harvest those investments. When the fund is about 70% invested, which usually happens in about three years, no more new investments will be made, and the remaining funds will only be used to support existing portfolio companies in that fund. Meanwhile, that VC firm will raise a new fund to start the whole process over again. As a result, a typical venture firm will have a number of funds being actively managed at the same time.  

Not surprisingly, when one VC firm has multiple funds under management, those funds will be different, and sometimes dramatically so. They may have a different pool of limited partners, or even different general partners – the venture capitalists tasked with investing that fund. And of course, each fund will have a completely different collection of portfolio companies.  

And so, each fund will have different performance metrics based on that portfolio – both unrealized (that is, companies that may have been written up or down but not yet exited), and realized (that is, companies that have been exited).

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So why should all this matter to the entrepreneur? Well, the performance of the fund you’re in may affect things like whether or not follow-on investment capital is available to you, how much attention your VC gives you, or even whether they’ll push you in one direction or another with respect to future financings or M&A.  

For example, if you’re in a fund that has already had multiple big exits, the VC firm may be more risk-tolerant for that fund and be willing to double down on you if they have any capital left. Or they might simply care less about you, especially if your expected outcome isn’t really going to move their needle. For some entrepreneurs, this might feel like desertion, but for others, well, let’s admit it, it might be welcome relief, depending on who that VC is.

On the other hand, if the fund has been a poor performer, and especially if your company is a big portion of the remaining fund value, you can bet that they’re going to pay a lot of attention to you – which could be a good thing or a bad thing. For example, if they have a significant preference and think you’re going down or even sideways, they might push for an exit, even a bad one for you, just to get some or all of their money back. On the other hand, they may so badly want to keep you alive that they’ll scrape every penny they can find to fund you, so you can live to fight another day, and so they can keep your company at their current holding value.  

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We haven’t talked about holding values yet, or why they might matter so much to your VC, so let me unpack that now.

The only thing that generates actual returns for a VC is when a portfolio company exits, either through an IPO, M&A, or a secondary sale. But most early-stage companies take seven years or even more for that to happen. In the interim, VCs keep tabs on how their portfolio is doing by determining a ‘holding value’ for each company using industry-standard accounting rules. And the events that tend to change holding values the most are new financing rounds.

Even though holding values are not liquidity events, they still can matter a lot to your VCs, especially if they’re raising a new fund.

Since it takes about ten years to fully realize an early-stage fund, old funds only show how well an investor did seven to ten years ago. But limited partners also want to know whether these VCs are still good at what they do, and for that they look to the holding values in more recent funds as a proxy.

And of course, if those holding values don’t look so hot, that can be the end of the road for an underperforming VC firm. 

In one case, one of our portfolio companies had had a near-death experience, and though they had turned things around, they still needed more capital to get to break even. A new investor came along and offered a round at a much lower valuation, which seemed fair to me given the company’s performance. But one of the old investors fought tooth and nail to have all the current investors participate in a bridge instead. There wasn’t a ton of appetite for that, but the old investor owned a big position and threatened to vote all his shares against any down-round financing, no matter how much the company needed the money.  

Well, it didn’t take much research to figure out why he was so opposed to a down round. It turns out that he was raising a new fund, and this particular company was on his books as a 10x multiple because of the high valuation of the last round. In turn, that holding value vaulted his otherwise lackluster fund into a 3x multiple, at least on paper.  

But if we did a down round, he would then have to mark his holding value down to 5x – still decent, but not enough to make up for the other craters in his portfolio. He knew that if he wanted to raise his next fund, he needed that 10x valuation to hold, at least for four or five more months. So, he proposed the bridge note, which wouldn’t change the company’s valuation and would last the company just long enough for him to get his fund closed. Good for him, but really, not the right decision for the company. In the end, the company took the down round, which was the right thing for them to do. And that VC, well, he’s not a VC anymore.

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Even more than a simple down round, a recap round can have an even greater impact on holding values, so recaps may prompt even more dramatic behavior from your VCs. I have a whole episode about recaps, and I've put a link to it in the show notes, but for today’s purposes, let’s just use a simple case.

Let’s say your company needs more money and some new investor offers to fund you, but only if your prior investors give up on all of their preferences. But the new investor also offers a sweetener, that if those old investors pony up additional money, they can keep some of their preferences in return.  

This is where a venture fund’s reserves really come into play. I talked about reserves earlier – that’s the money set aside for follow-on investments, usually about 30% of the fund. Of course, as the years play out, that reserve may get used up by the other companies in the fund. Which means that there may or may not be any money left for you when you need it.

And so, it’s really not surprising at all that, if more money from a given fund is required to protect a position, but that fund doesn’t have any money left, then that VC may fight against taking that new investment, even if it is the right thing for the company to do.  

I’ve had more than one early-stage entrepreneur complain to me: How can their VC be making new investments while at the same time saying they have no money for their existing portfolio company? Well, the fund-by-fund structure of venture capital explains that. If the fund you’re in is out of money, then there’s no money for you, even if there is money in other funds.  

But why can’t the VC just pull money from those other funds? That’s called a cross-over investment, and while it is done in certain rare situations, it’s generally not something VCs do. There are many reasons why, and I’ve put a link to a good explanation in the show notes. But for today’s purposes, just know that you can almost certainly only access money from the fund you’re in – and only if there’s any money left, and if your VC and their partners choose to invest it in you.

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Let me be clear that it’s not unfair for any investor to want to protect their investment as much as possible through the ups and downs of subsequent financings. After all, that’s why investors have voting rights. And we VCs also have a fiduciary duty to our own investors – the limited partners – to protect that capital. And so, it’s fair game to throw their voting weight around to do that. 

But in cases like this, I encourage investors to at least be transparent by talking to the CEO and the board members about it up front, before it goes to a board or shareholder vote. Bringing this to the foreground early may allow for the negotiation of a compromise that everyone can support. And if not, at least there won’t be any surprises once the voting starts.

But I’ve said this before and I’ll say it again: If an investor is also on the board, then they have to put the interests of all shareholders ahead of their own, at least when acting in their role as a board member – regardless of what they intend to do with their shareholder vote when that time comes. And if your investor director is not behaving that way, it’s time for a hard conversation.

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Let’s talk a bit more about preferences and their impact on VC behavior. In prior episodes, I’ve talked about how valuable they can be and how that might influence the people who have them. And they are the tail that wags the dog when it comes to the ‘investor zone of indifference’, which I talked about in the last episode. But the investors who don’t have big preferences can also be influenced by them, because other people’s preferences reduce their take. So those investors may actually benefit from financings that nuke preferences. And recaps aren’t the only game in town when it comes to blowing up preferences.

I had one situation where I was completely mystified by another investor's behavior. The company had been a rocket ship for a few years and had raised a ton of money, but its growth had slowed to a crawl. The board felt they needed to go out for another round, even if it was at a lower valuation, but this seed investor kept pounding his fist on the table, saying that instead, we should be exploring an IPO. OK, it was a hotter market than it is today, but still, we were only doing about $60 million in revenue with minuscule growth. It’s the only board meeting where I’ve used the phrase “I want what he’s smoking”.  Seriously, I thought he was just being crazy.

Until I took another look at the outcome waterfall – that’s an analysis of who would get what in a range of outcomes. And that’s when it hit me. This guy was freaking out because he was buried under $150 million of senior preferences. If we raised even more money, he’d be buried even further. And given that this company was likely headed for a mediocre M&A outcome, even after more funding, that seed investor was facing the prospect of a zero here.

However, a magical thing about an IPO is that all preferred shares convert to common when it happens. And so, if somehow this company could pull one off, all those preferences would disappear, and that seed investor’s chance of a return would go way up.  

So as crazy as the idea of going public was, he thought that if he just kept hammering on the idea, maybe he could build some momentum behind it. Long story short, that didn’t happen. But ever since then, I’ve paid a lot more attention in cases where there really is a choice between an IPO and an acquisition, to better understand how blowing up the preferences might change the outcomes for the people around the table. Because the difference can be huge.

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Of course, all we VCs are trying to maximize our funds returns, because not only does that keep us in business, but it’s also how we generate upside for ourselves. In the VC world, that upside is called carry. I’ll put more detail about carry in the show notes, but suffice it to say that it’s usually a much larger component of a VC’s comp than their salary, and so it can have a huge impact on how they behave.

For example, in large funds, it’s harder for a single exit to meaningfully impact carry. That can make a VC more likely to want to “swing for the fences” rather than work towards a more achievable but conservative outcome. On the other hand, in smaller funds, a $100M or $200M exit can have a much more material impact on carry, which might in turn make that VC more aggressive about looking for early exits.

There’s also a downside carry case that could impact you. Let’s say the fund your investment came from is a dog, and it’s never going to return the capital that was put into it, even if your company does pretty well. Since carry is only paid once the whole fund is returned, and the fund your money came from is never going to get there – well, the VC who sits on your board is going to make zero carry off of your company.  

Now imagine that they also sit on the board of another company in a different fund – a fund that’s already in a carry-paying position. Anything they do to improve the outcome of that company is going to result in more dollars in their own pocket. So it wouldn’t be that surprising if they put more of their cycles into that company instead of yours.

Even the age of the fund may change your VC's behavior. Early in a fund’s life, VCs might push for aggressive growth because they figure that they have time to help the company course correct if the bet doesn’t pay off, and they still have reserves to invest too. But when a fund is older, VCs may push for exits, especially if they need to show actual returns for the next fundraise, or if the fund is so old that the limited partners are pushing to have it wound down. And of course, the longer the fund runs, the more likely that its follow-on capital will run out. 

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Let me wind today’s episode up with one more factor that may affect your VC’s behavior. And that is their own performance and standing in their firm. Maybe your partner has had a string of losses, and they’ve been told, “one more down round and you’re out.” Or maybe they’ve not been completely honest with their partners about any problems that they’re experiencing, since they’re up for an end-of-year promotion. Things like this might influence them to steer clear of any financings that would indicate problems they hadn’t been up front about. Or maybe their firm is fundraising off their big markup on your company, and they don’t want to burst that bubble if they can just keep it from hitting the holding values for a few more months.  

So, now you know why your VC’s behavior might sometimes seem wonky. But what should you actually do with this knowledge?

Well first, I firmly believe that understanding what motivates the people sitting across the table from you is one of the most powerful tools you can have as an entrepreneur. When you start noticing behavior that seems off, step back and think about the bigger picture on the VC’s side of the table — what’s happening inside their fund, their firm, or even their own career that might be driving that behavior? 

Second, don’t be afraid to ask them. Ask them how they’re evaluating the deal on the table, and what fund or firm considerations might be impacting their evaluation. Ask them how they make follow-on financing decisions. Or just ask them why they’re pushing for whatever they’re pushing for. You might not always get the full picture, but you’ll almost always learn something useful. And no matter what, I think that your willingness to engage candidly will set the tone for a more honest, collaborative relationship – which always beats the alternative, if you ask me.

And the last point, which I’m going to keep hammering every time it comes up, is that if we’re talking about the actions of a board member, and you feel that they’re putting the needs of their fund ahead of their board duties, then you need to call them on that. They can put those interests first at shareholder voting time, but not in the board room.

Thanks for listening to this episode of “The Startup Solution.” We hope you have enjoyed this episode, and if you have, please share it with someone who might benefit from it. I’m Heidi Roizen from Threshold Ventures.

Further Reading

Here’s a good post about when preferred converts to common, including in an IPO, as I mentioned in this episode.

Here’s a short but sweet summary of how VC carry works.  

Mark Suster has written some great material on understanding venture capital. His post on crossover investments will help you understand why VCs don’t tend to do them.  

Here’s a link to my own prior episode about recaps.

And finally, I’ve linked to it before, and I’ll keep doing it – here’s a link to Evan Epstein’s great breakdown of private company governance to share with your VC if they are putting their own interests ahead of the company in your  board meetings.  

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