Building constructive relationships between founders and investors

This post has been edited from a speech I gave at the Follow The Entrepreneur 2019 Investor Summit in Taormina, Sicily

TL;DR

Once a founder invites an investor to acquire equity in their business, they are making a conscious decision to share in the journey. Their fates are now inextricably entwined. Yet while both regard themselves as champions of innovation, they approach the opportunity from fundamentally different perspectives. This creates an inherent tension, which sometimes results in the relationship breaking down, often to the detriment of the company.

The key is working out how to get the most out of each other.

Founders: Believe in your vision. Your investor is a conduit, not the solution. Their input is a perspective, not the rule of law. Ultimately they will never know more about your business than you do. But, you also have to recognise that you are not the finished article. Like an athlete, winning only comes if you train hard and stay focused, and this means building the right team of advisors to coach you. Your investor has the potential to deliver huge value in this regard, whether that be through their network, pattern recognition across their portfolio or their understanding of financial markets. It’s your job to learn how to extract it! At the end of the day you invited them on this journey with you, and you need them to stick with you to the very end.

Investors: You have huge value to offer, but don’t pretend you’re something you’re not. According to Diversity VC, only 8% of you have ever worked in a startup before! I’ve been in your shoes, before becoming COO of a startup, so trust me when I say it is very difficult to empathise unless you’ve done it yourself! Like a coach helping their athlete be the best, at the end of the day it’s their brilliance we need to nurture in order to make this company great. Be honest about where you have a meaningful experience and where you don’t. And be honest about what you can realistically deliver and what you can’t. Advice cloaked in experience when actually your experience isn’t relevant can be catastrophic for a founder. You have a unique position of authority. Respect it. Even if it means the best thing you can do is get out of the way.

Great businesses need founders and investors to work together

It really has never been a better time to be an entrepreneur. From the discussions last week at the FTE Investor Summit in Taormina, it’s incredible to see just how many industries are still ripe for disruption, from automotive to medical science, the food industry to childcare.

And to top it all off there’s more money than there has ever been in European venture. For the first time investment into European tech breached the €20bn mark in 2018. The average Series A cheque size in the UK has increased by 18% over the last 12 months. And we’ve also seen far greater participation from corporates and foreign investors. I wrote about these trends in a previous blog.

But for all this celebration of funding rounds and the hype built around ever-larger cheque sizes, at the end of the day none of this matters! Because at the point the industry press gets excited about the next completed investment, every entrepreneur knows the real work is only just beginning.

The challenge for the entrepreneur is they now have to bring an investor on the journey with them. And for all the good intent behind an investor’s commitment to put money into the founder’s business, it’s astonishing that we all have stories of when this relationship has broken down.

I’m privileged to have been able to work with over 20 startups as either an investor, mentor or operator over the last 6 years and unfortunately, I’ve seen my fair share of suspect behaviour around the Board table. Investors expressing interest in a business as a means to due diligence a competitor; founders fundamentally pivoting the business model without informing the Board; forced hiring; political in-fighting; egotism; false promises… We all know it happens, but as an industry, we rarely talk about it.

It would be fascinating to know how many more success stories we’d have if these types of behaviours didn’t happen!

The important consideration for founders is that by allowing investors to acquire equity in your business, you are also making a conscious decision to share your journey with your investor and allowing them to have a hand on the wheel:

• They will have a vote;
• They will have their own ideas about how the business should develop;
• And they will expect a degree of professionalism from the way you as the founder communicate with them and ultimately spend their money.

But the same is true the other way too. The investor’s ability to make a return on their investment is contingent on the founder (and their team) being able to build a great company. If the company is successful, everybody wins. If the company fails, everybody loses — or at least they would if everyone had the same class of share!

Ultimately, it boils down to one hard truth: once the funding round is complete, both parties have to recognise that their success is inherently dependent on each other.

The key to success is working out how to get the most out of each other — and I don’t just mean box seats to Wembley!

Understanding the motivations of both parties

To do this, we need to understand the motivations of both sides:

Founders want to change the world.

Yes, of course, the financial return is a nice by-product, if it happens, but that rarely the driving force. Their primary motivation is to make their vision of the future become reality. They have a singular focus to the point of obsession. They are prepared to take superhuman sacrifices to see their business succeed. They are prepared to risk everything to realise their vision. Ultimately, they are accountable to nobody, and would ideally like to operate with the same degree of independence after they’re raised money.

Investors, by contrast, are driven by their desire to make a return on their investment with the least possible risk.

They don’t make anything close to the sacrifices of a founder. They are in the job of managing risk, working across a portfolio of investments to maximise returns while ensuring they have the necessary downside protection in place. And ultimately, they are accountable to the Partnership and to their LPs to make the right decisions.

Although both are champions of innovation and disrupting the status quo, they approach the opportunity from fundamentally different perspectives. But each presides over one half of the equation that builds a successful company. This creates an inherent tension:

• Founders are driven by their vision, but know they need the investor’s backing in order to get there;
• Investors have to believe the founder’s vision will result in them generating a return within the timeframe of the fund, and constantly doubt themselves as to whether they invested in the wrong business.

It’s hard for founders not to look up to investors

Unfortunately for most founders, the scales are tipped against them before they even start building relationships with investors:

First and foremost it’s important to recognise that there are many more founders chasing investment than there are funders to fulfill the demand, which creates a huge imbalance of power in the market. Talking to various VCs, it appears the typical ratio is about 100 unfiltered opportunities landing on a VC’s desk to ever 1 successfully completed investment. According to Atomico’s State of European Tech report, in 2018 there were 3,952 venture deals completed by 2,513 investor participants, so that means there are a lot of disappointed founders out there.

But even if you’re lucky enough to win the VC lottery, this filtration process continues long after the first round of funding is completed. Because of the natural attrition rate at the early stage, VCs deliberately set themselves up to invest in more companies than they have funds to see them all through to exit. So there is an ongoing process to focus the remaining capital of the fund on those portfolio companies the VC believes will actually “make it”. According to Crunchbase data, only 62% of companies who raise a Series A successfully go on to raise a Series B, and of those only 61% go on to raise a Series C. That means of the VC’s portfolio of Series A companies, only 2 out of 5 continue to receive the fund’s backing at Series C.

This puts huge pressure on founders to continue impressing their investors, and by the same token, this gives investors significant implied authority in the relationship. And yet this dance adds little value to the founder’s primary mission to make the world a better place.

But it goes deeper than this. We have to understand that the founder is doing something for the first time. No one has built the business the founder is building. As a result, they do so in an environment where they are constantly being judged, told it won’t work, with very few trusted points of reference to know if they’re genuinely on the right path or not. Founders wear an incredibly confident and resilient suit of armour, but underneath it’s natural that in a world of uncertainty they too are searching for validation from those close to them, particularly when they are making such significant sacrifices.

Investors are in the position of a huge responsibility

This puts founders in a potentially vulnerable position. And by the same token, it puts investors in a position of huge responsibility. And yet according to a recent study by Diversity VC, only 8% of UK VCs have ever worked in a startup. That is an absolutely astonishing figure! It’s perhaps not surprising then that we see the behaviours we’ve sadly come to expect where there is little empathy for the situation the founder is in.

Let’s just step into the shoes of the investor for a few minutes…

I think we can all agree that founders take the most risk. But it’s also important to recognise that when investors take a risk, most of the time they are doing so on behalf of someone else. Now I don’t know about you, but I’m far more comfortable with risk when I know it’s only affecting me, as opposed to taking the decision on behalf of someone else that may result in them losing money. The level of responsibility suddenly amplifies. Now let’s say my chosen portfolio company fails, not only do I have to go cap in hand to all my LPs and explain what happened (awkward!) but it may also affect how I think about managing the rest of the fund because I now have fewer “bets” from which to make the required return. Investors have to balance the demands of their portfolio and those of their LPs.

Much like the founder, the investor is investing in a business that has never been built before with the same vacuum of trusted points of reference to really know if it’s going to be a success or not. Sometimes the best due diligence can never reveal how things will truly unfold. Just look at what happened to Fab.com, the darling of the e-commerce industry whose impressive growth, both in terms of revenue and users, attracted high-quality talent and investment from the Sand Hill Road elite. Between 2011 and 2013 the company amassed over $300m of investment valuing the business at $900m. Two years later in 2015, the company was sold for a mere $15m due to a combination of poor business planning and premature expansion into Europe.

And then once in a while, you get those rogue founders like David Brown of VE Interactive who raised £150m in debt and equity before going into administration thanks in large part to excessive spending on private jets, luxury parties, and designer furniture. These are the kinds of stories that keep investors awake at night.

Investors are backing founders, not businesses

The reality of backing any business is that for all the due diligence and third-party validation you can do, you never know for certain if you’re going to make a return on your investment.

The only thing the investor knows for certain is they are backing the founder. Everything else in the business is subject to change.

I’m sure you’re all familiar with the marketing automation tool Marketo, which IPO-ed in 2013 for $500m before being acquired and subsequently resold for $4bn. What you might not know is that the three founders — Phil Fernandez, Jon Miller and David Morandi who started the business in 2006 — spent their first year building the wrong MVP and burning through $3m of VC money, before turning to the Board and saying “we’re going to scrap this product and the $1m ARR we’re generating from it, and build something else instead”. It took a huge commitment from their original VC backer, Doug Pepper of InterWest, to agree to it. Most would probably have written off the investment. But hearing him tell the story at SaaStr’s European conference earlier this year he explained that fundamentally it came down to his belief in the founders.

The great thing about founders is you won’t find anyone as committed to the business as they are, even when things are going badly! Just look at the story of Elon Musk. He had spent everything he’d made from the sale of PayPal, the first 3 SpaceX flights blew up, Tesla was haemorrhaging money, and to top it all off he was getting divorced. Then in an interview on 60 Minutes, he was asked whether he ever thought about giving up, and his response was:

“Never. I don’t ever give up. I’d have to be dead or severely incapacitated”

Wind forward to today and SpaceX is carrying NASA supplies to the ISS and Tesla is successfully driving people home after a drunken night out.

It takes an incredible amount of belief and conviction to build these businesses. And by the same token, it takes tremendous courage and commitment to support these founders.

Founders are not the finished article

On the flip-side however, whether they like it or not, founders need the guidance of others as they go on this journey, whether from their investors or other trusted advisors:

1. First and foremost, building a business is never linear and the role of the founder is to take big decisions with very limited data based on their vision of what the market needs. So by definition, they will get things wrong from time to time. Fred Destin has a brilliant way of describing this: he said in a recent podcast interviewed by Harry Stebbings [and I’m paraphrasing here] that founders are playing for batting average, not the highest score. It’s probably not surprising then that 80% of unicorns have at least 1 co-founder who has gone on the journey to exit before, according to a recent study.
2. Secondly, founders have to realise that the job of starting the business is very different from the job of scaling the business, and most find it very difficult to make this transition. They may have come up with the idea and committed blood, sweat, and tears to get it off the ground, but typically they are the least qualified and least experienced member of the senior leadership team. A good friend of mine who runs a prominent UK VC said of the 34 companies they’re currently invested in, he’s only seen 1 founder successfully adapt to the role of CEO unaided as the company scaled.
3. Thirdly, and particularly in the current environment, it’s very easy for the founder to become so obsessed on achieving their vision that they unconsciously lose sight of the wider impact the company is having on society. Just look at Facebook’s abuse of user privacy, Uber’s disregard for creating a diverse and inclusive workplace, or the environmental impact of Amazon’s datacentres. These are vitally important considerations that somehow the founder has to layer on top of the already superhuman task of building their business.

There is huge scope for founders and investors to help each other, and it is the responsibility of both parties to create the right environment where they can work constructively together in the interest of the business. The investor can be a powerful driving force, but if they’re not careful their authority in the business can also kill the entrepreneurial spark that drives it. The founder brings the secret sauce, the brilliance that gets everyone excited, but they are rarely the finished article and if they don’t adapt as the company develops, they too risk killing the business they created.

The athlete and the coach

I liken this relationship to that of an athlete and a coach:

We’re all familiar with Rafael Nadal, former World Number 1, 18 time Grand Slam winner, the King of Clay. And yet it was his early coach, his uncle Toni Nadal, who told a right-handed Rafa to learn to play tennis with his left hand. Toni could never replicate Rafa’s genius, but that tiny insight is the foundation of the player Rafa is today.

In a recent interview with Paul Annacone, who for those of you who don’t know has coached Roger Federer, Pete Sampras, Tim Henman and more recently Sloane Stephens, he said:

“Coaching players like these does not at all involve helping them with their skills, it’s more about balancing the emotional and the psychological to make sure they keep doing what they need to do on the court.”

The investor-founder relationship is very similar.

The role of the investor is similar to that of a coach:

• They will never be as good an athlete as the founder.
• They will never know as much about the business as the founder.
• But they have huge value to offer whether because of their network, pattern recognition across their portfolio or their understanding of financial markets.
• Their role is to ask smart questions. To challenge the founder’s thinking, not because they think the founder is wrong, but so the founder is forced to build confidence in whatever decision they end up making.
• It’s the investor’s duty to support the founder when they’re down, to push the founder to think bigger when things are going well, and to never be afraid to say what needs to be said.

If the investor doesn’t think they can do this, then the best thing they can do is get out of the way!

The role of the entrepreneur is similar to that of an athlete:

• It’s your brilliance we’re all believing in, and that’s not something that can be taught.
• At the end of the day, it’s the decisions you make on the field that define whether we are successful or not.
• But you are not the finished article and you won’t always get everything right.
• Training from the right coach will pay off in the long run.
• It’s up to you to build the team you believe you need to help you.

Of course, the big difference is that athletes can fire their coaches. Founders can’t fire their investors!

So in conclusion…

To all the founders in the room: Believe in your vision. Your investor is a conduit, not the solution. Their input is a perspective, not the rule of law. Ultimately they will never know more about your business than you do. But, you also have to recognise that you are not the finished article. Like an athlete, winning only comes if you train hard and stay focused, and this means building the right team of advisors to coach you. Your investor has the potential to deliver huge value in this regard, whether that be through their network, pattern recognition across their portfolio or their understanding of financial markets. It’s your job to learn how to extract it! At the end of the day you invited them on this journey with you, and you need them to stick with you to the very end.

To all the investors in the room: You have huge value to offer, but don’t pretend you’re something you’re not. Remember, only 8% of you have ever worked in a startup before! I’ve been in your shoes, before becoming COO of a startup, so trust me when I say it is very difficult to empathise unless you’ve done it yourself! Like a coach helping their athlete be the best, at the end of the day it’s their brilliance we need to nurture in order to make this company great. Be honest about where you have a meaningful experience and where you don’t. And be honest about what you can realistically deliver and what you can’t. Advice cloaked in experience when actually your experience isn’t relevant can be catastrophic for a founder. You have a unique position of authority. Respect it. Even if it means the best thing you can do is get out of the way.

This post has been edited from a speech I gave at the Follow The Entrepreneur 2019 Investor Summit in Taormina, Sicily