Why venture capital don’t invest small amounts and startups think they do

(David Ventzel is Investment Manager at Accelerace. Accelerace is not a venture capital firm. Accelerace is an accelerator and seed investor. The insight provided in the article doesn’t reflect how Accelerace operates)

Conventional wisdom will tell you it’s easier to raise a little money than a lot of money. This post explains why it isn’t so. It will explain why VCs don’t invest small amounts. In the process you will meet my mother. You will see how VCs actually make money. You will learn what only few people know. Knowledge is power. Use it.

The elevator rushed towards the 5th floor. Seconds ago me and my co-founder had been buzzed in. Adrenaline rushed through my body. You can do this! you can do this, I said to myself. Ding! The doors opened. Two investment managers greeted us. We smiled. Made firm handshakes. The show began.

Earlier that day me and co-founder had prepared for the VC pitch. We would focus on our unique product. Then finish with a modest ask. Just €300K. The firm managed €1 billion. Surely our modest ask would be no problem for these guys.

Against all expectations the VC turned us down. Or rather they said: you are interesting and we would like to follow your progress. That’s VC language for No.

I didn’t know it then. It would take another 10 years before I knew. But we had made a fundamental mistake. A mistake that many startups make. We asked for a modest investment. I know what you are thinking. How can that be a mistake?

It seems strange indeed. You will learn why it’s not. But first, I will take you further back in time. To a summer when I learned something important.

Lesson one. Small asks are easy.

I was 10 years old. Me and my friend wanted ice creams. Big ones. But we didn’t have money. So we did what children always do. Asked for money. But this time we made a cleaver plan.

My mother was our biggest concern. Sugar was her enemy. She baked chocolate cake without sugar. It just tasted like regular bread.

We started with my mom. “Mom can we have a little money for ice creams? We just want the small round soda ones” The small round ice cream was the cheapest and smallest available. She gave in and handed us the coins.

Then we went to my friend’s mom. We asked for the same and got the money. Then our neighbor. They didn’t have kids and liked us. They gave us money too. We collected enough money to buy ice creams called Magnum. When my mom learned, she was furious. I was too high on sugar to care.

That day I learned an important lesson. Something I suspect most people have learned. It’s easier to ask for a little than a lot. Why? Because the less you ask for, the less the giver sacrifices. We all know this. Later I would learn a new lesson. A peculiar one.

I would learn that the complete opposite is true for VC investments. It’s easier to ask for a lot than a little. Why? Because the more you ask for, the less the giver sacrifices. Few know this. You are about to become one of them.

Lesson two. Small asks can be hard.

See, the thing is this:

My mom could take money out of her wallet. VCs don’t have a wallet.

My mom didn’t have a lot of questions for me. She trusted me. VCs do have lots of questions. They don’t trust you.

Once my mom gave us the money, she had no responsibilities. Once the VC invest, they will have lots of responsibilities.

And those differences have names. VCs call them:

  1. Capital calls
  2. Due Diligence
  3. Portfolio management

Let’s find out how they actually work:

Capital Calls (asking dad for money)

My mom just took money out her wallet. It was easy for her to hand us money. VCs don’t have a wallet. In fact, they don’t any cash. That’s right. So how do they invest?

VCs got investors too. They are called LPs (Limited Partners). The LPs don’t like the idea of the VC swimming around in cash like Uncle Scrooge. So LPs keep the money until the VCs need them. When the VCs need cash, they make a Capital Call. They ask for money. No one likes asking for money. It’s unpleasant work.

But there is one thing about capital calls VCs do like. Management fees! Every time VCs invest, they get 2-3% of the amount in annual fees. And that pays for the nice office. It also means they get more money if they make big investments. Bingo. That’s’ the first reason why VCs don’t invest small amounts.

But there are even bigger and more important differences.

Due Diligence (checking the merchandise)

My mom trusted us. So she just handed us the money. It took 2 minutes. Obviously, VCs can’t do the same. They spend 3-6 months seizing the startup. It’s called Due Diligence. You knew that already. But did you also know how much it costs?

Due Diligence isn’t just a long process. It’s also expensive. It often costs + €100K. Lawyers, consultants and accountants send big bills. The cost for Due Diligence is taken from the invested amount.  But Due Diligence is not proportional to the size of investment. It’s about the same for €10 million as for €1 million.

To spend €100K to do a small investment makes no sense. Even at €1 million the costs would be 10%. Bingo. That’s the second reason why VCs don’t invest small amounts.

Portfolio management (traveling to board meetings)

My mom never expected to see her money again. It was a gift. VC investments are not. A VC firm is a business. It has revenue and cost. The main revenue comes from fees. The main cost is time.

Most of the time is spent on board of director work. VCs prepare for meetings. They often travel far to attend them. Individual investment managers can sit on more than 10 boards. I have a friend who cried when he reached 12.

The problem is this. With each investment they get a new board seat. Board seats are time. Time is cost. A business wants to reduce costs. So the VC wants to reduce board seats. How? By making fewer, but bigger investments. And Bingo. That’s the third and final reason why VCs don’t invest small amounts.

What founders must do

Founders can do two things. Stop approaching VCs. Or get a valuation that justifies a big enough investment. I suspect you want the latter. How? Well, that’s a different topic. I plan to write about it. But I suggest you start with my earlier post on valuation.

That’s it. It took me 10 years to learn. Many up and down elevators. Including 3 years as an investment manager at Accelerace Invest. Now you know too. It took you 10 minutes.

Conclusion made:

  • VCs don’t have cash. They ask LPs for money and take a fee
  • VCs do due diligence and it’s really expensive. Only big investments can pay for the costs
  • VCs’ main cost is time spent on boards. The fewer investments, the fewer costs
  • Founders must either stop approaching VCs or get a valuation that justifies a big investment. Or turn to another type of investment vehicle.

 

How to build a Mastermind for your startup

This is a follow up post on my earlier blog post: ‘Why boards don’t work for startups and how to do it right’. If you missed that post, I suggest you read it first. It gives the right context for this post. Find it here.

My last post argued that boards were invented to solve a problem that startups don’t have. I argued that boards should be replaced with a Mastermind. This is a post on how to construct the Mastermind and how to make use of it. Ideas are power. Use them.

The purpose of the Mastermind

The fundamental purpose of the Mastermind is to help the founders turn their startup into a company. Startups are eighty hour weeks and burn money. Companies are forty hour weeks and make money. How can that be? How can input not equal output. Something isn’t right.

The difference is effectiveness. Companies apply their resources effectively. Startups don’t. And the reasons for this are relatively simple.

Startups need to spent time on plumbing. Founders need to set up payroll, implement a CRM system and assemble furniture. Companies got the plumbing done. Employees can spend all their hours on execution. But that fact only accounts for a tiny part of the difference in effectiveness. The big culprit is hidden elsewhere.

The real difference is this: Companies know exactly how to sell their products and who to sell them to. They know because a long time ago, their founder did eighty hour weeks. His picture is now framed on the wall.

Startups don’t know how to sell their products. Or to who. But they try. And try. And try. Trying is really experimenting. To be experimenting is to approach things differently every time. Founders approach customers in different ways. The times the approach doesn’t work is time spent that didn’t result in money. Bingo! We found the culprit of the ineffectiveness of startups. The main reason why twice the work hours do not equal twice the money. But how do we solve this problem?

Unfortunately, the problem can only be solved by continuous experimenting. By checking of things that don’t work and getting closer to what works. All human progress has been a result of experimentation. Thomas Edison knew this better than anyone.
The good news is that experimentation can be done wisely. So founders need a tool that makes them smarter. And by now you know where I am going.

The Mastermind is that tool. Groups outperform individuals every time. Humans have become the dominant species because of we are good at collaborating. Few would like to face a lion alone.

The Mastermind is the group that must help the founders experiment wisely. The question is how to create it?

Construction of the Mastermind

First the Mastermind must be constructed right. This is the most important part. Boards are constructed to protect interests and secure influence. Advisory boards are mostly constructed to look good towards investors. The mastermind must be different. It must be constructed with the single purpose of helping founders experiment smarter.

Now for the practical part. How to do it. And I want to start with an apology. I will give you a guide. I don’t like guides. They are simplistic and force multidimensional things into a linear format. I feel ashamed. But I found no better way to do it. I have rewritten this section over and over. Anything else than a “step by step” format becomes messy. Sorry. So here we go:

Step 1. Choose the right people. I mean the RIGHT people.

Getting the right people in the Mastermind is the most important. First of all, each member must want to do it. They must fundamentally want to help. They must be people who have experimented a lot and learned from it. Titles and career success can be a bad proxy for this. Take long walks to understand how much they have really learned. They must be reflective. They must fundamentally respect the other people. They must be factual and honest. If you doubt any of these qualities, find someone else. Find 3 people that match.

Step 2. Establish the Mastermind on a clear philosophy

The Mastermind must be constructed on a coherent philosophy that every member agrees upon. The philosophy should be something close to this: Every member is here to help the founders experiment wisely in order to speed up the process of turning the startup into a company. Any member not buying into this philosophy will disturb the work of the group. Be sure everyone is aligned. That includes the founders.Get everyone together and shake hands. Maybe even sign something.

Step 3. Execute meetings often and structured

Use the Mastermind. Make it your most important institution. If meetings are too far between, most the time is spent bringing everyone up to date. It becomes reporting. Each meeting should pick up from the last meeting. Weekly meetings work. Keep them short. Maximum 1 hour per meeting. Do long sessions once in a while.

The meetings should have a fixed agenda with only one topic. The topic should be experiments and learning. The founders must give insight into the latest experiments. The Mastermind will discuss how to interpret the results and what to do next. Limit the topic to this. Save the rest for other forums.

Step 4. Appreciate your Mastermind

Treat your Mastermind right. They have chosen to help. Don’t choose people who will only help if they get paid. But pay people who help. Most founders are not good at this. Pay them with recognition. Pay them with acknowledgement when you succeed and get interviewed. Pay them by showing respect for their time. Start meetings on time. End them on time. Make the time they spent productive and pleasant. Pay them money or stock if you want. Pay them anything you can. A true Mastermind is worth it.

Step 5. End the Mastermind

I said that startups are not companies. I said that companies have boards, but startups should have Masterminds. I said that the purpose of the Mastermind was to turn the startup into a company. Consequently, I must also conclude that the Mastermind must end. It will make itself obsolete. The day it happens the group should celebrate. They succeeded.

One day the startup has found an effective way to sell their product. One day they have identified the people who want to buy it. Now they just need to do more of it. The founders raise series B, C and so on. They go into hyper scale. They hire lots of people. Professional management will join. The founders will bring more investors onboard to finance the growth. New problems will arise. But the new problems well dealt with by the traditional board.

The board has stood the test of time. It works. But no governing structure has yet stood the test of time for startups. The modern tech startup is still a new invention. The Mastermind just might be what we have been missing.

Conclusion made:

  • The purpose of the Mastermind is to help the founders turn their startup into a company by speeding up the process of experimenting their way to a viable business model
  • The right construction of the Mastermind is vital
  • The successful Mastermind will make itself obsolete over time