VC Cliche of the Week

Venture Capital is supposed to be patient capital, willing to support an entrepreneur for a long period of time while he or she builds the business. In general, I have found this to be true of VCs, although there are clearly some in the business who can and should work on their capacity for patience.

But even the most patient investors can get tired of supporting an investment. This is called “deal fatigue”. I have seen deal fatigue, I have experienced it myself, and I think it’s an important emotion for VCs and entrepreneurs to recognize and understand. 

The typical life cycle of a venture deal is five to seven years. I have seen deals that have taken longer than that. At Euclid Partners, we had portfolio companies that were double digits in terms of years held. That is patience!

But beyond the years held, there is another factor that I believe is more important in the deal fatigue equation. 

Everyone has heard of the J-curve. It is used to describe returns in a venture fund. They are negative in the early years, get positive in year 3 or 4, and then grow from there.

That J curve can also be drawn to show the typical annual cash flows of a startup company. They are negative for two to four years, turn positive, and grow from there, thereby creating value for the entrepreneurs, operators, and investors. During the early years, the VCs support the company with capital infusions, thereby acquiring their ownership stake. 

But sometimes the J-curve flatlines. It doesn’t turn positive.

In the simplest case, the patient dies. That’s usually good for everyone involved. The company didn’t get customers, revenues, and build a business. 

But it’s rarely that simple. Some companies get customers, revenues, create value, but don’t get cash flow positive. They end up on life support and nobody wants to pull the plug for good reason. This is by far the most common cause of deal fatigue.

It’s important to get inside the head of the investor for a moment. Let’s take an investor who is putting up his or her own cash. The first time they write a check to invest in a startup they are excited about the possibilities and are eager to make the investment. When the Company comes back for another investment, the investor often continues to be excited by the possibilities and eagerly opens the wallet. But a second emotion starts to creep in and that is obligation. After that, every time the wallet opens, the excitement dims and the obligation increases. It’s just human nature. 

Now, let’s add to that simple investor emotion equation the notion of investing other people’s money in a partnership structure. The VC isn’t opening his or her wallet. They are asking their partners to authorize the investment of other people’s money in the company. That is called “going back to the well” and is another great VC cliché. Think about the emotions for everyone involved in this exercise if it’s done time after time.

So that’s deal fatigue. It’s driven more by money than time and it can be a very destructive emotion in the board room if it is not managed properly. 

So what can an entrepreneur do to protect him and his company from investor deal fatigue?

First, don’t let the J curve flatline. Get profitable in a reasonable period of time. Two to three years is typical, five years is too long. 

Second, bring new investors into the syndicate every time you raise money. The investors who wrote the checks in the A round might be tired by the E round, but the D round investors will have fresh legs.

Third, start with a low valuation and slowly and carefully build it in each investment. The investors will be less tired if they see the value of their investment increasing in each round. But if you start at too high of a price and then get stuck there or worse, go down, then you are in for trouble. There is nothing worse than a tired investor with a paper loss on his or her hands. 

In summary, VCs as a group are the most supportive and patient investors I have ever met, but they are investors and are subject to the same emotions that all investors experience. There is not an unlimited supply of capital and patience in a venture capital firm and entrepreneurs need to be acutely aware of that fact if they choose to finance their company with venture capital.

Comments

[Michael Weiksner]

Fred,

I appreciate what is an interesting account of the emotional side of investing. Perhaps because I lack real investment experience I am surprised how much importance you place on emotion (e.g., versus reason).

For example, I would expect that you evaluate the prospective value of each round of investment. The companies track record might make you rethink your assumptions about market size, management team competence, etc. and I can also see some shenanigans to protect investments in prior rounds.

In the end, though, it seems that the rational decision-making process shouldn't really differ from the first, second or sixth round of funding.

- Mike

[Karen E]

Dear Fred,

You're showing off your skills like a peacock. Analysis of the J-curves and knowledge of the investment cycle PLUS a golden antenna tuned to the emotions of investors.

I'm getting ready to get on the road for the first time to promote my product (23 appointments in LA next week) and I'm terribly excited! By this time in August I suppose I'll have hit promotion fatigue.

I've said it before: fine blog.

Karen

[josh kerbel]

Part of the problem is that first time/young entreprenuers are often oblivious to the concept of deal fatique.

It isn't just cutting cheques, its managing personalities........its dealing with a client's advisor who is out to lunch most of the time and when he is paying attention, is usually giving bad advice.

[Alan]

I have often heard the term "deal fatigue" used with a different meaning - the loss of interest that occurs when negotiation and documentation of a specific transaction takes too long. The timeline of most transactions, viewed from the legal side, is 2-6 weeks. However, we've all seen deals that stretch out over many months or even years. Usually these involve parties that are over-negotiating the document either from the legal or the business side. Is this really the 19th draft? As the weeks turn into months, deal fatigue sets in.

The worst offenders are transactions where someone is sophisticated enough to dream-up a new structure, but not sophisticated enough to understand all the implications. Sometimes these are great innovations, but 90% of the time they are simply walks in a mine-field. Long, expensive, painful walks.

[Barry Lyons]

Fred (if I may), never mind deal fatigue. For the moment I'm experiencing fatigue trying to reach you at Flatiron, but my e-mail keeps bouncing back. I discovered your great site a few days ago, and wanted to respond to your call for RSS entrepreneurs. I happen to be one and, amazingly, I live in NYC. Do you have aother e-mail address I can use? Here's hoping you read all the comments to your various posts. Thanks.

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