Since I was pounding the pavement on Sand Hill Road as a young entrepreneur in the late 1990s, VC has evolved dramatically. Capital was scarce, and founders had to literally beg VCs to invest in their businesses. Our funding choices were restricted to a few blue-chip companies and angel investor networks. After two decades, money is coming from more places than ever before, and equity capital has become a commodity.
In today’s market, it’s typical to hear that VCs must work hard to sell their investments. We’ve entered the era of “value-add venture capital,” in which investors must demonstrate to entrepreneurs that they will do more than just write a check. It’s a power shift, and the promise these VCs make to entrepreneurs is that they’ll be genuine partners who’ll be there for them every step of the way. However, all too frequently, entrepreneurs learn the hard way that these value-added services have a limited lifespan.
We discovered that even the best-intentioned investors seldom deliver any value-add beyond 90 days after signing the term sheet when we questioned founders across our portfolio. The investor’s involvement at that stage is restricted to their participation at the quarterly board meeting — and that is the lead investor. While many VCs consider themselves to be investors, they ultimately serve their founders as consultants.
Aside from the rare introduction, many of the other attendees contribute no value beyond their check. According to our founders, over 20% of cap table donors don’t even assist their founders in making crucial relationships. They toss their money into the pot and then vanish. VCs that don’t give value-add are dead weight in a world where money is freely flowing. When it comes time to raise a new round, they usually utilize their contractually stipulated pro-rata rights. Other VCs are discouraged from working more for their founders just because they are on the cap table.
After all, why should they go above and above for their founders if they’re both assured a seat at the table? “This is how it’s always been done” isn’t a valid reason. It’s past time for entrepreneurs to hold their investors to a higher standard and demand that they continue to support them as their business grows. Traditional pro-rata privileges must be abolished.
The pro-rata clause in a term sheet ensures that an investor may keep (or enhance) their equity position in the firm by participating in subsequent rounds. There are no conditions attached, and the investor is not required to meet any KPIs for its founders. Pro-rata rights are an unavoidable feature of the bargain. In reality, pro-rata is a huge benefit that VCs take for granted.
Because money is becoming a commodity, founders may and should insist that the opportunity to invest in subsequent rounds be conditional on showing value-add. Consider it “performance-rata,” a new sort of pro-rata reserved for investors who contributed more than cash to the partnership.
