Sunday, February 28, 2010

It's OKAY to "pull a Patzer", if you have founder-friendly VCs

 There was an insightful guest post on TechCrunch today about some sobering lessons learned by Tod Sacerdoti, CEO of BrightRoll (a video advertising network), while raising his recent Series B round from Sand Hill Road. To his surprise, Tod found many VCs were worried that he would "pull a Patzer" and wanted to get comfort that he wouldn't commit such sin. This is how he puts it:
By most accounts’s rapid rise to prominence and ultimate acquisition is the quintessential Silicon Valley success story. Yet, the acquisition brought to light an interesting phenomenon, one I’ve coined the “Patzer Problem.” Prior to submitting offers to invest, three separate VCs wanted to confirm that we had no intention of “Pulling a Patzer,” modern-day Sandhill Road parlance for selling too early.
Here’s why: with large funds being raised on Sand Hill Road and returns from previous funds underperforming, investors are becoming increasingly desperate for that single homerun investment that returns $1B or greater. Even though was a huge success for the founder and team, generating $60 million in equity value per year, many VCs believe they sold too early and left too much potential value on the table.
I believe the "Patzer Problem" has always existed in the VC community and is not specific to our current, dismal economy - although of course the terminology is a Post-Mint pheonomenon. This is an inherent problem of BIG VC FUNDS who are more or less HIGHLY LEVERAGED PORTFOLIO MANAGERS, rather than company builders. I have even heard the less charitable term "Spray and Pray" applied to many such big funds in the past (but I won't name names).

If a VC fund makes 10 or more investments per partner, and the expectation of each partner is that only 10% of his or her investments will truly "make it", then of course unless the return on investment for any one portfolio company is pegged at over 10x, the fund could not return its capital commitments. However, all VCs are not created equal, and for every BIG FUND, there are plenty of smaller, founder-friendlier funds who invest in a much smaller number of portfolio companies and therefore, are happy with smaller returns.

In fact, as a rule of thumb:

# investments / partner = Expected breakeven multiple for the fund / investment

That is, the lower the ratio of investments per partner, the lower the multiple you will need to hit before you can get the wholehearted, enthusiastic nod to an acquisition from that VC firm. And such firms typically tend to be more "founder friendly" as they allow the founders/executive team to be in the driver's seat when it comes to the acquisition decision, and also have a lot more bandwidth to help the founders build great companies, something that the big funds are not particularly positioned to do.

P.S. The above formula is a "rule of thumb" and not an absolute statement. It just shifts the burden of proof unto the VC to give comfort to the entrepreneur as to how they would help the entrepreneur achieve his or her dreams.