Venture Capital: Not A Love Story

Too often, entrepreneurs who join financiers in marriages of convenience are headed for heartbreak

The dream wasn't supposed to end like this. Three years after founding Athena Design Systems Inc. in a creaky old customs house on Boston Harbor, Mary F. Howard had to return to her original backers for crucial new product financing. Brynwood Partners II LP offered loans--but only if Howard secured them with the rights to two patents, her most valuable assets.

Howard took the money rather than "shut down the company," but her control of the struggling software maker was quickly ebbing. With sales dead in the water, Brynwood--which owns 75% of the company's shares--ousted Howard and, in early 1995, made its newly hired vice-president for sales and marketing the CEO. Today, the company is little more than a shell. And Howard, like the mythical Athena, has turned warrior, suing her former partner for breach of fiduciary duty. In court papers, Brynwood counters that it dumped Howard only after she had "four years of time to prove herself...and failed to sell a single Athena system."

Welcome to venture-capital hell, a place of punctured egos and lost millions, where entrepreneurs and their financiers typically land when things don't work out. It's well-populated: For the $3 billion that investors bestow annually upon young business ventures, only 1 in 10 ever hits it big. Of the rest, most simply muddle along or fail; perhaps 30% turn into sound public companies.

POWER & MONEY. Failure isn't inevitable, but the makings are usually present. Entrepreneurs and venture capitalists come together in a marriage of convenience, a potentially volatile mix of egos wrestling over power and money. The company may be its founder's life's work, representing an enormous emotional commitment. For the venture executive, it's just another investment to get into and out of in five years, tops.

Can these marriages be saved? Sometimes not. Products fizzle, spending spirals over budget, founders prove lousy managers, investors become too intrusive. "There are more opportunities for the wheels to fall off [young companies], because there are simply so many unknowns--from whether a market exists to management," says Gordon B. Baty, co-managing partner of Zero Stage Capital Co. in Boston.

Beneath it all lies a subversive, fundamental difference in perspective. "The entrepreneur has the idea he is giving a free ride to someone whose only contribution is money," says Andrew J. "Flip" Filipowski. "The venture capitalists' attitude is that if it wasn't for them, the world would end." Filipowski knows whereof he speaks: After being forced out by one-time partners in an earlier software startup, he now heads Platinum Technology Inc. and also runs a $100 million venture fund, Platinum Venture Partners, in Oakbrook Terrace, Ill.

HEAVY-HANDED. The way out of VC hell lies in both sides recognizing and accommodating their divergent priorities. It takes some frank discussions at the time an investment is made about the goals and strategy of the company, investors' expectations, and founders' limitations. Often, too, it demands quick, decisive action when things go wrong in midcourse.

Last-minute salvage attempts typically aren't the answer. Venture capitalists took charge of a startup apparel company, for example, after it became clear that cash flow and working capital were in disarray. But their fix proved too heavy-handed and too late. A new team of high-salaried managers alienated existing employees as well as the company's vendors. The founder, who insisted on not being identified, was fired--only to be brought back recently. And the company continues to lose money. Engulfed in uncertainty, "it's still almost intolerable," says the founder.

A modicum of agreement on terms at the outset can ease the pain of separation later. Increasingly, venture firms are defining from Day One specific expectations for startups' operations and financing. Baty cites a common problem: Founder/entrepreneurs often have trouble managing larger companies. Having replaced some two-thirds of its founding CEOs, Baty's firm now insists that every company have a management succession plan in place within a few years. "If the founder is unwilling to listen," he says, "we're not really interested [in investing]."

Indeed, it's the issue of management control that most often sparks discord. In some cases, it may serve everyone's long-term interest for the investor to take charge--but it usually doesn't seem that way to the entrepreneur. "I had the founding entrepreneur of a cardiac medical-device company call me up and go ballistic" when backers moved to take control of 70% of the startup, recalls board member James Schrager, a senior lecturer at the University of Chicago's Graduate School of Business.

But clearly, something had to change. After $8 million in research-and-development spending on a new catheter, market demand had shifted, leaving the original product outdated. "He was a bright scientist," Schrager says. "So I calmly told him he could have 100% of nothing, and this will die, or 15% of a company that will be worth eight figures." Within weeks, the founder had left the company with his 15%. Four years after going public, Schrager says, the company is worth $150 million.

Such forced resolutions can turn potential disasters into hits before personal disputes ravage the business. But it's the founder who often feels short-changed. Steven Quay turned to a blue-chip group of Silicon Valley venture firms to back his drug startup, Salutar Inc., in the mid-1980s, getting 40% of the equity in the $600,000 first round. As the clinical-trial process ate up early funding, Quay returned for two more rounds, worth $7.1 million--but saw his interest dwindle to 15%.

RELUCTANT SALE. Quay's loss of control grated on him. Meantime, his backers, seeking more seasoned management, brought in a new CEO, who began spending heavily on a large building and dozens of new employees. By the time Salutar was ready to go to market with its first drug, the company needed an additional $20 million--and its backers were looking for a way out. Quay says he reluctantly agreed to a sale in 1990 to Norway's Hafslund Nycomed for $55 million. He left bitter, a year later, convinced that more patient investors could have reaped far higher returns in a year. But he also pocketed $7.5 million.

The ride could have been smoother if Quay and his investors had agreed at the beginning on a strategy and timetable for selling the company. But even such foresight won't defuse every problem. Entrepreneurs and their financial backers necessarily have their own interests to protect. Better to plan instead for the eventuality of discord.

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