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There’s an entrepreneurial lesson in the current Facebook dustup:  hubris can quickly lead to trouble.

There’s a fine line between confidence and arrogance.  Confident companies know what they’re going to do, and they do it.  Arrogant companies take it a step further and make it about proving something.

Arrogance is trouble because it kills the fan base.  Companies and entrepreneurs, like sports teams and rock bands, need fans to be successful.  Even famously arrogant companies like Google and Wal-Mart treat their user-customers well, and when they mess up, they usually attempt to make it right.

Facebook is in the middle of pissing off all the fans.

Check out this great post from Union Square Ventures:

My friend Dick Costolo, co-founder of FeedBurner, describes a startup as the process of going down lots of dark alleys only to find that they are dead ends. Dick describes the art of a successful deal as figuring out they are dead ends quickly and trying another and another until you find the one paved with gold.

(from: Why Early Stage Venture Investments Fail)

This relates to my Fundamental Theory of Startups: success is about staying in business long enough to get to the third idea.

I recently got a small dividend check from a venture-funded startup.

This was unusual:  why is a startup giving out precious cash to stockholders?  It seems counter-intuitive;  the company should be (re) investing any cash into growth.

But in some cases, this move can address a real problem.  I’ve written before about the risk problems when you pair entrepreneurs (e.g. all eggs in one basket) with VCs (e.g. a whole portfolio of eggs).  For entrepreneurs with no previous exit, a startup with real traction creates a wealth concentration problem.  With 95% of her net worth tied up in the startup, the entrepreneur starts to get conservative (as she should).

This scenario is certainly a good problem to have, but is far from hypothetical:  there’s a recent unnamed but well-known startup exit, where the widely-held view is that the CEO pushed to sell out too early.  A major factor (insiders say), is the 8-figure personal outcome for the CEO — he didn’t want to risk losing that.

Unfortunately, many investors let emotions dominate, and won’t let anyone make money before they do.  A rational investor will understand founder wealth concentration.  If the company is doing well, is solidly capitalized and is cash-flow positive, it’s a reasonable idea to give entrepreneurs some diversification and re-align interests for a “go long” play.

I just finished up stock paperwork for a new venture-funded startup. Each time I do this, I’m shocked by the complexity in stock terms. I’ve written before about the general problem of venture capital overhead, but there’s a slightly different issue here.

I think the core problem is a kind of “feature creep”. Preferred stock terms are designed to protect investors in downside scenarios. Everything some new bad thing happens, the lawyers come up with a new term that protects investors the next time around. Examples:

• Had a company go on forever (e.g. not go public, not shut down — no closure)? Let’s put in redemption rights.
• Had a co-investor bail in a later round? Let’s put in pay-to-play so they get spanked (converted to common) for not participating.
• Had an entrepreneur buried in preference resisted an exit where the commons make nothing? Let’s put in drag-along rights.
• … etc …

Stuff gets added, but never taken out. Trying to get rid of it gets responses like, “we always do things this way”.

Unfortunately, I think, entrepreneurs have to get educated, get good representation, and live with it. Two excellent resources: Brad Feld’s series on term-sheet terms, and the National Venture Capital Association’s model financing documents.

One of the problems in venture capital today is a fundamental impedance mismatch: fund sizes remain large, while capital requirements for many Internet/software deals are shrinking.

You don’t need much money anymore for many software ideas: the software stack is free, servers can be rented for $50-$100/month, and there’s cheap labor offshore. There are a lot of ideas that can be vetted for $100k to $1m.

At the same time, venture funds have grown and stayed big, driven in part by VC compensation. As I wrote in an earlier post: venture isn’t generating great returns these days, pushing VCs to make their money on fees. The larger the fund, the larger the fees.

The mismatch happens when you do the math: for a $200m fund with 4 partners, each partner needs to invest $50m. If each partner does 1-2 new deals/year, and the fund is committed over 3 years, then each investment has to be a $8-$16m commitment. (That doesn’t mean that Series A needs to be $8m, but it means that the total invested is in that range).

You can see where it is hard for many firms to do $1m investments — it’s just too small. And some of the most interesting stuff is happening “down there”!

We all know folks that made money on Bubble 1.0 that shouldn’t have and vice versa. The point: no matter what you do, sometimes you’re just lucky (or not).

Startups are calculated risks. Entrepreneurs work hard to manage all of the factors for success, but you can’t manage everything. Sometimes the low-probability, high-impact “perfect storm” happens and wipes things out. Or sometimes, the stars align in surprising ways and everything takes off.

The key, I think, is to be as relaxed as possible about it. Sometimes you do everything exactly right and it still doesn’t work out. The trouble starts when the anxiety of failure starts to creep in. When that happens, remember, it will all be OK: your spouse will still love you, and your friends will still call you back.

A while back, I wrote an essay on the pitfalls of Entrepreneur In Residence (EIR) arrangements for entrepreneurs. (And I’m now shamelessly recycling bits for blog fodder).

The essential point: EIR arrangements give quasi-exclusivity from the entrepreneur to the venture firm. Entrepreneurs need to make sure getting enough value back for that exclusivity.

For companies seeking additional funding with new investors: watch out! Inter-firm relationships can be “interesting”.

Your existing VC investors frequently have an agenda when they refer new follow-on investors (or steer someone away). Most often, VCs want to expand their relationship with another firm (one way VCs get to know each other is by doing investments together). Or, they’re returning a favor — the other investor helped them with another deal, and they’re giving back.

When you’re steered away, it can sometimes be because of a grudge, or a competitive issue. Maybe your VC felt screwed in some previous deal with the other investor. Or, they feel like it’s a one-way relationship: they show the other group deals, but don’t get anything back. Or, they feel like the investor will hear the pitch just to get competitive info, not with any intent to invest (sometimes, a very legitimate concern).

The key point: the company (usually the CEO) should lead the fund-raising process, not the VCs. The CEO has a clear fiduciary responsibility to act in the best interest of the company. The VCs on the board also have this same responsbility, but sometimes can’t separate that responsiblity from their own firm’s agenda. (NOTE: If the VCs are driving the process, that’s a sign of a weak CEO).

When existing VCs are suggesting leads for follow-on investors, the CEO should do her homework with the VCs:

• Have you done any deals with this firm before? Which partners have you worked with? If so, what was the outcome?
• Has this firm ever referred you deals? Have you referred them deals? How recently? If so, what was the outcome?
• If you haven’t worked with this firm before, why not? How do you know them, and what do you know about them?

Entrepreneurs should understand VC compensation, because it’s occasionally helpful for understanding VC behavior.

The general partners (GPs) at a typical venture firm get paid two ways: management fees and carried interest.

Management fees (typically 2%) get paid per year over the life of the fund, typically 7-10 years, but may decline over time. Carried interest (the “carry”) is a percentage of investment returns shared with the GPs, and is typically around 20-30%. For example, if a $100m fund returns $300m, the GPs would get a percentage of the $200m investment gain. In some funds, the carry may be net of management fees.

For firms with multiple funds, fees stack up. With $2 billion “under management”, GPs could bring in $40m annually. Deducting operating expenses for the firm, you find VCs making several million per year (or more), each, on average — even if all their investments are duds.

The “dirty” secret in venture capital is that industry returns these days are barely beating (if at all) other, less risky, asset classes. The real money is in fees, pushing VCs to raise larger funds and do larger investments. They in turn push entrepreneurs to take more money, sometimes more than they need.

And, the carry only becomes meaningful if a partnership has serious home-runs. As a result, VCs may push entrepreneurs to take more risk and “swing for the fences”, instead of taking a solid double or triple outcome.

One of the costs of raising venture capital is overhead: it takes a lot of energy to navigate the complexity of term sheets, to manage investors, and to navigate follow-on rounds of funding. It gets even worse if you’re dealing with “unique” investor personalities, immaturity, lack of experience, or intra- and inter-firm politics. One CEO friend recently bemoaned that 25% of his time went to “investor stuff” — that’s a typical number.

Venture investing is not a simple business, and investors are adept at adding terms and structures that protect increasingly narrow outcome cases. If getting a home equity loan were like raising venture capital, the kick off meeting has 4 people coming to your house and would take all day.

Investors argue this is the cost of doing business: no capital, no company. True, but the overhead has become a real issue in certain sectors (e.g. Internet projects) where the capital requirements are dropping. If you have an idea that needs $500k, and you raise money the “classic” way, you’ll spend 10% of your capital on the legal bill alone. (Remember, the company is paying both sides of the legal bill).

There’s got to be a way to fund capital-efficient ideas with lower overhead (and more time going into creating value in the company). I don’t know what the answer is, but I did think Dave McClure’s rant on the general subject was dead on.